Fixed income: performance drivers as peak rates approach

As the US rate-hiking cycle nears its zenith, two positive drivers for fixed-income investment are coming into view: stronger performance prospects for sovereign bonds and the return of the low correlation between duration and credit risk. In the Q2 issue of Alphorum, we assess these dynamics while providing new fundamental and portfolio-construction insights on fallen-angel bonds. Key points include:

• Two upsides of peaking rates. First, given the trend established in hiking cycles dating back to 1995, Treasuries are likely to outperform¹ cash for up to 18 months after the final interest-rate hike. Second, the lack of correlation between duration and credit risk – absent during the aggressive tightening of 2022 – is normalising, enabling carry to help absorb shocks and rates to support returns amid an economic slowdown
• Why do angels fall – and is it always bad news? Maybe it’s a tough business cycle, or the result of a one-off shock. Perhaps a bond’s downgrade from investment grade is due to the issuer’s intentional change in financial policy. Whatever the reason, understanding why a fallen angel has descended is essential to determining whether these new entrants to the high-yield universe are mispriced and likely to pull to par, delivering returns
• Green stimulus heightens US, European climate risk and opportunity. The Green Deal Industrial Plan from the European Union aims to simplify regulation towards decarbonising energy and industry while diversifying sources of critical materials and technology. Like the US Inflation Reduction Act, it ultimately aims to accelerate progress towards climate goals, and both stand to heighten transitional risks – and opportunities – for credit investors
• A new hedge against investment-grade losses? Fallen angels can be used as a diversifying, more convex or generally up-in-quality high-yield exposure. But we believe they can also complement investment-grade portfolios. Our analysis shows that a relatively small allocation can potentially recover the losses incurred when bonds downgraded to high yield become forced sales

To read more, please download the Q2 issue of Alphorum.

1 Past performance is not a guarantee of future results.

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