The comeback of certainty: fixed income shines amid market volatility

During the quantitative easing (QE) era following the 2008/09 financial crisis, fixed income was often treated as an afterthought in portfolio construction. With low or even negative yields and central banks acting as consistent buyers, bonds were seen as dull, included mainly to satisfy rating agencies.

Key considerations like duration, inflation linkage, and credit spreads were frequently overlooked in favor of equity discussions. However, we have consistently prioritised fixed income, dedicating time and resources to its positioning—an approach we believe has proven to be worthwhile.

We look here at why we think fixed income warrants attention within an asset allocation process, and actively managing the underlying exposures is key to building well balanced and diversified portfolios.

The macro picture

Following the Covid-19 pandemic, another dose of easing was delivered to prevent a broader global crash. In hindsight – this has contributed to a substantial inflationary shock which has subsequently necessitated an aggressive tightening cycle. This tightening cycle has highlighted problems with a broad all-maturity implementation of fixed income exposures within portfolios.

2022 caught a lot of people by surprise, as fixed income assets sold off aggressively during the re-pricing of interest rate expectations. “Safe” assets such as UK government bonds (GILTs) lost vast amounts of capital value as yields rose – with the longer maturity and duration vehicles punished the most. In many places, this left lower-risk solutions feeling more pain than higher-risk ones, as equities managed to stage a recovery. Since then, inflation persistently above central banks’ targets and the resulting higher rates have continued to cause issues to bond exposures.

Key considerations

• Fixed income is not homogenous

Most people can easily name major global equity indices like the FTSE 100, S&P 500, or TOPIX, but few can list more than a handful of fixed income indices. This reflects a common misconception: many investors assume the “Global Market Portfolio” (GMP)—a theoretical portfolio weighted by the market cap of all investable securities—is dominated by equities. In reality, fixed income makes up the majority. This raises important questions about how we view bond indices. Differences between sovereign and corporate bonds, inclusion or exclusion of mortgage-backed securities (MBS), currency hedging, and maturity ranges can lead to significant performance divergence—especially evident during this tightening cycle.

• Duration matters

Prior to the recent inflationary shock, investors have been able to buy bonds knowing that there is a decent chance the central bank will want to buy them off them at a higher price, and lower yield, than they purchased them. When yields are falling, longer durations bonds are more sensitive to these moves, so the upside is even greater. All is well as yields fall – but the opposite is true when yields rise.

Taking a real-world example here, the UK Government 0.625% 22/10/2050 bond was issued in 2020 at a price of 96.343 per 100 of face value. i.e. if you paid 96.343 at the time, you would be paid the 0.625 per 100 pounds invested per annum for the next 30 years before having 100 of par value returned to you. Sounds like a pretty safe investment given it is backed by the government? At the time of writing, this bond is trading at around 36 per 100 of face value. If you had to sell this bond now after buying it at issuance, you would lose more than 60% of your capital value.

• Credit spreads must be considered

The credit spread reflects a premium paid to investors for taking on more risk. Buying debt issues by a corporate poses higher risk of default, and therefore permanent loss of capital, than investing in a developed market sovereign bond issued by a government. At times, these spreads can be very generous and you are well rewarded for bearing this risk. At others, these spreads are tight and there is little pick up in expected return from moving out of sovereign and in to corporate debt. Relative value between investment grade (higher credit rating) and high yield (lower credit rating) also plays into this.

Asset allocation – active approach to fixed income

The variables discussed above are just a some of the factors we consider when managing fixed income exposure. In recent years, we’ve actively adjusted the composition of our sovereign and corporate bond holdings, and our positioning along their respective yield curves.

While nominal sovereign bonds—traditionally seen as “safe” assets—have underperformed, we continue to view the 7–10 year segment of the curve as a key risk anchor, offering valuable diversification during equity market sell-offs. To guard against inflation surprises without increasing duration risk, we’ve added short-dated inflation-linked bonds where appropriate.

As yields rose across the curve, we also noted that corporate fundamentals remained strong, prompting us to increase exposure to short-dated investment grade credit to benefit from tightening spreads without additional duration exposure.

We also emphasise the value of active management in areas where passive exposure may fall short. Our high yield credit managers have consistently added value through disciplined security selection across the cycle.

These decisions illustrate how active fixed income management can enhance portfolio outcomes. By selectively taking risk—whether in duration, credit quality, or inflation sensitivity—we aim to add value and avoid adverse shocks.

When we are looking to make asset allocation changes, we are considering the various components that make up portfolio returns. These include the sovereign yield, any inflation compensation, any credit spread and the term premia. Changes in these over time drive our relative value decisions, as well as considering how these piece together with our broader equity and alternatives positioning.

Conclusions

Fixed Income warrants as much attention as equity and alternatives when building portfolios. It can be actively managed using both passive or active vehicles and doing so provides opportunities to capture upside returns and downside protection. With changing fiscal and monetary conditions, make sure your DFM is actively managing the risks and opportunities that this market environment is presenting us with. Static allocations and all-maturity vehicles are not refined enough to implement a granular asset allocation view.

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