Why the old rules of fixed income no longer apply, and what to do about it

For many years investors have relied on fixed income (bonds) to limit their overall portfolio losses when equities fall. However the negative correlation investors relied upon is no longer consistent. In an era of shifting global alliances, sticky inflation, and decoupling economies, the global economy and investment assets are not performing the way they used to.

In this Q&A, François Collet, Chief Investment Officer at DNCA Investments talks to Claressa Monteiro from The Business Times about:

• Why markets are behaving in unexpected ways
• How positive correlation between stocks and bonds requires a rethink of global asset allocation
• How fixed income can help fight inflation and
• Where active fixed income genuinely earns its place in investment portfolios today.

This is an edited version of the Q&A from the original interview.

Claressa Monteiro: We have experienced highly turbulent and unpredictable markets lately. From your vantage point, managing money through all of this, what has genuinely surprised you about how markets have behaved?

François Collet: The war has been quite difficult to predict and during the past five years, I think that we had a lot of events that were almost unpredictable: COVID, Ukrainian war, Iranian war. All these kinds of events are repeating even faster, and it's very difficult to navigate fixed income markets, and I would say overall markets.

We are in a time that seems much more complex than any time in the past. Two important factors have surprised me this year:

1. The first thing is, despite there being a divergence between economies, and countries in very different economic cycles, you're still seeing very high correlation between all fixed income markets. This year Canada has been in recession versus the US being very strong. Australia has been very strong, while New Zealand has had a recession as well.
   
   But at the end of the day, whether you were investing in New Zealand, in Canada, in Australia or in Europe, it was almost the same as being invested in Europe. And this is something that is shocking me. The fact that all markets are behaving in the same direction despite the fact that countries are decoupling from one another.
   
   
2. The second thing which is intriguing or astonishing me is the belief of the market that central banks are going to succeed in their inflation targets. It's been more than five years since the Fed was able to bring inflation back toward two per cent, and the market is still thinking that it is going to deliver over the next few years. Then you have a new Fed chair who comes in and says: "No, with me it will be different," and the market goes all in in the same direction thinking that Kevin Warsh will bring inflation down toward two per cent. It may be wishful thinking.”

Claressa: For years, the conventional wisdom was quite simple. Hold equities for growth, hold bonds for safety. Does that rule still hold, or has the role of fixed income actually fundamentally changed?

François: Yes, if you want to invest in growth, if you want to invest in the future, you should stick to equities. I think that's the best opportunity long-term, no doubt about that. But fixed income gives you a kind of a steady coupon, which is very attractive for risk-averse investors.

Also, what was very interesting for years was to mix equities and fixed income because at the end of the day, fixed income investments tended to pay off when economy cools down, which is not the case for equities. So the idea was to mix both of them, and reduce your risk and enhance your risk-return profile.

The fact is that this theory of negative correlation between fixed income and equities stands very strongly when inflation is under control. It was the case from the mid-'90s until 2020 — it's not the case anymore. Inflation is above target like it was during the '70s or the '80s (and keep in mind that back at that time we had positive correlation between fixed income and equities) and we now have this positive correlation between fixed income and equities again, making global asset allocation much more difficult than during the '90s or at the beginning of this century.

Claressa: Passive investing has become enormously popular. What are the honest advantages of both approaches and where does active management genuinely earn its place in fixed income today?

François: There is, generally speaking, one advantage from passive investments in fixed income is that it's cheaper most of the time.

Nevertheless, I think that people who can afford to pay for good fixed income portfolio managers do it because these managers tend to outperform the benchmark. I think that more fixed income managers beat the benchmark than equity portfolio managers because fixed income markets are slightly easier to predict, generally speaking. This is because the return to fair value tends to be much shorter in the fixed income space than in foreign exchange, or equities, where you can have prices disconnected from valuation for years at a time. It's not like that in fixed income. You can have disconnection for a few months, but it's not going to last forever like it can in equities.

So, I would say that if you can pick the right fixed income portfolio manager, you should stick to them. Generally speaking, it will be worth the investment rather than a cheap investment in passive solutions.

Claressa: With inflation a very real, daily challenge for investors, what can fixed income realistically do to help us preserve our purchasing power?

François: You have a part of the fixed income market that was launched three decades ago which can help — it's the inflation-linked bond market. 

You can buy inflation protected securitiesⁱ, but the issue is that they don’t always give you a positive yield against inflation. For example, during the last decade and beginning of this decade, you had negative real ratesⁱⁱ, meaning that when you were buying these securities, you were sure to lose some purchasing power in the future. And that is why people have been disappointed by this asset class in the past. 

However after 2022, and the strong rise that we've seen in inflation, now that central banks have been restoring monetary policy toward a more normal level, we are back seeing positive real rates. That means that you can buy these inflation protected securities at a positive spread versus inflation, meaning that it protects your capital against depreciation, which inevitably comes with inflation.

Claressa: Fixed income often has a reputation for being dull. How do you answer that, and, in practice, how can investors decide when to stay defensive versus lean into opportunity across duration, credit quality, geography, currency, and sector exposure?

François: Well, being dull is not that bad. Fixed income brings greater safety to your investments, which is a key point for investing. And yes, we all need some sources of safety because you can't just rely on equities having very good years. Keep in mind that if get a 50% return one year, and the following year you get minus 50%, you will end up in two years at minus 25%. That's something that people don't necessarily understand.

To the question of how to decide when to stay defensive versus lean into opportunity: that's a very important thing to have in mind.

So first, it’s very important to have clear understanding of where we stand in the economic cycle. And second, having an idea on valuations. 

A lot of people do not correctly understand the fixed income market. They believe that the level of yield of the bonds that they buy will explain their performance in the future. It's not that simple, here’s an example which explains why:

• Would you prefer to invest in US Treasuries at 3%, when money market rates in the US are at zero? 
• Or would you prefer to invest at 5% if money market rates are at 7%? 

Obviously, the correct answer, if you don't want to take currency risk, is the first answer. Your level of remuneration is much higher than the cash rate. That means that whether you buy bonds should not be judged by the level of rates, but by the slope of the curve.

Having said that, you have to take into consideration that investors need to measure the risk. When you buy a 30-year bond, a very small movement in rates is going to have a huge impact on the performance of your bond. So having a good notion of how to manage the different risk premiums on the fixed income market is, I think, the secret sauce to be able to deliver returns over time.