Spotlight Q&A: Yield opportunities and the case for going global | Insight Investment

Insight’s Senior Portfolio Manager Nathaniel Hyde argues the case for an opportunistic and active approach to fixed income and makes the case for global fixed income exposure.

What can investors make of a market in which credit spreads are narrow, but yields are historically high?

Nate: Ultimately, we think yield trumps spread for most investors.

For those looking for regular and reliable returns from bonds, yield – absent default – is what they will get paid over the long term (absent default).

In most macroeconomic environments, we expect credit spreads and government bond yields to be negatively correlated and move in opposite directions. Since the pandemic, however, the monthly correlation of these two series has been -0.2¹. This means that waiting to invest at a wider spread will not necessarily guarantee a higher all-in yield.

Figure 1: Yields are historically high, but credit spreads are historically low¹

This is not to say that credit spreads are not important. They are a key valuation metric, and current levels suggest stretched pricing. We think taking an active approach could therefore be important here. As an active player with a wide opportunity set, our approach is to be highly selective and keep some powder dry in case market sell-offs deliver opportunities.

Consensus estimates indicate the economy is slowing, is this a threat to credit?

Nate: Provided nominal growth remains comfortably positive, a slowing economy is not necessarily a problem for credit. It would potentially be a trickier environment for equities, because it implies that profit growth rates will be hard to sustain organically. In fixed income, however, we do not need companies to grow faster, we just need them to pay back their debt. Given this, even modestly positive nominal growth can provide a supportive environment for credit assets.

Figure 2: Fixed income has historically outperformed equities through slower GDP growth periods²

A significant deceleration in economic activity would be a danger to credit, however). While a recession is not our base case, or projected by consensus forecasts, but we cannot rule it out.

With that in mind, we focus on compensation for risk. Unfortunately, at present we find that many assets with lower credit ratings and lower liquidity do not generally offer that compensation. So, at present, our bias is to stay relatively high quality and relatively liquid to be ready for opportunities for markets to sell-off in areas and like longer-dated, investment grade and BB corporate bonds.

One potentially compelling area that we see is in senior tranches of so-called “esoteric” ABS sectors, which we believe a higher yield over equivalent-rated corporate bonds with added structural protections. The drawback can be lower liquidity. 

Is fixed income attractive for those concerned about US fiscal risks to the Treasury market?

Nate: We believe all investors, but particularly those concerned about US debt dynamics, may wish to consider expanding their exposure into a global fixed income approach.

We do not advocate leaving the US behind entirely as a capital market of this size will also always offer opportunities of some sort to the active manager. This said, global diversification increases the breadth of the investment opportunity and, historically, has yielded a less volatile return stream than single market strategies.

Global bonds have consistently delivered higher returns for meaningfully lower volatility than US bonds on a currency-hedged basis. Since 2005, the US has never been the best-performing country within the Bloomberg Global Aggregate Bond Index in a calendar year³.

Figure 3: Global bonds have offered higher returns for lower volatility³

Global bonds also offer a larger universe for those with large enough global teams to mine alpha opportunities from. Such opportunities may be driven by rising monetary policy divergence and geopolitical uncertainty (relating to tariffs for example), which can create sectoral and security selection-based winners and losers across the globe.

Given that markets like Europe and Japan have significantly lower central bank interest rates than the US, is that not likely to be a drag on global bond returns relative to the US?

Nate: That would be true if investing on an unhedged currency basis.

But in a USD-hedged strategy, currency hedging costs are negative for markets like euros and Japanese bonds, which effectively add yield back to the strategy. Hedging costs are determined by short-term interest rate differentials.

For example, the Japanese Yen portion of the Global Agg⁴ currently yields 1.6% in local currency terms, but 5.5%, when hedged to USD dollars on a three-month basis, which is higher than the 4.4% yield on the US dollar component.

On the flip side, the effect is the opposite for markets that have higher interest rates than the US, like Mexico. The Mexican peso share of the Global Agg yields 8.4% on an unhedged basis, but 4.5% on a USD-hedged basis.

But overall, because yields are mostly lower outside the US, the Global Agg yields 3.4% on an unhedged basis, but 4.5% on a USD-hedged basis, or slightly higher than the 4.3% yield on US bonds (Figure 4). In other words, global fixed income strategies do not force you to give up yield.

Figure 4: On a USD-hedged basis, global fixed income yields may be higher than you think⁵

Could unhedged local currency global bond exposure benefit from a weakening dollar over time?

Nate: Yes, the upside of investing on an unhedged basis is the portfolio would likely gain from US dollar depreciation over time. In a hedged portfolio, currency fluctuations become irrelevant.

But currencies are highly volatile and can end up dominating the periodical performance of a bond portfolio. Fixed income investors typically look for a negative correlation against equities, which may be less reliable when assuming a high degree of currency risk.

What are the main risks to fixed income right now?

Nate: We are clearly in unusual and uncertain times, so there are many non-traditional as well as traditional sources of uncertainty. 

On the immediate horizon, continued interest in US sovereign debt dynamics has meant greater sensitivity to US Treasury supply patterns. At the same time, foreign demand for US Treasuries may be about to weaken, which could be a challenge to the Treasury market. From a fundamental standpoint, a reacceleration in developed market inflation could limit the ability of policy markers to meet weaker economic activity with monetary stimulus. In our view, these remain tail risks, but tail risks of sufficient magnitude to meaningfully impact the performance of the asset class in aggregate.

Elsewhere, the on-going recalibration of global trade may have unexpected side effects on private sector demand.

Ultimately, we believe this justified a value-based, diligent approach targeting security selection and diverse opportunities across the widest possible universe and fixed income sectors, with the flexibility to deploy capital quickly when value presents itself.