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ARE BONDS STILL A HEDGE
AGAINST MARKET VOLATILITY?

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SPW Contributors

Sanlam Private Wealth

Erik Keller, client portfolio manager at Robeco – a leading global investment manager based in the Netherlands – discusses the outlook for global fixed interest. Robeco is one of our preferred managers for global fixed interest, with the RobecoSAM SDG Credit Income Fund forming part of our global multi-asset model portfolios.

We believe we are getting closer to the end of the rate hiking cycle by major central banks. Markets are likely to remain volatile in the near term amid still elevated inflation and heightened recession risk, meaning the focus will remain on inflation data as a guide to central bank policies.

Both in the US and Europe, a strong labour market and resilient service sectors are supporting positive economic growth. However, industrial and real estate sectors are already suffering. As the higher policy rates by central banks and tighter lending conditions filter through the US and European economies, we’re starting to see a slowdown in economic growth. In China, economic data continues to disappoint with the housing market suffering from the unresolved crisis in the property sector.

The fierce policy-tightening programmes by central banks in the US and Europe have resulted in a sharp rise in short-term interest rates. Moreover, a tremendous amount of money has moved out of bonds into cash as investors have chosen to reduce their core bond allocations amid these hawkish central bank policies.

However, as higher rates filter through in the real economy, markets are starting to price in that the tightening of financial conditions will start to negatively impact economic growth and ultimately help bring down inflation. In our view, the risks are that central banks are overtightening and that there will be a stronger contraction in economic growth. This is also supported by historical analysis indicating that rate hiking cycles by central banks always end up in recessions.

Another (historically reliable) recession indicator is the inversion of yield curves, meaning that yields on shorter-dated bonds are now higher than yields on longer-dated bonds. This shows that bond investors are pricing in a slowdown of inflation and economic growth.

UNIQUE OPPORTUNITIES

As the global economic outlook remains uncertain with the US and European economies having to digest higher rates and tighter lending conditions, while Chinese economic growth has fallen back significantly, we think it’s very likely that bonds will soon reassume their role as a hedge against equity market volatility. Whether you believe in a soft or a hard landing, the global economy is set to slow and central banks will ultimately respond by ending their respective rate hiking cycles.

As we are nearing the peak in interest rates and global yield curves remain very inverted, investors should take the opportunity to position effectively to benefit from the higher rate environment while also limiting risk given the uncertain economic and market outlook. Although it is likely that company earnings will also be under pressure in an economic slowdown, high-quality short-term debt typically performs well in such an environment. This represents a unique opportunity for investors wanting to benefit from a higher rate environment without taking significant duration risk.

While short-dated bonds typically trade at a premium compared to longer maturity bonds, it is now possible to achieve the same (or higher) yields in short-dated high-quality corporate bonds as in all-maturity corporates, but with around less than half of the interest rate risk. As such, this can be a powerful way for investors to boost their returns versus cash (without a material sacrifice in credit quality) or to maintain an attractive yield and credit spread, with enhanced protection from interest rate volatility.

ROBECO’S STRATEGY

In our RobecoSAM SDG Credit Income Fund, we primarily invest in short-dated global bonds with a focus on high-quality investment-grade bonds and high-quality BB-rated bonds. The fund has the flexibility to invest across developed and emerging markets to source the most attractive yield opportunities and is a good solution for investors wanting to benefit from the higher yield opportunities in shorter-dated bonds.

Another feature of the fund is that it has a clear sustainability objective, primarily investing in bonds issued by companies that positively contribute to the 17 United Nations Sustainable Development Goals (SDGs), and consequently avoids investing in bonds issued by companies that harm these goals.

The fund currently has a large allocation to financials, driven by the fact that we find the most attractive value in European bank and insurance debt. The larger banks in Europe are well capitalised and benefit from the higher rate environment, reflected in the strong earnings reported by banks. This is a tactical view. Once we see better value opportunities in other parts of the global fixed income market, the fund has the flexibility to change the asset allocation.

The interest rate sensitivity of the RobecoSAM SDG Credit Income Fund can range between roughly one and six years. We have gradually increased the duration to five years to benefit from both the higher yield environment and to serve as a hedge, anticipating that a higher interest rate duration can mitigate potential market volatility.

When market volatility increases because investors become more concerned about a slowdown in economic growth, we typically see a flight-to-safety effect where investors sell more risky assets and buy safe government bond debt. This will result in a decline in bond yields and should therefore benefit investors that have more interest rate duration in their portfolios.

The RobecoSAM SDG Credit Income Fund can invest across the US, European and emerging markets. The fund currently has a larger allocation to European debt – a tactical position primarily driven by our current preference for European bank debt. The fund has the flexibility to change the regional allocation if we see more value opportunities in other parts of the world.

The emphasis of the investments is on investment-grade corporate bonds and BB-rated high-yield bonds, where we see the most attractive yield opportunities and limited default risk. In addition, we hold some exposure in AAA-rated bonds and securitised debt, where we see attractive value relative to the high credit quality of these instruments.

PORTFOLIO DIVERSIFICATION

Global financial markets will continue to be driven by rates and recession fears and although US and European yields seem close to the cycle peak, volatility and uncertainty remain. However, after the substantial increase in bond yields over the past two years, bonds now provide a very attractive yield and income, so they can once again increase diversification in an investment portfolio.

Bonds have historically played the part of providing income and a hedge against market volatility. We do think they will play this role again as we near the end of the rate hike cycle by central banks and as inflation starts to moderate.

However, as we still expect some rate volatility in the coming months, in our view, an investment in short-dated bonds is the best solution in the current environment. In addition, fixed income investors should emphasise quality in their portfolios with a focus on investment-grade and high-quality (BB-rated), high-yield bonds.

Comment by Renier de Bruyn, Head of Asset Allocation at Sanlam Private Wealth:

We have maintained a large underweight exposure to offshore fixed interest in our multi-asset portfolios over the past decade, as yields were supressed by central bank quantitative easing. As a result, the return prospects relative to those of equities have not been favourable. However, this has started to change over the past 18 months as monetary policy has become more restrictive, driving up bond yields.

We now see a more favourable risk-adjusted return outlook for fixed interest versus equities over the next cycle. Given the uncertainty around an economic slowdown on the one hand and inflation risk on the other, we prefer to invest in higher quality bonds while avoiding too much duration risk – similar to the view of Robeco above.

Using your equity portfolio to secure credit allows you fast access to capital.

Sizwe Mkhwanazi has spent 14 years in Investment Management.

Sizwe Mkhwanazi

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