'Clients are now being paid to take fixed income risk'

0:02Hello and welcome to this special edition of the FT Advisor Vantage Point podcast. Today we'll be discussing outlook and opportunities within the fixed income universe. I'm Tara O 'Connor, Chief Reporter at FT Advisor. Joining me today are Iain Stealey, International CIO for Fixed Income at J.P. Morgan Asset Management and Richard Carter, Head of Fixed Income at Quilt Achieve It. This is a podcast sponsored by J.P. Morgan Asset Management. Ian, if we start with you, tight credit spreads and volatility in government bond yields is a sign of the market pricing assets logically or rationally right now.

0:36But in such an environment, where do you find value? So you're right. It's been obviously a very interesting year. If you think about where we started when there was expectations that possibly we might see some further rate cuts from the Federal Reserve or the Bank of England. And obviously that completely turned on its head following the start of the conflict in the Middle East. and concerns around inflation picking up with higher energy prices. And then the market kind of filtered on to possibly stickier inflation longer term, government deficits. There's obviously been a lot of issuance coming out to fund those deficits.

1:09We've had a lot of issuance from the corporate market as well. And we've seen north of 100 basis points move higher in yields. And that's been across all parts of the fixed income market, whether you look at government bonds, whether you look at credit bonds or parts of the emerging markets. And it's created, I think, a pretty attractive opportunity for a fixed income investor. I do think we're in a world now where you are compensated for fixed income risk. We're not some of the low yield environment that we saw following the financial crisis. But we do have to take into consideration that inflation is more elevated.

1:44Central banks are in the process of tightening policy. So I think volatility is going to be here to stay. there's a nice cushion now within the fixed income markets on for the yield you're receiving but it does feel like it's an environment we're having sort of an active management mindset you know which countries do you want to be involved in we obviously obviously seen a bit of a flare up within French government bonds more recently and I think that's just sort of a sign of the times that we're we're likely to continue with and then as you said corporate spreads are are tight but we think that's justified by strong fundamentals.

2:18And we've just started Q3 earnings in the US, and we're expecting another good round, another good set of corporate earnings, which really, from a fundamental standpoint, argues that credit spreads should be tight. And I get a lot of people saying, I'd rather buy a corporate bond than a government bond, just given the fundamentals of both at the moment. So I think that's a fair valuation argument there. And I just think it's the all-in-yield argument that's now kind of sucking people and making them look at the sucking people into the bond market and making them look at investing in fixed income again yeah with those tight credit spreads what do you think about you richard yeah i would totally agree what ian has said i i mean it's a lot easier to find value now than it was uh a few years ago when it was next to impossible and strangely everyone loved bonds at that point now they've Now the yields are quite high, people don't like them.

3:09I mean, we have to be quite careful to invest in the right area of the bond market, depending on the nature of the client. I mean, 30-year gilt yields look super attractive, but if you're a low-risk client with a short time horizon, they're not going to be for you. So it's kind of horses for courses in terms of where to find value. But I agree. I mean, yes, spreads are tight, But I think, you know, the all in yield in sort of short to medium dated IG credit is, you know, it's hard to turn your nose up at that, really. Yeah. And on that kind of duration point, what do you think in like, how do you think about duration in the current climate, specifically maybe looking at gilts?

3:49You know, so as I said, it's been a move higher in all parts of global fixed income markets of which gilts have been been part of. and we've gone back and we've looked historically and you typically when you move 100 125 basis points higher that's a good entry point for investing on the fixed income space we've seen that um and i do think now there's quite a lot priced into central banks that's the other thing you need consideration always like kind of what is actually priced into the market we're in the uk now we've got 100 basis points of hikes priced by the bank of england i think there's a question mark as to whether they will actually deliver all all of that so as richard said there is a lot of values being created in the market now as i said earlier volatility is likely to remain but what again when we've looked back and we've said at this starting point in in yield what should you be thinking kind of from a return expectation and we looked at the bloomberg u.s aggregate index all the way back through to 1990 currently yields about 5.3 percent or so and for this starting point you know in in yields historically over the next three years the worst you would have ever had would have been about a 3.8 percent return the best would have been around about eight and on average you'd get about six and we know the starting point your starting yield is a very good indication of what you should be looking to achieve over the medium medium term so the fact that we've had this back up in yields the fact there's quite a lot priced into the central banks already does really make us actually want to lean in to duration and we've been looking to increase that across our portfolios yeah i mean we're slightly sort of long versus uh benchmarks again it's kind of you know shorter duration for low-risk clients and and you know a balanced client with a bit more of a longer time horizon can can take a bit more of a duration risk i'm just you know i'm just concerned that uh you know we might be in a bit of a sort of regime shift potentially where things have you know remain bad for bonds for a long time and and you are you are kind of having to hope that you can read the ruins or get the crystal ball out and and and see what's going to happen at least or what trump's going to do next so a little bit still a little bit cautious about to taking too much duration risk but uh yeah i agree you know the sort of where we are with yields you know you think bond markets are pretty attractive yeah and other lessons that investors can learn from uh 2022 yeah massively i mean that's 2022 still a you know what we're four years on i mean that's still a topic it comes up a lot i think it's it's you know gone are the days where you look at a sort of guilt fund and go this is my low risk thing i don't need to worry about that you know i buy some 10-year linkers or something and and uh and it's you know that's fine for a low risk client that's changed a lot um again back to the sort of horses for courses on the duration front also the correlations you know when particularly when And there's a rising euro price, problems with inflation.

