Martijn de Vree, head of Fixed Income Solutions, and George Bory, chief investment strategist for Fixed Income at Allspring, discuss strategies that global fixed income investors can pursue in today’s markets. A more complete discussion can be found in Allspring’s midyear report to investors.
Martijn de Vree: I think investors shouldn’t lose sight of the opportunity for selection alpha in this environment. Alpha is, by its nature, a source of return that is uncorrelated to risk. This means that managers who can capture it offer their investors yet another source of diversification.
George Bory: That’s Martijn de Vree, head of Fixed Income Solutions at Allspring. I’m George Bory, chief investment strategist for Fixed Income at Allspring, and you’re listening to On the Trading Desk®. Today, we’re discussing how yield-based strategies can help investors pursue attractive total returns, preserve capital, and maintain adequate liquidity in today’s very challenging markets. Thanks for being here, Martijn.
Martijn: Hi, George. Thanks for having me. This should be a timely discussion. We’ve both recently contributed to Allspring’s midyear report, which discussed how policymakers and investors are now trying to balance weakening growth prospects and banking system fragility against persistent inflationary pressures. This is an important moment to optimize fixed income allocations.
George: I agree, Martijn. As you recall, we laid out five basic strategies that investors can use to navigate global fixed income markets. This included extending duration; maximizing yield; staying up in credit quality; using U.S. municipals for stability; and, importantly, going global where you can. And one of the key takeaways from our five strategies is the importance of driving expected total returns by maximizing yields. It’s a cornerstone of our strategy.
Martijn: That’s right. Income remains the primary driver of total returns for most fixed income portfolios. The most efficient way to harvest income opportunities is to look for the most attractive locations along the yield curve and among the various credit sectors that make up global fixed income markets. The current flatness of the yield curve makes income quite attractive on the short end, and this is true for lower-rated segments of corporate and structured product markets. Investors can also look globally to find yield. To me, European loans stand out with yields near 9%. Moreover, they can offer diversification benefits and they also enjoy senior-secured status in the capital structure.
George: Yes, 9%. That is a quite attractive yield. I agree. I also agree with the notion that managing risk through choosing appropriate locations in the capital structure is an excellent idea in this environment. For example, when we discussed how moving up in quality will be important to counter some of the increasing leverage trends we see in the market that also include declining interest coverage and rising default rates in the corporate credit sector, moving up in the capital structure can really help a portfolio. In addition, structured products, which pool loans, mortgages, and debt from several issuers, can mitigate some of the specific credit risks that we see in individual issuers. In addition, as I mentioned before, municipal bonds. Municipal bonds offer some portfolio diversification benefits for both taxable investors as well as crossover investors from the tax-exempt side. Importantly, tax revenue streams tend to have imperfect correlations to deteriorating credit quality of corporate issuers. For example, some municipal issuers that support public services, like water or sewer systems, they’re often much less affected by cyclical factors that might really stress or strain some of the sectors on the industrial side. So, it’s a nice counterpoint to the cyclical risk that you might find in a typical credit portfolio.
Martijn: Indeed. And another way to diversify is through optimizing currency exposures. The dollar may face some long-term headwinds in the years ahead, and I think that diversification into euro-denominated credit markets, which are very developed and broad, could offset at least some of the dollar risk. In Europe, I’m seeing attractive yields return to higher-quality and liquid segments of European credit markets. For example, currently, European investment-grade debt yields about 4%, and yields rise close to 6% when hedging these exposures back to the U.S. dollar. I think this presents a really nice opportunity to improve portfolio yields and risk diversification for global investors.
George: It’s right on target, Martijn. Maximizing yield in portfolios is pretty much the best thing a fixed income investor can do. But it’s also important to note that there are some attractive opportunities to enhance total returns by recognizing the normalization of the yield curve over time. If longer-term yields fall, as we expect they will in a weakening growth environment, this should set up well for pursuing capital appreciation from longer-maturity bonds. Extending along the curve and adding duration can really help a portfolio in this type of environment. As we know, the Federal Reserve is much closer to the end than the beginning of its tightening cycle, so finding the right balance in portfolio duration should help investors manage curve risk and overall interest rate risk in this very volatile environment.
Martijn: I agree with that. Moreover, I think investors shouldn’t lose sight of the opportunity for selection alpha in this environment. Our global credit research across Allspring should allow various fixed income strategies to pursue attractive opportunities with specific issuers that have resiliency in their balance sheets and the financial flexibility to be opportunistic in their competitive positioning. Alpha is, by its nature, a source of return that is uncorrelated to risk. This means that managers who can capture it offer their investors yet another source of diversification.
George: Martijn, that’s spot on. Security selection is critical. When you take good security selection and combine it with income, you really maximize a portfolio’s performance. So, I’d like to remind listeners to check out our midyear report, which discusses these five strategies in more detail. Thanks for joining me on this podcast.
Martijn: The pleasure is all on this side of the table, George. Thanks for having me.
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Disclosure: Alpha measures the excess return of an investment vehicle, such as a mutual fund, relative to the return of its benchmark, given its level of risk (as measured by beta). Alpha is based on historical performance and does not represent future results. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
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