Reasons to believe: time for fixed income

Recent history has included some tough periods for fixed income investors, with rising inflation and aggressive rate hikes taking their toll on the asset class. Fast-forward to today, however, and the backdrop for fixed income is far more encouraging.

Global inflation is largely under control, and the major central banks have started their rate-cutting cycles. This includes the US Federal Reserve (Fed), which reduced rates by 50 basis points in September. While economies are cooling, we don’t expect widespread recessions. Fixed-income yields are relatively high compared to the past few years, offering an attractive entry point into the asset class. We therefore expect positive total returns, driven by the attractive carry and a tailwind of falling interest rates.

What are current market conditions and risks?

The reaction to Trump's re-election has been mainly as anticipated: US Treasury yields have ticked higher, with the yield curve steepening as investors price in the potential impact of the president's policy agenda. Robust corporate profitability looks set to continue, which has been one of the factors compressing credit spreads across investment grade (IG) and high yield (HY) bonds, which have tightened below their respective long-term averages. 

Corporate fundamentals remain resilient, with leverage and interest coverage ratios at comfortable levels, indicating investors are being adequately compensated for taking on credit risk. This view is also supported by credit agencies, which are forecasting a relatively benign default environment. However, we are more cautious on the lower-rated HY bonds and are very selective regarding exposure to these names.

The main risks to the current environment stem from the mix of policies that Trump implements. The primary concern is that higher tariffs and reduced migration could lead to a resurgence of inflation. This scenario might compel the Federal Reserve (Fed) to adjust the path of rate cuts. Additionally, it could impact the economic growth outlook for trading partners affected by the tariffs, resulting in divergent monetary policy paths between countries.

How might investors access the fixed income story?

The focus on outcome-oriented strategies is driving interest and asset growth. Achieving a compelling yield in a risk-controlled manner is an attractive outcome for many bond investors, especially as the return on cash deposits begins to fall. This includes the short-dated enhanced income strategy, which can aim to generate excess returns relative to cash while providing significant liquidity.

In this space, we concentrate on high-quality, short-term bonds, commercial paper, and other fixed income instruments with maturities typically under one year. Our goal is to minimise interest-rate and credit risks to ensure a stable return profile, particularly regarding potential drawdown risks. Additionally, this strategy offers potential diversification within a fixed income portfolio, with more effective balancing of risk and return.

Sweet spots in the bond universe

The first step to achieving specific outcomes is identifying bonds that provide reliable income and resilience across various market conditions.

Long-term analysis of credit markets shows that combining BBB (the lowest IG rating) and BB (the highest HY rating) bonds consistently offers the best risk-adjusted outcomes. This can be captured in a global income bond strategy. Investors who concentrate on strategies managed against traditional credit benchmarks often overlook and underappreciate this section of the market. Structurally, a global approach can provide unique benefits, such as high yield-like returns, with investment grade-type risk.

When combined with disciplined bottom-up credit research, global income bonds can be an attractive option for delivering client outcomes.

Investing in climate, investing for the future

Sustainable bonds, particularly those focusing on climate transition, present a forward-looking investment opportunity. Many climate-related products concentrate on portfolio appearance, such as emission targets or ‘green’ bond labels. In contrast, our approach prioritises real-world decarbonisation and adaptation. By identifying major emission sources across sectors like energy, transport, materials, real estate, and industrials, we target companies with robust, credible plans for emission reductions.

Our aim is to capitalise on multi-decade climate initiatives, while seeking attractive returns with a focus on a tangible environmental impact.

Final thoughts…

There’s currently US$6 to 7 trillion sitting on the sidelines of the investment world. We believe fixed income offers a compelling destination for much of this capital. Interest rates are forecasted to head lower, which will be supportive of bond returns. Although economies are slowing, we anticipate a ‘soft landing’, particularly in the US. Lastly, while we don’t expect large-scale defaults, careful selection to avoid underperforming securities and industries will remain crucial.

Jonathan Mondillo is head of fixed income at abrdn.

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