CIO Insights: Bond voyage! Our no-nonsense guide to fixed income

Kick-start your journey into the wide world of bonds

15 minute read

The past two and a half years have been turbulent times for fixed income. A combination of soaring inflation, macroeconomic uncertainty, and rapid interest rate hikes contributed to the biggest bond bear market in history.

But with bond yields now at their highest level in nearly 25 years, this rocky period has also provided a great reset for the asset class. As we reach a turning point and global central banks begin to cut interest rates, this could create opportunities in different corners of the bond market.

In this month’s CIO Insights, we deep dive into the asset class and explore how to think about investing in a diversified fixed income portfolio.

Key takeaways:

• The fixed income universe is vast and diverse, offering a range of opportunities for investors seeking relatively stable and predictable returns. Each of the market’s various sectors – from government bonds to high yield securities – provides a different risk-return profile to suit individual risk appetites. 
• Income generation and relative stability are two reasons to consider bonds. Bond coupons, or the periodic interest payments distributed to investors, offer a steady flow of passive income. In addition, bonds offer lower volatility compared with equities and can provide a buffer during economic downturns – making the asset class a strong diversifying component in a multi-asset portfolio.
• Diversification and effective portfolio construction are key to managing risks. Diversifying your bond exposure by investing in broad-based ETFs or funds is one way to help mitigate credit risk. The data also show that active management can benefit bond portfolios in terms of security selection and asset allocation, as can staying attuned to macro conditions. Here, our Economic Regime Asset Allocation (ERAA®) investment framework optimises its portfolio allocations according to the prevailing environment.
• A “great reset” in bond yields now offers a renewed opportunity for fixed income investors. With interest rates at their highest levels in nearly 25 years, bond investors are better positioned compared to the zero-interest rate environment just 3 years ago. In the current inflationary growth environment, our  ERAA® framework has taken a "barbell approach" with allocations to short-duration bonds and higher-yield credit.
• How should you consider incorporating bonds into your portfolio? It depends on your financial goals, life stage, and risk tolerance. If steady income is your priority, consider an all fixed income portfolio to take advantage of current high yields. For investors seeking total return, a balanced approach incorporating bonds and other asset classes can offer both income and potential capital appreciation. In general, investors’ exposure to bonds tends to increase with age, and the key is to align your investment strategy as your needs evolve over time.

The fixed income universe offers a wide level of risk points to suit diverse risk appetites

Before we dive into the details, let’s start with the basics: fixed income is a broad category of investments that provide a regular stream of payments (hence the name). Bonds are a common type of fixed income security that represent a loan made by an investor, the lender, to a borrower, such as a government or company. 

Like a loan, the borrower promises to repay the principal amount at maturity along with periodic interest payments, known as coupons. The total return an investor can expect from a bond – taking into account its coupon payments and any difference between the purchase price and its face value at maturity – is known as the bond's yield to maturity (YTM). (Check out Bond Market Basics at the end of the article for an explanation of key terms.)

And you may not realise it, but the global fixed income market is one of the largest securities markets in the world: it was valued at US$130 trillion as of 2022, according to estimates from the Securities Industry and Financial Markets Association. That’s more than the US$101 trillion market capitalisation for global equities. 

It’s also diverse, comprising a wide range of sectors based on attributes such as the type of issuer, credit quality, and maturity – each with different risk and return characteristics. Here’s a quick overview of the market’s largest sectors:

Government bonds

Government debt is the largest segment of the global fixed income market, and refers to bonds issued and backed by national governments (though it can also include bonds issued by government agencies and local governments). The US government bond market is particularly important for the global fixed income market due to its deep liquidity and high efficiency. The interest rate on US government debt is often referred to as the “risk-free rate,” as it serves as a key benchmark for other interest rates and is crucial for valuing securities globally.

Because these bonds are backed by the government's creditworthiness, they are generally less volatile and offer lower yields compared to other bond sectors. This also is why they tend to appeal to more conservative investors seeking predictable returns with lower risk. The chart below illustrates that US government bonds – especially those of shorter duration – have the lowest volatility among major fixed income sectors.

Corporate bonds

Corporate bonds are the second largest sector of the fixed income market, used by companies to raise capital for expansion or operations. This type of debt tends to be divided into two main categories, depending on the creditworthiness of the issuer: investment-grade bonds, which have higher credit quality and lower default risk, and high-yield bonds, which have lower credit quality and higher default risk. As their name suggests, high-yield bonds tend to offer higher yields than investment-grade bonds to compensate for their higher risk.