6:47It all sort of goes down together. So I think, you know, search for good alternatives is still, you know, it's still prevalent. I think it's important from a 2022 period because a lot of clients do come to us and they don't remember 2022 that fondly from a bondholder standpoint, obviously. But I think it's worth putting in context. I mean, the yield level that we started at the beginning of 2022, the 10-year treasury was about one and a half percent. We had zero interest rate policy across most of the central, particularly the developed market central bank with negative interest rate policy in some places around the world.

7:22We are in a completely different environment today. We've got rates back up to normal levels, pre-financial crisis levels. We're north of 5%, whether you look at the UK market, whether you look at the US market. And there's a huge amount of yield cushion there, which can offset capital losses. And again, people are sort of fretting a little bit about what's happened this year. It's not been a great environment for bonds this year. Happy to agree with that. But when you look at some of the performance across the indices, we're down maybe a percent or so. We were down double digits in 2022. So I think it's actually really important that you sort of take a step back or take a step back now and don't look backwards and look forwards and look at what is the opportunity that's being created.

8:05And actually, when we think about what happens, and Rich is absolutely right, the correlation. what hasn't been favorable, but that's because of the starting point. And that's because this has been inflation driven. If you did get a growth shock, and we've seen a little bit over the last couple of days and concerns around the AI trade, actually, bonds have been doing what they should be doing, which is giving you some form of protection. So I do feel that if it's a growth problem, not an inflation problem that the market gets concerned about, bonds are going to do absolutely what they should be doing in a balanced portfolio.

8:35So definitely it's worth having some, just given where yields are and given the protection they could offer you in a downturn. Yeah, and bringing it back to kind of the present and this year, what is the most important research generated insight that you've had this year? So I think there's a couple of things. I look at it from both a kind of a macro standpoint and maybe a micro standpoint. So we're spending a lot of time on the macro side, utilizing the benefits of AI now. So using LLM models, we'll go through sort of the Russell 3000. Companies will look at sentiment from their earnings reports.

9:06We'll look at job trackers, layoff trackers, how we think the economy's likely to behave or how they think the economy's likely to behave and try and kind of really gather that information quite quickly. because obviously we've got the advantage of being able to pull all of that now. And then we link that to what we call our own chase data where we can see sort of the underlying spending patterns within the US. Just to give us a sentiment of consumers, as we all know, consumer is the big driver of growth across the economies. So trying to get a sense of that. And then maybe on a more micro side, I think we've really benefited from having kind of boots on the ground in some of the emerging markets.

9:44So we've had within our emerging market, we've got a very well resourced emerging market debt team. We've had four trips to Colombia over the last 12 months. We've had two trips to Brazil in the last four months. Both have had big sort of movements in the political aspect over there, which has been very favourable for the bond market. And we've managed to capture some of that. So I think there's some really good opportunities in this sort of environment when you can do the research to get an understanding of what's going on to generate alpha opportunities. With kind of using the LLM models, how do you use that and how long has that been a part of your process?

10:21So it's obviously evolving, you know, as every single kind of day that goes past, we're doing more, but we're trying to spend a lot of time sort of scraping data, you know, being able to pull more data in, being able to read the data quicker, effectively trying to give us insight, but also trying to, I think the other thing we're trying to do is sort of free up time for the portfolio managers, maybe, you know, reduce some of the mundane tasks or speed up some of the more mundane tasks to allow them to actually do what we really want them to do, which is spend time thinking about the markets, thinking about where we should be making investments.

10:52Richard, how about you? Yeah, I think the sort of active passive debate is a big one, particularly in equity markets. But I think we're in fixed income, I'm sure Ian agrees, that there are some great active managers and there are some great funds that are delivering above index returns without taking sort of stupid amounts of risk. And one of the areas that's very important for us, for our clients, is sterling credit. And, you know, we've added another manager this year who's, you know, been excellent at identifying opportunities in sort of small and medium corporate bonds. And, you know, anything like that really helps, you know, drive performance for clients.

