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Kelly Prior: What’s your fixed income outlook?

What does the outlook for fixed income look like for the rest of the year?

It was a sobering start to the year for fixed income, and we observed a more divided set of opinions than we have seen for a long time. Aside from the brief wobble in the last week in December, which soon evaporated, asset prices remain mixed at best.

What I saw was an increasing level of caution based on the compensation being paid for the risk of inflation and default, and the risk of more volatility from here.

Investment grade

You can still find a complexity premium in some pockets of investment-grade assets, enabling investors to generate more exciting returns, particularly in the student debt and senior secured space.

There still seems to be a lot of money looking to be deployed from longer-term investors – but ultimately returns in this space overall are likely to be unexciting.

The sector is longer in duration and therefore has benefited from the fall in expected future interest rates that we have seen this year.

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High yield

This was where the real fireworks went off in December and where we saw the biggest split of opinion on whether it was the right time to go all in.

Having been defensive for much of 2018, the wobble in December gave the Schroder Strategic Credit fund the opportunity to buy into BBB pan-European issues, which reached all-time cheap levels –these are long-term buy-and-hold investments.

The Liontrust Strategic Bond team also took advantage of the festive volatility to increase their level of exposure to high-yield at 35 per cent. They are now back to around 15 per cent exposed following the subsequent 2019 bounce.

Emerging market debt

This was probably the area with the most positive sentiment overall, although there was much activity following a torrid year in 2018.

Barings, with its mandate that is more total-return-focused, leant heavily in to corporate paper with its EMD Blended fund, whereas the more income-focused Ashmore Total Return fund has upped risk through local currency debt.

TwentyFour Dynamic has a 10 per cent weight to the area, and Legg Mason’s WA Macro Opportunities Bond fund was also exposed to the tune of 35 per cent, with the majority of this being in local currency sovereign paper.

Markets are steady, but something doesn’t fit

Alternative fixed income

We have widened our horizons in recent years to look for beneficiaries of the change in the shape of lending opportunities. As the interest rate landscape moved from falling to rising, floating-rate assets became more interesting.

One of the key take-aways of our review was how companies have taken advantage of the thirst for loans in this market, rather than issuing bonds to borrow. This has led to a deterioration in this market in quality, but also in the long-term prospects for recovery if conditions become more challenging. There is higher yield and total return to be found by taking risk in the alternative space, but you should expect volatility to be higher too.

Portfolio construction

Whether it is to generate income or as a contributor to overall total return, the need to have the right blend of fixed income has never been greater. Quantitative easing has driven the yields on offer from lending to government to exceptionally low levels, which in turn means companies who issue debt using this yield as a base reference point are also able to borrow at very cheap terms.

We do seem to be edging closer to a fork in the road as the benefit of rolling your debt at eye-wateringly low levels comes to an end. Making sure you get enough return for your risk, and that you understand what risks you are exposed to, has never been more important.

Kelly Prior is investment manager in the multi-manager team at BMO Global Asset Management

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