Podcast: A new era for fixed income investors
A volatile interest environment is presenting new opportunities for investors in fixed income. James Ringer joins the pod to discuss what's happening and the implications for investors' portfolios.
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David Brett
The value of investments and the income from them may go down as well as up, and investors may not get back the amounts originally invested. Past performance is not a guide to future performance. The information is not an offer, solicitation or recommendation of any funds, services or products, or to adopt any investment strategy. This pod is marketing material issued by Schroder Investment Management Limited, registered number 1893220 England. Authorised and regulated by the Financial Conduct Authority for informational purposes only. Please contact your financial advisor before making any investment decisions.
David Brett
Welcome to the Investor Download, the podcast about the themes driving markets and the economy now and in the future. I'm your host, David Brett. It was Bill Clinton's political adviser, James Carville, back in the '90s, that said, I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a 400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody. That was the power of the bond market, at least up until recently. But years of low rates following the financial crisis hurt returns and stripped away that patina of intimidation.
David Brett
As a result, investors looked elsewhere.
James Ringer
People, I guess, questioning the role fixed income has in portfolios.
David Brett
That's James Ringer, a fund manager and fixed income specialist at Schroders. But the return of inflation after the pandemic forced central banks to respond and interest rates to rise. For the first time in nearly a generation, investors could look at fixed income for the income.
James Ringer
Certainly things have livened up since most central banks were stuck at zero for a lot of the last decade.
David Brett
Despite recent cuts, US interest rates are expected to remain elevated for longer. That presents investors with a potential opportunity in fixed income. It also poses them some questions which we'll tackle in this show. First up, what's happening with interest rates?
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David Brett
The market expects up to five more additional interest rate cuts in 2025, taking US interest rates down to near 3.5%. Schroders' own economists expect rates to fall, too, although they expect fewer cuts than the market. Much will depend on economic policies around the world, particularly in the US. We can't talk about interest rate expectations without mentioning the yield curve, which reflects market expectations of future Fed actions. It is said that central banks, with their ability to control short term interest rates, have more influence over the front end of the curve, while the longer end is determined by macroeconomic policies and investor behaviour.
James Ringer
I forget the technical term or the theory. I think it's market expectations theory, but it is the idea that different parts of the yield curves are driven by different investor types. It's the idea that different parts of the bond market have different drivers. We've seen that over the last year and probably more pronounced over the last couple of months, is that they can actually move in different directions. To the example of the Federal Reserve, who rates 100 basis points last year, since then we've actually seen two-year yields, so shorter dated maturity bond yields decline, but actually longer dated bond yields have risen, what we call a pivot steepening. You've seen shorter dated yields fall, but longer dated yields rise. That's to the point that really the central bank has diminishing returns or diminishing control, sorry, the further up the curve that you go, which is why I think it is so important when you're allocating to fixed income and when you're running fixed income to actually have a view on different parts of the interest rate curve. Especially if you want to play central banks, you need to be much further down the curve.
James Ringer
Your correlation between the bonds in the two-year space and what central banks are doing is going to be a lot higher than the correlation between 30-year bonds and what the central bank is doing.
David Brett
The yield curve which is more of a jagged line, really, slopes up or down. It illustrates the difference between the yield on a bond that matures in the shorter term, say two years, and one that matures in the longer term, say 10 years. In normal times, the line should slope upwards from left to right. That's because you should receive less income or interest for lending over a short period of time as potentially less can go wrong. However, the curve can invert in times of stress, say when interest rates are rising unexpectedly. That's when shorter dated bonds could pay more than longer dated bonds. That was the case for a long time between 2022 and late 2024, when central banks were raising rates rapidly to combat inflation, but the curve reversed as it looked like central banks were in rate cutting mode. But what's the yield curve telling us now?
