Alex Lee outlines the upsides and advantages that investors can still find in fixed income, but notes that some active strategies could come with advantages
US bond yields keep rising, and global bond markets seem to be following along. 10-year US treasury bonds have hit yields in excess of 5.3 per cent as investors price in high fiscal debt levels, wider global credit issuances, and the expectation of future interest rate hikes by the US Federal Reserve and other central banks. This spike in bond prices and renewed volatility on bond markets has some investors and advisors wary of what the future holds for this space, with echoes of 2022’s bear market getting louder and louder.
Alex Lee, Senior Fixed Income Client Portfolio Manager at Vanguard Canada in Toronto, explains that despite the volatility now present on fixed income markets, there is still utility and even opportunity in fixed income allocations. He explains that higher yields can offer better income offsets to periods of volatility and emphasizes the view that inflation and energy supplies sit at the core of contemporary challenges. Fixed income isn’t broken for retail investors, but he believes advisors need to be aware that the space is diverging.
“You have income, which is really attractive and you don’t have to take a lot of risk in today’s market,” Lee says. “Spreads are relatively tight. If you just look at the high yield market we’ve seen a widening of CCC spreads relative to a BB. We think that there are strong fundamentals to support current spreads, but we think that clients should consider more quality in their fixed income. In today’s work, you’re starting with a very attractive yield, but you want something that will have that balanced equity risk.”
What’s driving yields higher?
Lee notes that fiscal deficits are on investors’ minds, but that some of the initial ideas of correlation between all developed market bonds might be overstated. He contrasts French and German bonds as an example. France has a public debt to GDP ratio of 119 per cent and 10-year government bonds are hovering at yields around 5 per cent. Germany has a debt to GDP ratio of 63% and it’s 10-year bond comes with a yield of around 3.5 per cent.
US bond yields, Lee says, are largely being driven higher by inflation and expectations of Fed policy. Investors are growing more concerned that a prolonged period of oil prices above $100 per barrel will cause inflation to widen beyond energy. Those fears were validated at the September Fed meeting when Federal Reserve Chairman Kevin Warsh made it clear that the Fed would be more strident in achieving its 2 per cent inflation goal. While Lee acknowledges that there are a host of prevailing narratives explaining this volatility in US bonds, he believes energy prices and inflation remain the core concern for the Fed and for investors.
Despite energy prices’ role as a catalyst in this bond volatility, Lee doesn’t yet know if a fall in energy prices automatically prompts a fall in yields. While yields and energy prices have been highly correlated in the later part of this year, he notes that the relative strength of the US economy introduces other inflation drivers. The market is still trying to figure out if the Fed’s tightening will get those drivers under control, he says.
Is it time to reassess fixed income?
While another period of bond volatility can be difficult for investors’ fixed income sleeves, Lee adds the context that we’re starting from a point of far higher yields and lower prices than we saw in 2022. The ‘income cushion’ of a US aggregate bond vehicle with a yield to maturity of around 5.5 per cent offers some stability. He adds that the current ‘breakeven yield’ on those US aggregate bonds is around 100 basis points, meaning yields would have to rise by another full per centage point to wipe out the returns an investor would get from the income on their bonds.
While Lee believes a wholesale reassessment of fixed income allocations may not be warranted, he notes that divergent performance is something investors and advisors need to stay aware of. Developed market debt is showing less direct correlation as investors factor in different debt to GDP ratios. Credit markets, too, are being reshaped by significant bond issuances by AI and technology hyperscalers. Lee says that Vanguard is responding to this demand for more targeted exposures, working with clients to combine active and index products to offer the kind of fixed income that advisors want for their clients.
“The key message that we’ve been speaking to a lot of advisors when we meet with them is really diversification,” Lee says. “We diversify because we don’t know what the future holds. I think fixed income or bonds have a role to play. I think it generates income, it provides stability. With the 5.5 per cent yield just to be an investment grade, that really gives you a nice cushion. So I think we should really reconsider bonds from today’s lens than maybe the experience that certain clients have had a few years ago.”