Emerging market bonds

Debt issued by governments or companies in emerging markets (EMs) is a growing sector of the fixed income market. These bonds can be denominated in hard currencies – widely accepted, stable currencies – like the US dollar or the euro, or the country’s local currency. EM bonds tend to offer higher yields compared with those issued by developed markets (DMs), to compensate for risks associated with generally higher economic, political, and currency volatility.

Securitised products

This growing sector of the fixed income market refers to assets that are securitised – that is, pooled together and repackaged into bonds. The most common type is mortgage-backed securities (MBS), which represent the bundled cash flows from the mortgage payments of residential homeowners. Bonds that are backed by auto loan payments, credit card payments, or other types of loans are referred to as asset-backed securities (ABS).

The bond market offers a spectrum of returns to match its range of risks

To match their unique risk profiles, each of these fixed income sectors offer varying levels of returns to investors. The top chart below shows each sector’s yield spread, which is the annual yield over what you would get from the risk-free rate. To isolate credit risk (more on that later), we can compare their yields to US Treasuries of similar maturities, as shown in the bottom chart. From this, we can glean a few takeaways:

• Currently, most major fixed income sectors offer yields below the risk-free rate. This is unique to the current interest rate environment, and is likely to reverse when the Fed starts to cut interest rates.

• When accounting for duration, most of these sectors offer yields above US Treasuries of similar maturities – particularly EM and high yield. That said, many still have spreads below their historical averages. This suggests their valuations are relatively less attractive.

• Elsewhere, ABS offer spreads above their historical averages – as do US aggregate bonds and MBS to a lesser extent. This points to potential opportunities in these asset classes. US investment-grade corporate bonds appear fairly valued.

Fixed income can offer investors with cash flow, relative stability

Given the above, under what circumstances would an investor consider including fixed income in their portfolios? There are two main reasons: income generation and capital preservation.

Income generation

For many investors, the reason for investing in a fixed income portfolio is simple: they have regular cash flow needs and would like to match that with a steady flow of passive income. 

That’s because bonds provide predictable cash flows via periodic coupon payments – unlike stock dividends, which are discretionary in nature. In addition, investing in bonds offers the potential for higher yields versus keeping your money in cash deposits, as the asset class has a historical track record of outperforming savings accounts in terms of income generation.

Capital preservation 

Fixed income securities – and more specifically, high-quality bonds that are held to maturity – also offer attributes of capital preservation and stability when compared with equities. As part of a multi-asset portfolio, they offer diversification benefits and can often lower overall portfolio volatility during periods of market turbulence. 

For example, as the chart below shows, during recessions like those during the Global Financial Crisis or the onset of the COVID-19 pandemic, bond returns were positive as the asset class benefited from investors seeking safety.

Diversification and effective portfolio construction can help to manage risks in bond investing 

The primary risks in bond investing involve credit risk (the chance that an issuer defaults on their obligations) and duration risk (the change in bond prices due to interest rate changes if a bond is sold prior to maturity). While these risks can't be eliminated, they can be managed through diversification and effective portfolio construction.

Diversification through funds

Passive bond funds like ETFs offer investors access to institutional-level diversification and professional management at a low cost. For example, the iShares Core Global Aggregate Bond ETF holds over 15,000 individual securities. This level of diversification would be impractical, if not impossible, for most individual investors to replicate.

Active bond funds have also demonstrated value in the fixed income space. A study by PIMCO shows that US active fixed income managers outperformed their passive counterparts by 23 basis points (bps) annually over the past 10 years. This is in stark contrast to equity funds, where active fund managers underperformed by 93 bps annually – possibly due to the more efficient nature of the equity market.

Effective portfolio construction

While bonds are generally less volatile than equities, their prices can fluctuate due to interest rate changes and shifts in credit spread. As mentioned above, duration measures a bond's sensitivity to interest rates, with longer-maturity bonds typically more volatile during periods of rate changes. Credit spreads reflect default risk perceptions, widening during economic downturns and narrowing during recoveries.