James Ringer
Well, there are a number of things and it depends on which country. But if we focus on the US at the moment, we can talk about the UK, it's probably a fairly similar story. But it's simply saying that investors demand more money. Sorry, a higher interest rate or a greater return for lending to governments for a longer period of time. The longer you lend to someone, you'd traditionally expect to earn a higher rate of return given the uncertainties, in particular given the inflation uncertainties and the interest rate uncertainties. If you think about a 30-year bond, you've got 30 years of things that potentially happen, so you need to be compensated for that additional risk. That's all the bond market and an upward sloping yield curve is telling us is that investors need greater compensation for taking that risk.
David Brett
That risk isn't going away. With the election of Donald Trump in the US and the high level of borrowing by governments around the world, we'll look at the potential problems facing fixed income investors in part two of the show.
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David Brett
The yield curve is illustrating some return to normality in terms of interest rate expectations. After a couple of years of predicting a US downturn or recession, most market commentators, including Schroders, are predicting a positive outcome for the US economy this year. However, there are a couple of known unknowns that are causing turbulence.
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The Fox News decision desk can now officially project that Donald Trump will become the 47th President of the United States. Today, goods from Mexico, Canada, and China could become more expensive. President Trump said he's We've seen import tariffs on production from those countries. Trump first threatened tariffs during his campaign and seems likely to follow through with that plan.
David Brett
The first is the election of Donald Trump as President of the US and his policies in particular, which may cause inflation to remain sticky and interest rates may be required to be kept higher for longer as a result. That's causing some volatility in the market.
James Ringer
Yes, interest rate volatility is higher, but that's a function of the fact that really the data that we're seeing is a lot more volatile. A lot more volatile because we're still really seeing the impact of reopening from COVID. We've seen really a deterioration in the quality of a lot of the data that we actually receive on a daily basis. We look at things like response rates. That's the number of people who are responding to surveys. Even things like the employment report that you'll hear about from the UK and the US, the response rate for that has fallen quite significantly. The quality of the data we're receiving has declined. That just makes investors a lot more sensitive to data releases. It means that the narrative can change very, very quickly. We've seen it on a few occasions where we talk about the three scenarios being the no landing, a hard landing, and a soft landing that everyone is very familiar with. We've seen how just one single payroll report, that's the US jobs report, how that can flip the narrative just from one to another, just with one data release. Whereas historically or prior to COVID, it would take months or even quarters for the type of narrative to change.
James Ringer
The biggest change that we have done, and I think most investment processes need to do it, is move away from really, really, certainly from from active fixed income managers. I think it's obviously different when you're doing a strategic asset allocation. But from our perspective, we have moved away from longer run thematic investment process, which is in this world quite binary. You're either very, very right or very, very wrong. That produces quite low risk adjusted returns to something that's a monthly scenario based, which is there really to ensure that we can capture opportunities when they arise quickly. But also if we're wrong, which happens, we're basically quick to change portfolio positioning. The ultimate goal of that is to produce much better risk adjusted returns. That's the biggest change. I think it's just to improve the investment process and recognise that we are in a different regime. To your question, that regime is one of higher volatility.
David Brett
The second is the level of government borrowing. For instance, US public debt as a percentage of GDP is at levels not seen since World War II, and it's predicted to rise even more over the next few decades. The US isn't the only country experiencing these issues, but it is home to the biggest bond market in the world. And bond markets tend to punish borrowers if they feel the debt is becoming unsustainable. Trump and government debt are both playing into the higher cost of borrowing in the longer term.
James Ringer
Oddly, we were actually seeing that more in other things such as what we refer to as asset swaps. That is the difference in yield between a government bond and a swap rate, which is really the perceived risk-free rate at the moment. In the US, for example, if we take the 30-year bond again, the US Treasury is having to borrow at nearly a percentage point higher than the equivalent risk-free rate. We're seeing those fiscal concerns not only playing out in curves and steeper curves, but also in things like asset swaps as well. It's a phenomenon that we've started to see post-COVID. It's a function of... It really can be simplified by the idea of supply. Prior to the last couple of years, central banks were buying bonds, not selling bonds, and budget deficits were under control, and so issuance wasn't going through the roof. At the moment, we've got the double whammy of issuance increasing because governments are borrowing so much money, but also central banks are actually selling bonds back into the market. You have those two sources of supply of fixed income coming to the market that investors have to take down.
