15 Nov 2023

Aegon Asset Management: Income. From fixed income.

A soft landing or a hard landing? As we look to 2024, markets are still searching for an answer to this key question. In the minds of many investors either of these two very distinct outcomes has a high probability of occurring. Yet they would lead to diametrically opposite asset allocation decisions, so trying to solve categorically in favour of either could leave one exposed to substantial risks in the event of being wrong.

Given the unusually elevated macro risks on the horizon, we believe a focus on a high-quality, predictable stream of returns works in both scenarios. We find this in fixed income. The asset class is again providing both capital preservation qualities and a high level of income, a role it had relinquished in the immediate aftermath of the Global Financial Crisis and the ensuing central bank financial repression.

Let’s look at the possible implications of the two most-commonly quoted macro-outcomes for 2024:

In a soft-landing scenario, growth would be relatively modest, but not negative, while inflation would likely be contained at around current levels and/or still modestly declining. In this case, we assume there would be minimal room for interest rate cuts in the US, and probably only towards the tail end of 2024. It is reasonable to expect some modest rate cutting, as according to the Fed’s own account, monetary policy is already restrictive.

In this scenario, both fixed income and equities would likely do okay. Interest rates would probably fall somewhat, while credit spreads across both investment grade and high yield would likely rally as we price out a recession / reduce the realized default rate. Equities would also benefit as financial conditions ease and corporates make use of relatively cheaper funding, while demand remains in place due to firm employment.

In a hard-landing scenario, growth would be negative, demand would fall and with it, employment as well as inflation. In this environment government bonds would likely perform best, as central banks would be forced to ease materially. Investment-grade credit would fare second best relatively (inherently not a default risk asset class), while high yield and equities would fare worst, owing to depressed revenues and a rise in defaults.

Clearly, two very different sets of outcomes for risk assets, both with a non-trivial probability of occurring. This is one of the most uncertain environments that many investors have faced in a while. It also inherently comes with many lucrative opportunities down the line, if navigated correctly.

In that regard, an allocation to fixed income offers arguably the best risk-adjusted return potential that it has had for some time. The asset class currently offers access to historically elevated levels of yield, without over-committing to a binary outcome. At current levels, bonds have two distinct advantages:

  1. A major return of the traditional income asset class after a 15-year hiatus; and
  2. A free option to de-risk investment portfolios, while increasing yield.

Investing in bonds has traditionally been a conservative asset allocation decision. Their place in an overall portfolio was to provide a steady stream of recurring income, with the benefit of capital preservation. Since the Global Financial Crisis in 2008, global central banks embarked on a massive quantitative easing, which has also colloquially become known as ‘Financial Repression’. The process killed bonds as a natural source of income in investors’ portfolios. This has now changed, and we can again obtain income from allocating to fixed income.

The return of income is evident from the yields on the US investment grade credit and US high yield indices. As global corporate bond yields have more than doubled in the past two years, they now offer another rare and unique characteristic – yield that are higher than equities.

As Chart 1 shows, comparing the yields on the investment grade corporate bond and high yield indices with the earnings yield of the S&P 500 reveals a market opportunity that occurs very rarely and doesn’t typically last very long. This is the ability to de-risk one’s portfolio by moving up the capital stack from equities to bonds, while picking up yield along the way.

Chart 1: Yield-to-worst of US fixed income relative to US equities (%)yield-to-worst.jpg

Source: Aegon AM. From 16/9/2010 to 16/10/2023. Indices are S&P 500, Bloomberg US Corporate Index and Bloomberg US Corporate High Yield Total Return Index.

This is why we find bonds so interesting at present. We do not pretend that we have a perfect foresight as to which macroeconomic outcome is most likely to transpire. However, we also want to be alive to the attractive market opportunities that this uncertainty brings. Weighing the balance of probabilities from a risk and reward perspective, we find fixed income to be as attractive as it has been in well over a decade.


Important Disclosures

This material is provided by Aegon Asset Management (Aegon AM) as general information and is intended exclusively for institutional and wholesale investors, as well as professional clients (as defined by local laws and regulation) and other Aegon AM stakeholders.

This document is for informational purposes only in connection with the marketing and advertising of products and services, and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon AM investment strategies. References to securities, asset classes and financial markets are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions. It has not been prepared in accordance with any legal requirements designed to promote the independence of investment research, and may have been acted upon by Aegon AM and Aegon AM staff for their own purposes.

The information contained in this material does not take into account any investor's investment objectives, particular needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon information in this material is at the sole discretion of the recipient. Investors should consult their investment professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for  purposes of any applicable US federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.

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