Fixed income is often seen as the dependable corner of client portfolios, but recent market shifts have highlighted both its risks and opportunities. In the following analysis, Richard Parkin (pictured), Head of Retirement at BNY Investments, argues that advisers should rethink the “jobs” fixed income can do, from reducing volatility to generating growth, and ensure that bond strategies are fully aligned with client goals.
By Richard Parkin, Head of Retirement at BNY Investments
Fixed income is more than just the “boring” part of portfolios
There’s nothing that fixed income managers hate more than being told that fixed income is a boring asset class. But for many years, fixed income was perceived as a “steady eddie” investment providing balance to far more exciting and productive equity investments. And then 2022 happened and reminded us that this perception is simplistic and misplaced.
The different “jobs” that bonds can do
At BNY Investments, we talk about the “jobs” we need fixed income investments to do for us and how important it is that we choose the right fixed income tool for the job. The traditional role for fixed income in many client portfolios has been to reduce portfolio volatility. In our recently published research, Shaping Tomorrow’s Portfolios: The strategic role of fixed income, 59% of firms said their primary objective when investing in bonds was to reduce volatility and offset equity market risk. But fixed income strategies can also help preserve capital and generate income, jobs that are essential when thinking about how we support income in retirement.
Higher yields mean bonds can also generate growth
While 2022 was a painful year for many investors, the rise in yields has made fixed income a very attractive asset class for a fourth job, that of generating growth. With yields on a diversified portfolio of investment grade bonds now well over 5%, the potential to generate performance simply through compounding returns means the asset class offers strong potential for growth. And higher yields provide a cushion against price falls that might come from rising rates. This means that the downside risk associated with generating this growth is far lower than it was when yields were at the much lower levels we saw in the years following the Global Financial Crisis.
Advisers are already increasing fixed income allocations
Advisers have recognised this. Our research found that 31% of firms had increased fixed income allocations over the previous 12 months with only 7% saying they had reduced their fixed income exposure over this period. Moreover, 23% of firms expected to increase fixed income allocations over the coming year against 4% who expected to lower them. But we also found that advisers are more alive to the risks that fixed income carries and are responding by increasing diversification across different types of bonds, making greater use of shorter-term bonds, and employing flexible strategic bond funds to navigate changing market conditions.
Strategic bond funds offer flexibility – but carry risks
Strategic bond funds are seen as having the ability to better navigate changing interest rate environments, a feature identified as important by 77% of respondents. 38% of firms also value them as offering one-stop diversification. But advisers are concerned that these funds also carry risks. The biggest concern, expressed by 43% of firms, is the effect concentrated positions can have if the manager’s view turns out to be incorrect. This points to a preference for strategies that seek to add value incrementally from diversified positions rather than pinning hopes on one or two “big bets”.
Complexity and transparency remain a challenge
Another challenge is the complexity and transparency of these funds. Successful fixed income management is complex, involving techniques such as duration management, yield curve positioning, currency hedging and credit risk management. It is incumbent upon us as asset managers to explain clearly what we’re trying to achieve and how we’re seeking to achieve it in a way that not only will advisers understand but which they can easily explain to their clients.
Choosing the right tool for each client outcome
This is where the concept of choosing the right tool for the job comes in. We need to consider how the fixed income approach aligns with a client’s goals and what risks to those goals it might bring. Retirement clients are more likely to hold a higher proportion in bonds. For these clients, managing volatility is important but so is preserving capital. As 2022 showed, some “lower-risk” multi-asset portfolios perhaps focused too much on return generation and diversification and not enough on capital preservation.
Advisers should scrutinise the bond element in multi-asset solutions
Given this experience, we were surprised to find that the fixed income approach employed in outsourced multi-asset solutions was not being given closer scrutiny. Only 7% of firms said they separately evaluated the fixed income element when assessing these solutions. A further 33% said they reviewed it but that it was secondary to overall solution performance and 60% said they focused on the overall solution performance and risk profile not specifically the potential performance and risk of the fixed income element.
Asset managers must take responsibility
As fixed income managers, we recognise our responsibility in making it clear how the solutions we offer, be they multi-asset funds or dedicated bond strategies, align with client goals and what risks there might be in meeting those goals. We continue to look at how we develop and manage solutions that better target client outcomes not just meet assumed levels of risk and return of markets which, as 2022 showed, can turn out to deliver very different outcomes from what clients and advisers expect.