11:33So that's been good. And are you using AI as well? Yes. I mean, we're probably not on the stage where Ian and JP Morgan are quite yet but uh it's certainly becoming a bigger part of what we do yeah okay interesting um and what has been kind of the most important investment decision or change in positioning that you've made this year well to be honest i'd like to say it was it was sort of loving bonds and buying more of them but actually at the start of the year you know in terms of asset allocation we sort of sat down and went through a lot of various economic scenarios and really struggled to make the case that bonds were going to do much better than equities in most of the realistic outcomes.

12:13I mean, they might sort of tread water or hold their ground, but we basically reduced our exposure to fixed income much earlier in the year. We were also worried about correlations. It goes back to that sort of issue that we could see this running on for some time. Maybe that might change soon. I mean, what you're talking about, slower growth. I mean, I think you do need to see either a resolution in the Middle East, which seems unlikely, or some sort of slowdown in growth for bonds that are outperforming. But certainly, like I say, starting level of the year is suggesting they could. Yeah, and how about you mean?

12:45Any changes in positioning? I think actually one of the things I've been happiest about this year is actually not sort of being shaken out of owning corporate bonds. And I think it goes back to something we've been talking about within the team for a while. It's just the resilience of the global economy. And I just think just over the last five years, no matter what you throw at the global economy, I mean, it seems to be able to withstand it. If you think about the 500 basis points of rate hikes, the regional banking crisis, we had obviously Russia, Ukraine, Liberation Day, and then more recently the Middle East.

13:16Yet corporates remain in pretty sound fundamental strength. So we've continued to own corporate bonds. We've continued to own parts of the credit market. And that has given us the additional yield kicker. As I said, there's been parts of emerging markets, which I think has been good investments for us. And then more recently, just trying to take advantage of this backup that we've seen in core yields. And I think we are at a level now where you do want to be having some duration in your portfolio. I fully agree with Richard. For a really kind of sustained rally, you probably do need to see a slowdown in growth.

13:50That's not our base case. I'm not calling for a big capital gain. But if I build up a sort of a global portfolio today, I can get you a yield of 7 % without taking a huge amount of sort of down in quality credit risk. And that's in line with most people's long-term expectations of what the equity market should do. So you'd be getting that similar return stream with significantly lower volatility. So it feels like this is becoming a pretty good opportunity for us and for the fixed income market. Yeah. And where will your focus be for the rest of the year? I mean, it's got to be around the duration aspect of it.

14:26I mean, that's been where the volatility has happened. That's been where we've seen the big movements and trying to get a sense of how are the central banks going to react to this? I say there's quite a lot priced in. We've just been hearing more recently over the last few days at the IMF meetings in Bangkok. The central banks do not believe that there is significant sort of second round inflation effects going through the system. I think, again, if oil stays elevated or energy, it's not just oil, it's energy prices stay elevated, then I think there is going to be question marks around that. So we are going to spend a lot of focus on that.

15:04But we're also going to be focusing on the kind of the bottom up credit fundamentals because spreads are tight. There's not a huge amount of conversation. I do think that's fair at the moment. But if you do start to see cracks in the AI sort of sentiments or sentiment around AI, if you do start to see cracks in the technology and there's kind of question marks being brought in around the resilience of the global economy, then we could see some widening there. So I think it's a couple of things we do need to make sure we focus on into year end and also into the beginning of next year. Yeah. And will you be looking at similar areas?

15:36Definitely. Also, I mean, there's a huge focus on fiscal stuff, right? I mean, the budget coming up and France and even the US, I mean, that's going to be huge. I do think sometimes it gets a bit overblown. But yeah, between that and the Middle East, that's going to be the big focus. And hopefully for some volatility, some movement wider in spreads, we can take advantage of it. Yeah. And what would be the best outcome, do you think, from the budget in the UK? Sort of boring, you know, boring kind of budget like they used to be, right? I mean, they don't need to be sort of really exciting every time.

16:08I mean I think the government's constrained with what it can do it'll have to stick to the fiscal rules you know we've got a slightly bit of better growth coming through in the UK I mean that helps sentiment they just need to be helped out by to be honest the international situation and so you know Bank of England doesn't have to raise rates and you know at some point can go back to cutting them but yeah I think a boring budget is probably best yeah you want to see a boring budget as well I'd love to see a boring budget Yeah, and I think ultimately the government have actually, the messaging so far has probably been well received by the bond market.

16:46Actually, if you look at, say, the UK guilt market, I wouldn't call it a sort of an oasis of strength over the last few weeks, but it's definitely outperformed things like the US market. So we have seen a bit of resilience there, and I think it's actually down to the fact that we haven't seen anything that's sort of bond market unfriendly coming out of the government. and I hate to say it, but I do think lessons have still been learned from a few years back and they're not probably going to want to upset the apple cart too much. So yes, hopefully nothing to see here would be what the bond market would like to see.

17:17Yeah, brilliant. Well, thank you both so much for a bit of a dive into the fixed income universe. That's it for us today on the FD Advisor Vantage Point podcast.

17:35Thank you.