With inflation and interest rates pushing up rather than down and fast-changing policies and scenarios in the US, UBP’s fixed-income experts explore how investors can put together a flexible and resilient bond portfolio in an approach favouring the long term.
When we look back at the last three decades, we can see that economic recessions and major market crises have mainly produced disinflationary shocks for the economy. Notable events such as the Great Financial Crisis, marked by the collapse of Lehman Brothers, and the Covid-19 pandemic led to a pronounced decline in nominal growth, with both inflation and real growth moving lower.
Each of these events also fuelled a significant rise in unemployment, as companies suffered from the collapse in nominal growth and were forced to lay off employees. The resulting sharp increase in jobless numbers created a negative feedback loop for consumer spending and ultimately inflation, allowing the Federal Reserve to deliver substantial monetary easing and driving the lower bound of the Fed funds rate towards zero.
In stark contrast, the current economic cycle, which began when economies reopened after Covid, has been subject to an inflationary shock rather than a disinflationary one. In the US, headline inflation peaked at 9.1% year-on-year in June 2022. High inflation compelled central banks to adopt aggressive interest rate hikes, with the Fed increasing rates by 525 basis points.
The current macroeconomic cycle cannot be understood through the lens of previous crises involving disinflationary shocks. This time, US growth remains robust, consistently exceeding its estimated potential rate of around 2%. Our scenario therefore assumes a soft landing rather than a recession, underpinned by consumer strength and a labour market that remains robust.
Whilst inflation has receded from its highs, underlying trends suggest that it is unlikely to return to the Fed’s target any time soon, especially given the backdrop of tariffs. So-called supercore inflation – which tracks service prices excluding housing – has remained sticky at around 4% since mid-2023. In the circumstances, the Fed seems ready to accept higher inflation as long as US growth and employment remain robust while inflation expectations stay anchored.
A notable change from the pre-Covid economic cycle is the persistent US fiscal deficit. Historically, that deficit followed a cyclical pattern: it would typically increase during recessions and decrease during periods of growth. However, the pattern has been broken post-pandemic and the Congressional Budget Office is forecasting a deficit of approximately 7% over the next decade. Whilst the new administration has an aim of reducing government spending, the budget deficit is unlikely to return to the low single digits in the near term.
The current economic landscape means that a soft landing is likely, with inflation stabilising at a higher level than before Covid. This would mean the Fed may not have to ease policy too aggressively, and the short-run neutral rate would be higher than initially perceived. Increased support from fiscal policy also removes the need for significant monetary easing, allowing interest rates to remain higher. A similar story could also develop in the eurozone, where more fiscal spending to meet defence and infrastructure needs is clearly on the cards in Germany.
The outlook for interest rates has shifted significantly since the pandemic. We believe that the pre-Covid era of “lower for longer” interest and inflation rates has come to an end and a new one of higher rates has begun. This is ultimately positive for fixed income as it should allow investors to focus on the resulting carry opportunity. Accordingly, we are looking to build more balanced portfolios given that we still expect the Fed to loosen monetary policy gradually.
We maintain a positive long-term outlook on credit, which is backed by a robust growth trajectory that should keep default rates low. In credit markets, we like:
- Assets offering a yield premium to cash deposit rates
- Higher-income assets, including high-yield paper, whose fundamentals remain favourable: for example, default rates are currently at a historically low level of under 3%, whilst the quality of the high-yield market has improved
In addition, in the event of market shocks, the Fed has plenty of dry powder to support the economy by cutting rates aggressively, which should also limit the downside for credit.
In terms of portfolio construction, there is a case to be made for a strategic shift away from the conventional allocation to five-year investment-grade corporate bonds. There is a growing recognition that greater flexibility and resilience are needed in the face of evolving market dynamics and the new era of inflation and interest rates.
By diversifying into other areas of the credit market, investors can achieve a better position from which to navigate potential volatility and capitalise on higher-yielding opportunities.
This approach focuses on reallocating assets towards short-dated investment-grade floating-rate notes (FRNs) and segments offering higher income, including high yield.
Short-dated floating-rate notes (FRNs) have proven to be more defensive than a conventional investment-grade credit portfolio, demonstrating a remarkable 5% outperformance during the Covid sell-off, coupled with an attractive yield pick-up. The yield on FRNs remains attractive compared with investment-grade securities, even when factoring in market expectations for potential Fed rate cuts.
Investment-grade portfolios are also increasingly being replaced with multi-sector income strategies. This approach offers default risk comparable to a BBB-rated bond portfolio while delivering a yield pick-up of 2%. Multi-sector income allows for investments across a broader spectrum, including BBB- and BB-rated bonds, subordinated debt and securitised debt such as collateralised loan obligations (CLOs). Investing across various sectors allows investors to capitalise on the best opportunities, taking both valuations and fundamentals into account.
High-yield CDS indices are attracting investor interest as they offer better liquidity across varying market conditions than high-yield bonds. They also mitigate the illiquidity costs typically associated with high-yield bonds, resulting in both yield enhancement and outperformance historically.
To conclude, when constructing a bond portfolio for the post-pandemic era of higher interest rates, it is worth considering a strategic move away from the conventional five-year investment-grade corporate bond allocation and focusing on income opportunities. There is a case to be made for an allocation to investment-grade short-dated floating-rate notes and higher-income segments, with the ultimate aim of building a flexible and resilient portfolio.
The views and opinions expressed by partner managers may differ from the house view. They are shared for informational purposes and do not constitute investment advice or a recommendation.
