Build core exposure to quality, short- and medium-maturity government bonds
We believe the recent increases in benchmark government bond yields in USD, EUR, and GBP provide an opportunity for investors looking to lock in elevated yields and diversify portfolios. Despite the extent of moves and some signs of higher volatility in longer-duration debt, we still think highly rated government bonds offer appealing risk-reward qualities across multiple economic scenarios. We believe markets may have moved too far in pricing hawkish monetary policy, even if some near-term rate hikes may happen, for example in the Eurozone. And in alternate scenarios to our base case, yields could fall over the medium term if a more prolonged disruption in oil supply triggers growth concerns, and investors begin to price recession risks and central bank rate cuts.
After many years of strong equity performance relative to bonds, investors may have an opportunity to rebalance toward bonds, to bring allocations back in line with long-term plans, and to help manage potential equity risks. We like looking for opportunities in quality government bonds with short to medium maturities. In Europe, yields may remain volatile as the European Central Bank is likely to tighten policy, so selectivity is important. Even in markets where yields remain low and inflation muted, we still think some allocation to government debt can make sense for adverse economic scenarios, in which government debt tends to rally and yields fall in anticipation of monetary easing. However, we would caution against yield-seeking investors extending their interest rate (duration) exposure in government bonds, as this part of the yield curve is most sensitive to worries about both fiscal sustainability and long-term inflation expectations.
Seek diversified income-paying exposure by favoring credit, equity income, and structures over duration
For a holistic and well diversified fixed income exposure, especially for investors relying on their portfolio for income, we like select exposure to more growth-sensitive and higher-yielding bond market segments such as emerging markets (EM), high yield, or subordinated debt. Amid elevated geopolitical and sector-specific risks, investors should avoid overexposure to any single segment of the credit market.
EM bonds have benefited from resilient global GDP growth and commodity strength—enhancing their role as a key allocation and alternative to developed market fiscal challenges. Additionally, many emerging markets have maintained restrictive monetary policy to keep inflation in check. This means real rates in the EM complex are high and should benefit from capital inflows looking for diversification away from traditional markets. Despite some expected spread widening, we believe elevated yields and supportive central banks underpin a positive outlook for EM debt, which we rate Attractive, with continued outperformance versus cash expected.
Investors seeking more defensive ways to access higher-yielding bonds amid uncertainty may also look at diversified and risk-controlled tools to invest in subordinated debt, including hybrid bonds. These are a type of subordinated debt instrument issued by investment grade, non-financial companies that blend the characteristics of standard corporate bonds (paying regular interest) and stocks (no fixed maturity date and the ability to defer coupon payments).
Looking across asset classes, we also believe equity income strategies (especially in Switzerland and Southeast Asia), yield-generating structured investment strategies, and multi-asset income approaches that may also include derivative strategies can also support income objectives. However, investors should be willing and able to bear the unique risks of investing in options.
