Can fixed income rally during inflation and interest rate regime change?
After decades of low inflation and interest rates, we are facing a global macroeconomic shift; what we consider regime change. Heightened geopolitical tensions, deglobalization, steep inflation, and a course-reset in the Fed’s monetary policy have created uncertainty in the markets and caused many of us to question long-held investment beliefs.
The era of easy money might very well be gone. But fixed income isn’t. In fact, after a rough 2022, where the bond market plummeted and coupon income failed to offset the price drops, yields in fixed income are above dividend yields for the first time in years. As I write in our latest white paper, investors might no longer need to look for riskier investments to achieve their target returns.
With credit curves flat, there is also no need to acquire longer-maturity corporates with high spread sensitivity. The focus should be on the short end of investment grade credit, with its low vulnerability to price swings and high levels of income.
The 60/40 portfolio had its worst year in decades in 2022, with stocks and bonds declining in tandem for the first time in 45 years. However, positive correlations tend to be associated with periods of higher inflation because of inflation’s impact on short-term interest rates. As inflation and rates start to normalize, we expect a return to a more average correlation. Higher yields should allow bonds to resume their role as stable, low-risk income sources for investors. Since higher-than-average gains usually follow negative returns, the losses of 2022 might very well provide an excellent setup for potential opportunities this year.
Of course, there are still risks to consider. In the face of a slowing economy and even a potential recession, we should be wary of assuming excessive credit risk. Going forward, quality and prudent credit selection are key.
Uncertainty may linger as the markets adjust to a new era of high real rates. However, there are reasons to be optimistic about fixed income. Inflation has slowed. The Fed rate hikes will likely peak in 2023. And higher yields and the threat of even a recession may entice investors to return to bonds in pursuit of relative safety and income.