The economic environment significantly influences both these factors, making it crucial for fixed income investors to stay attuned to macroeconomic conditions. At StashAway, our Economic Regime Asset Allocation (ERAA®) investment framework adjusts bond allocations in our portfolios based on the prevailing economic regime. For instance, in the recent environment of higher inflation, it called for increased allocations to ultra-short-dated bonds in our lower-risk General Investing portfolios to mitigate the impact of the Fed's aggressive rate hikes.

A “great reset” in rates offers new opportunity for bond investors

Following an aggressive rate hiking campaign from the Fed and other global central banks, interest rates have experienced a “reset” – now at their highest levels in nearly 25 years. That means income seekers are in a much better position compared to the zero-interest-rate environment just 3 years ago. For one, real rates are positive – which means at current rates, US government bonds offer about a 2% return over inflation.

In the current inflationary growth environment, investors can consider a “barbell approach,” or a strategy that aims to balance risk and reward via exposure to different ends of the risk spectrum. For example, we believe allocating to short-duration bonds and high-yield credit makes sense – especially since the yield curve remains inverted (i.e., short-dated bonds still offer higher yields than longer-dated ones), and the economy remains strong with default risks remaining low for now. 

As for risks, although there are pockets of concern in the US commercial real estate market, it remains a small segment of the overall fixed income market. In addition, data suggest that ample liquidity should keep systemic risks low – for more on that, check out our 2024 Mid-year Outlook.

Furthermore, while we expect a higher-for-longer interest rate environment could persist, a higher starting level for interest rates offers some cushion against potential price fluctuations. For example, take a bond with a 5% yield and a 5 year duration. Interest rates would need to increase by more than 100 bps to completely offset the income generated over one year. The chart below illustrates this close correlation between bond yields and their returns over the past several decades, of about 94%.

Taking action: how should you incorporate fixed income into your overall asset allocation?

Your approach to bond investing should ultimately align with your life stage, financial goals, and risk tolerance.

With longer term goals in mind, a 10–20% bond allocation in broad market ETFs can provide stability and growth potential for young professionals (or those between 25–35 years old). Mid-career investors (35–50) might increase this to 20–40%, diversifying across government, corporate, and international bonds, while near-retirees (50+) often shift towards a 40–60% bond allocation, focusing on high-quality, investment-grade bonds.

Remember, while these guidelines provide a helpful framework, your investment strategy should be tailored to your unique financial situation. Regardless of your age, a higher allocation to a diversified portfolio of bonds can help to achieve shorter-term goals, given their lower volatility.

Whether you're prioritising income, total returns, or a mix of both, bonds can play a crucial role in your portfolio. The key is to align your bond investments with your overall financial plan and adjust as your needs evolve over time.

A good starting point is our new Income Investing portfolio, powered by J.P. Morgan Asset Management. As a bond-focused portfolio built on the principles of diversification and low volatility, it not only offers reliable income but also gives you the flexibility to adjust your payout preferences as your needs evolve.

Bond Market Basics

Coupon

The fixed interest payment that a bond issuer agrees to pay to bondholders, typically an annual percentage of the bond's face value.

Face value

The amount the issuer promises to repay at maturity, which can differ from the bond’s market price. It also serves as the basis for calculating coupon payments.

Maturity

The date on which the bond's principal amount is to be paid back in full.

Yield to maturity (YTM)

The total return an investor can expect from a bond held until it matures, taking into account both coupon payments and any difference between the purchase price and face value.

Yield spread

The extra yield a bond offers compared to a benchmark rate, usually government bonds. A higher spread can mean higher risk.

Yield curve

A graph showing the relationship between bond yields and maturities. A normal yield curve slopes upwards, with longer-term bonds having higher yields. An inverted yield curve slopes downwards, with longer-term bonds having lower-yields.

Risk-free rate

The theoretical rate of return of an investment with zero risk, often represented by the yield on government bonds.

Credit risk

The possibility that the company or government that issued the bond will default – that is, failing to make scheduled interest or principal payments.

Credit rating

A grade given to bonds indicating how likely the issuer is to repay the debt, assigned by independent credit rating agencies 

High-yield

Bonds that offer higher interest rates to compensate for their lower credit quality.

Investment-grade 

Bonds with higher credit ratings, considered to have a lower risk of default.

Duration

The weighted average time until all cash flows from the bond are received, used as a measure of how sensitive a bond's price is to changes in interest rates.