Fixed income is an indispensable field within the investment world. In our previous foresight, we shared the story of US debt and analyzed the factors for asset allocation in a rising interest rate environment. In the current market marked by delays in US rate cuts and increased geopolitical tensions, fixed income has become one of the most popular choices among investors. In this article, we will introduce the reasons behind the popularity of fixed income, the risks involved, and how investors can develop suitable fixed-income strategies.

The Allure and Risks of Fixed Income

Fixed income, as the name suggests, refers to investments that provide regular income, including government and corporate bonds, certificates of deposit, etc. For investors seeking stable income streams, the periodic coupon payments are highly attractive. Furthermore, fixed income guarantees the return of capital. Although the bond market experiences fluctuations, from a contractual perspective, bond issuers have agreed to repay the principal at maturity. In contrast, stock market investors do not have such assurances. Additionally, fixed income, on average, exhibits lower volatility and greater stability compared to the stock market.

In general, fixed income carries relatively lower risk compared to other investment instruments, but it is not entirely risk-free. Firstly, bond prices fluctuate due to changes in market interest rates. Taking the US for example, the current high rates have persisted for nine consecutive months, surpassing the historical median of eight months. As a result, there has been continuous pressure on Treasury prices. Secondly, fixed-income products face the risk of issuer default. To assess the credibility of issuers, investors refer to credit ratings, which serve as a reliable indicator of the issuer's ability to repay. Please refer to our previous articles for a comprehensive introduction to credit ratings. Additionally, fixed income also entails reinvestment risk and early redemption risk.

Fixed Income Strategies in Volatile Times

When formulating an investment strategy, the investor’s preferences and risk tolerance should be the primary considerations. For example, investors focused on wealth preservation should maintain a portfolio primarily composed of investment-grade bonds. After determining the appropriate risk profile, the next step is to establish investment objectives and expected returns and select suitable markets and securities based on the current market environment. Furthermore, given interest rate uncertainty and the impact of duration (the weighted average maturity of a bond's cash flows, which reflects the bond's sensitivity to interest rate changes) on portfolio volatility, investors should determine an initial duration target and dynamically manage, and hedge risks as market conditions and interest rate expectations evolve.

The current market is characterized by volatility, with the timing of a Fed rate cut uncertain and geopolitical tensions escalating. As a result, investors are adopting a more conservative approach. We believe that the elevated interest rates in the US have enhanced the allure of the bond market, enabling investors to generate stable income through a relatively conservative approach. Therefore, when developing a fixed income strategy in the current market, we recommend prioritizing the following aspects:  

• Dynamic Management: Actively manage portfolio duration and credit exposure to navigate market fluctuations and optimize returns.

• Focus on Developed Market Investment Grade Bonds: Prioritize investment-grade bonds issued by entities in developed economies to mitigate credit risk and enhance portfolio stability.

• Capital Preservation: Emphasize capital preservation by investing in high-quality bonds with low default risk.

• Stable Cash Flow: Generate a predictable stream of income through regular coupon payments from the bond portfolio.

We believe the barbell strategy emerges as an optimal allocation approach in the current market. Specifically, this strategy entails primarily investing in long-term bonds (maturities exceeding ten years) and short-term bonds (maturities within three years). Short-term bonds provide liquidity, ensure regular coupon payments, and offer protection against interest rate fluctuations. Conversely, long-term bonds aim to capture capital gains from price appreciation following anticipated interest rate cuts. The current market context presents a compelling case for the barbell strategy. For one thing, the US economy exhibits robustness based on short-term data, and inflation remains persistent. For another, the Fed is likely to hold off on rate cuts until after the election. However, considering the negative impact of high interest rates on economic growth over the long term, we still expect rate cuts to occur within the year. Therefore, simultaneously buying long- and short-term bonds to hedge can reduce portfolio volatility and achieve a balance between risk and return. In terms of the market timing, we recommend starting with a focus on short-term bonds and then increasing the allocation to long-term bonds after hawkish events (such as high CPI or non-farm payrolls).

In terms of bond selection, we believe that investment-grade single bonds offer attractive risk-adjusted returns. US Treasury bonds, considered risk-free assets, have set the benchmark rate at elevated levels. Moreover, investment-grade bonds, particularly those with maturities within three years, carry a low default risk. According to S&P Global, even the lowest-rated investment-grade bonds have a mere 0.72% three-year default rate. As such, investors can achieve higher returns and liquidity at relatively low risk.

The following table illustrates a sample barbell portfolio and a scenario where every $100 invested yields an annual return of $6.33. Assuming two interest rate cuts totaling 50 basis points, the average capital gain can still reach 4.67%.

In addition, investors may also consider allocating a portion of cash to money market funds or cash notes, thereby earning higher interest income while maintaining the flexibility to reallocate quickly when other investment opportunities arise.

Summary

Fixed income plays a crucial role in portfolio construction. It offers unique advantages and risks just like any other investment product. By understanding the characteristics of fixed income and dynamically adjusting its allocation in response to market changes, investors can better balance risk and return within their portfolios and achieve greater certainty in uncertain environments.