Regime shift: Investing in a new Fixed Income world

The rapid rise in Treasury yields last year has attracted the pen of many opinions and the resulting negative returns, the worst in over 200 years, have inspired even more debate. This unprecedented market move is now in the rearview mirror and it is time to assess today's fixed income landscape and outlook. It has been more than a decade since we have seen yields at this level and it has been some time since investors have considered Treasury bonds an attractive option for income (see Figure 1).

Figure 1: 10-Year Treasury yield vs. Federal Funds target rate*

There has been a significant regime shift at the Federal Reserve (“the Fed”) over the last nine months. The accommodative monetary policy that investors have come to expect since the Global Financial Crisis has ended as the Fed is now actively trying to temper growth to lower inflation – even if it means causing a recession. Over the last decade, The Fed has cut interest rates to record lows, which produced an environment that forced investors  to accept more risk by moving down the credit spectrum, further out the yield curve or into less liquid assets to achieve their return targets.

The backdrop of fixed income looks much different today. Investors now can invest in higher quality parts of the market, like short duration investment grade corporates, Treasuries or agency backed mortgages, and earn attractive yields. In fact, those are the segments of the market that we believe are the most attractive as growth concerns and rising expectations of a recession overtake the focus of inflation that has persisted for the last 12-18 months.

It is important to note the global regime shift taking place today results from a significant change in both monetary and public policy. Low inflation, cheap/abundant labor and energy have bolstered the last few decades. These trends are changing and have structural implications for markets. A regime with higher input costs (whether due to labor or energy) means that inflation could run structurally higher, which will cause monetary policy to remain more hawkish and lead to shorter boom/bust cycles. This volatility and higher cost of capital will have a material impact on business investment and the allocation of resources.

We believe the market environment over the next year will feature less central bank intervention that will lead to more volatility than the prior decade. Increased volatility will cause more disruptions and dislocations and therefore more instances for a dynamic multi-sector manager to add value. Our value-driven philosophy combined with our opportunistic, high conviction approach lends itself to shift allocations towards pockets of promise. We are unbiased as to where those opportunities arise, whether it be it in agency mortgage backed securities, municipals or corporate bonds. We will deploy capital wherever we see the most attractive relative value prospects. We possess a history of capitalizing on market dislocations and have been building liquidity across all of our strategies over the last several months. As the market morphs, we are ready to adjust our allocations. We accept short-term volatility and instead focus on longer term value propositions, which are reflected in our attractive performance over the last three-, five- and ten-year timeframes.

In addition, while the majority of managers are positioned to short index duration, our benchmark-aware methods have always maintained a neutral stance on duration. Our focus is to add alpha through our ability to identify the inflection points in markets and to allocate capital to those undervalued sectors and issuers. We have demonstrated an ability to do this successfully during various periods of volatility. The following (see Figure 2) are a few examples: Taper Tantrum (2013), energy crisis (2015-2016) and most recently the pandemic (2020).

Figure 2: Core strategy allocation (in market value %) relative to the benchmark vs valuations

Source: Bloomberg and Schroders. Representative Value Core account; OW/UW = overweight/underweight. Historical trends should not be solely relied upon to evaluate current market activity.

It is clear that the current environment and the Fed’s aggressive policy this year have led to a different market than the one we experienced this last decade. We believe investors should opt for a dynamic and active manager with proven credentials to capitalize on market dislocations during periods of elevated volatility. This could lead to outperformance over the coming years.