Rethinking Fixed Income Allocations

Lenny McLoughlin

Chief Investment Strategist

Inflation has fallen significantly over the last two years and is not far from the ECB’s 2% target, yet monetary policy remains restrictive. Structural headwinds in the Eurozone may limit inflationary pressures going forward, allowing the central bank to ease policy by more than is currently priced. In this environment government bonds are attractive both in terms of return potential and their diversification characteristics.

The macro backdrop has changed markedly over the past few years. In 2022, the global economy faced an inflation shock for the first time in decades. Central banks moved from the notion of “transitory” price pressures to embarking on the sharpest rate hiking cycle in 40 years. The resultant higher yield environment – the 10-year German bund yield was close to 3% in October 2023 compared to 0% in January 2022 – tightened financial conditions. This helped push inflation down substantially, allowing central banks to start easing in 2024 with further rate cuts expected in 2025. We believe the trend towards looser monetary policy is more clearcut in the Eurozone, where disinflationary dynamics are expected to continue.

Our long-term expected returns for fixed income have increased from a few years ago due to a combination of higher yields and a benign inflation backdrop.  This supports the case for allocating to core rates. In the event of a negative growth shock, currently elevated policy rates provide room for central banks to cut rates aggressively. In such an environment bonds would provide protection in a multi-asset portfolio, at a time when riskier assets are likely to struggle.

Moreover, the case for raising duration as a hedge against non-inflationary growth shocks is supported by historical analysis. During low inflation environments where the 12-month rolling return of the S&P 500 has been below -10%, longer duration bonds have outperformed their shorter duration counterparts, including during both the unwinding of the Dot-com bubble and the Global Financial Crisis. Given our base case that inflation remains under control, we believe that extending duration can enhance overall portfolio resilience.

In riskier parts of the fixed income universe, credit spreads currently appear tight compared to historical averages. This is reflected in the lower long-term expected returns we now see for high yield bonds, investment grade corporate bonds and emerging market sovereign debt. With banks having retrenched globally, opportunities to earn higher returns from private credit have come to the fore. The seniority of some of these assets means they rank relatively high in the capital structure, while also offering superior yields to equivalent publicly traded credit[1], meaning they also look attractive on a risk-adjusted basis.

ILIM’s Bottom Line

Global inflation has been on a downward trajectory since peaking in 2022. We expect this trend to continue and for it to be more pronounced in the Eurozone, allowing the ECB to loosen policy by more than is priced in at present. Government bonds look attractive given the healthy yield on offer, with the potential for capital gains from those with longer duration. With tight credit spreads having reduced expected returns for riskier bonds, allocations to private credit make sense in our view, especially given the superior risk-adjusted returns on offer.