Fixed Income Boutique

Why and how you can still make money in fixed income

| Read | 3 min

Bond markets took a beating lately. Prices fell not only due to inflation fears but also because two big names of the investment world, Warren Buffet and Ray Dalio, took a punch at the asset class. They mainly blame low yields for the supposedly bleak future of fixed income investing. Yields have been on a downward trend since the 80s and have deprived investors of valuable, dependable income streams, they say. When bonds sold off across the board lately, the markets seemed to prove them right in calling an early “death of the bond market”.

However, this is the wrong way to look at it. Here is why you can still make money by investing in bonds.

First of all, when interest rates and yields fall, bond investors make capital gains – significant ones at times. For example, last year, 10-year Treasuries started out with a yield of 1.9% and fell to half of a percent within 3 months, which means bondholders made about 10%. And make no mistake, yields can fall again if the economy gets into trouble. For me, there is no floor on bonds. Therefore, there are sizable capital gains out there for bondholders, even on defensive developed-market government bonds.

Second, the current inflation and taper tantrum fears are overdone. What happened in March was an overly sensitive market reaction to increased reflation expectations, which pushed long-term sovereign bond yields higher. These expectations are driven by the fact that government spending and pent-up demand will hit the economy as a double whammy. As a result, some big institutional investors decided to reduce duration and take risk off the table, which spooked the market. As much as you have FOMO (Fear of Missing Out) driving investors into growth stocks, you have FOGK (Fear of Getting Killed) in bond markets pushing investors away from bonds. Once this dynamic kicks in, markets tend to develop a life of their own, which is often disconnected from economic reality. The government spending we are seeing now is a one-off, and due to potential budgetary management cannot be produced year-in year-out. Therefore, at some point, the steam from this engine will die out. I believe we will be lucky if we normalize growth back to pre-pandemic levels, which will equate to a similar level of pre-pandemic inflation. Besides, at some point, higher taxes and a still high unemployment rate will weigh on both the economy and thus inflation. Therefore, it would be wrong to assume that the Covid pandemic ushers in a new economic era where growth and inflation rise to a higher level over an extended period of time. Furthermore, there will be no tapering any time soon. Jerome Powell has repeatedly said that the Fed wants to see inflation pick up and unemployment come down before they start withdrawing support. If the Global Financial Crisis has taught us anything, it is that when you fight the Fed, you lose.

Third, today money in fixed income is made in spread products. This becomes apparent if we decompose a bond's total return which is made up of a rates component (Treasury yield or the equivalent “risk-free” rate), the spread and carry components. In the old days, all you had to do was to focus on the Treasury return as this was the main driver of total return. Today, this would lead you astray as the low yield environment has reduced the Treasury portion to a minimum and even turned it into a detractor of total return. The good news is that spreads have risen to be the main return drivers in bonds. For example, for an average mid-yield euro corporate bond with a 5-year maturity, the rates component is -0.55% and the spread component is 1.4%. This means that when spreads compress, you make money and when spreads widen, you lose. High-spread products, such as emerging market bonds, are most promising in the current environment. This is because they not only provide a cushion for further interest rate declines but they also stand to benefit from reflation as growth picks up after the pandemic.

Picking promising spread products requires skillful active management as does protecting a portfolio from inflation. For those who doubt that the current inflationary tendencies will be transitory, Treasury Inflation-Protected Securities (TIPS) are an obvious and widespread choice to shield portfolios from the nefarious effects inflation. However, the benefit of holding TIPS can only fully unfold if inflation will be higher than what these instruments have already priced in. If inflation turns out to be in line with market expectations, you end up holding a bond that behaves like a normal Treasury bond but that is less liquid. In fact, actively managing conventional bonds in a portfolio is an effective inflation shield since they also price in the market's inflation expectations. This is done by reducing or increasing duration in your portfolio depending on where inflation is expected to go.

Active management goes a long way in finding the best spread opportunities and protecting against inflation, which will prove key in mastering this year's challenges in fixed income investing.