David Brett
As ever with investing, nothing is straightforward. What's the role of fixed income in investment portfolios? That's coming up in the final part of the show.
David Brett
Interest rates are on a downward trend. Inflation appears to be under control, and the yield curve has righted itself. There is a sense of normality returning to the world of fixed income. But an abundance of risks remain from rising debt levels to potentially inflationary economic policy. In this new volatile world of interest rates, what role does fixed income play in portfolios?
James Ringer
We see it as a three-pronged thing. It's probably the first time we've actually had three strong investment cases for fixed income. The first is diversification, and this is probably the most contentious one because 2022 really called that into question. You had a year in which both bonds and equities returned very, very deeply negative numbers. But what we can see is there is a very clear relationship between equity bond correlation correlations, i.e. the level of diversification. The lower the correlation, the better the diversification. We see a very strong relationship between that correlation and the level of inflation. We've run the numbers since 1960s. I think our multi-asset colleagues have done the same. What you see is that when inflation is high, that correlation is high, which is exactly what we saw in 2022. That is when bonds do not provide the hedge that people think they should. But what we've seen since then is not only has inflation declined, but also that correlation has declined. We think we're moving into the world again, not necessarily going to see negative correlations. I think that would be a bit of a stretch, but certainly, correlations declining, and so bonds should work as a better diversifier than they have.
James Ringer
But importantly, a diversifier actually pays you an income. Prior to COVID, it was a diversifier, but it didn't pay you an income whilst you waited. Now it does, which I think takes me on to the second point, which is income. We often talk about, you often hear people on headlines and titles of thought pieces talking about putting income back into fixed income, which is exactly what's happening at the moment. It's finally become a compelling investment case in its own right. We've got yield to maturities on some portfolios, comfortably over 4% that are investment grade rated. You compare that to, I think, your starting point of expected returns for equities when multiples are so high, we think that fixed income in its own right is quite a compelling investment case. Then finally, is the idea of just being able to generate some outperformance through active management. I think prior to COVID, all central banks were stuck at zero. There was very little difference between what economies were doing, very little difference between inflation rates, and so quite hard to make money from relative value and from active management. Fast forward to COVID, and all central banks did the same thing.
James Ringer
All economies experienced the same inflation. Again, it was difficult to really see much difference between economies and different bond markets. But where we are today, you have economies doing very different things. You've got inflation rates falling at different levels. You've got very different growth rates. With that, central banks doing very different things. That provides us opportunities to generate some performance, some outperformance, just by being in the right country, by being in the right part of the bond curve that we've mentioned about. So I think those three cases, which I think at different times and for different investors, you place different importance on each one of those three. But certainly there's a bit more of a case for, I think, optimism than a lot of the headlines that you might see.
David Brett
That was the show. We very much hope you enjoyed it. You can subscribe to the Investor Download wherever wherever you get your podcasts. If you want to get in touch with us, it's schroderspodcasts@schroders.com. You can find out much, much more at schroders.com/insights. New shows drop every other Thursday at 05: 00 PM UK time. In the meantime, keep safe and go well.
David Brett
The value of investments and the income from them may go down as well as up, and investors may not get back the amounts originally invested. Past performance is not a guide to future performance. The information is not an offer, solicitation or recommendation of any funds, services or products, or to adopt any investment strategy. This pod is marketing material issued by Schroder Investment Management Limited. Registered number, 1893220. Authorised and regulated by the Financial Conduct Authority for informational purposes only. Please contact your financial advisor before making any investment decisions.
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