This article first appeared in Livewire on 6 June 2024
The higher interest rate world combined with the expectation for rate cuts is creating the perfect environment for fixed income.
The steepest interest rate hiking cycle brought about the most savage increase in bond yields for generations. But after the hikes stopped, bonds have become a great place to earn 4-5% yield.
While yields have slowly crept back up over the last six months, primarily due to stubborn inflation in many economies around the world, we believe having an active exposure to global fixed income can provide ballast and income in a world where valuations across many other asset classes are demanding, and the volatility in owning these same assets is hard to reconcile.
In this wire, we'll discuss why we think a combination of bonds and credit is the right strategy for this asset class, our process for finding the best assets, and our positioning given our high-level macro views.
Why combining bonds and credit the best way to maximise an investor’s income opportunity
Government bonds and credit securities both provide investors with a source of income. Corporate bonds generally provide investors with a higher level of income relative to government bonds due to the additional credit risk investors take on when investing in credit.
Combining bonds and credit diversifies an investor’s risk exposure. Bonds expose investors to duration risk (interest rate risk), while credit exposes investors to credit risk (that is, the risk of a company defaulting on its debt).
Additionally, from a diversified portfolio perspective, bonds have historically been a source of diversification to equities, while credit securities are generally more correlated to equities. Combining bonds and credit provides diversification of income and risk.
Our biggest edge is our process
Fidelity takes a contrarian active approach to fixed income investing. The fund is managed in a risk-controlled manner while also being nimble in its investment approach to exploit investment opportunities.
Fidelity’s investment approach has been applied consistently over time and has delivered returns from a diversified range of alpha sources, including asset allocation, rates, credit and currency.
Our investment philosophy is based on the belief that fixed income markets are semi-efficient and that through rigorous research, investment opportunities can be identified.
Fidelity's Global Bond Fund targets four main sources of return: asset allocation, interest rates, credit selection, and currencies. Proprietary fundamental research underpins all holdings and in constructing the portfolio, we target a moderate number of high-conviction holdings (100-200), making the portfolio more concentrated than many of our peers.
The fund is active in its approach so its position will deviate from the benchmark within limits to ensure that the portfolio is managed within a risk-controlled manner and true to label. That is, we are not taking on excessive non-index positions to generate alpha.
Our current macro views and where we are overweight
We are generally cautious about the global economy. While inflation has been moderating, the transmission of higher rates into the real economy is being felt across the globe, especially in Europe and emerging markets.
While so far, the US economy has remained resilient, over the next 12 months we anticipate a slowdown in US growth. We believe that the consumer which has been resilient to date will begin to show signs of weakness as excess savings get depleted and the impact of higher costs starts to impact spending.
Our view on government bonds remains constructive. We believe current levels of yields are unsustainable compared to the long-term potential growth rate of those issuing economies.
This is particularly relevant in the German, US and UK rates markets where we are seeing a faster-than-expected slowdown and hence where we have increased our overweight bias as a result. Our strategy is to continue taking advantage of the attractive valuations on offer by increasing our exposure to these high-quality government bonds.
Within our credit exposure, we maintain an overweight position to investment-grade financials and underweight exposure to investment-grade corporates, notably in more cyclical parts of the market. Our exposure to corporates is largely focused on quality shorter shorter-duration assets. In a similar vein, we remain selective in our high-yield exposure as we believe that the risk premium required for high-yield corporates should be higher going forward, considering the increased challenges that these companies are likely to face in a slowing growth environment.
Similarly, we see valuations for emerging market debt stretched and the overall risk-return profile of the sector offering limited value at this point.
One risk that novice fixed income investors may be exposed to and how the fund mitigates those risks
Duration risk, sometimes called interest rate risk, reflects the price sensitivity of bonds to interest rate changes. Duration is shown in years e.g., a portfolio may have a duration of 5 years. Somewhat counterintuitively, a rise in interest rates adversely impacts the price of bonds. Conversely, a fall in interest rates positively impacts the prices of bonds.
The higher the duration - or the more years of duration a portfolio holds - the greater the impact on the portfolio value. For example, a rise in interest rates by 1% would impact the price of a portfolio with a duration of 3 years by approximately 3%, compared to a portfolio that has a duration of 5 years would be roughly impacted by 5%.
At Fidelity, we manage duration risk on a number of levels including by being selective and taking active positions in specific bonds and also having limits on the amount of duration risk we are allowed to take as part of the portfolio mandate.
Where the fund might sit in an investor’s portfolio
We believe that the Fund sits within the defensive part of a typical diversified portfolio providing a source of diversification to equities, but also providing a source of diversification to other income-generating assets such as credit and hybrid securities which tend to be more correlated to equities.
