NOVEMBER 2024
Bond market resurgence: A new era of opportunity
In this Watchlist...
Adapting to changing market conditions and seizing opportunities as they arise will be key to unlocking the full potential of fixed income investments.
s we navigate the interest rate descent and investors remain optimistic that the economy will see a soft-landing, a compelling case emerges for focus on fixed income. Central
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This presents a unique opportunity for investors to diversify their portfolios and potentially enhance returns. By strategically allocating to bonds, investors can capitalize on attractive yields and capital appreciation.
In our exclusive Fixed Income Watchlist, we hear from managers at Aegon and RBC BlueBay Asset Management as they discuss the trends and themes emerging in the new era in fixed income. Explore:
• How to strategically shift from cash to bonds • Strategies to harness opportunity in EM debt • Can high yield bonds help achieve financial gains and climate goals? • Why a soft landing favours corporate bonds
Harnessing EM debt opportunities through unconstrained investing
Bonds look as attractive as ever. Being nimble will be key
The path forward: High Yield Bonds and climate transition opportunities
INSIGHT
Q&A
WATCHLIST
The business of investment management is increasingly complicated because Consumer Duty means advisers who continue to manage client portfolios themselves face rules akin to asset managers. As a result, a growing number of advisors prefer to rely on MPS to manage assets and focus their efforts on financial planning and maintaining client relationships.
In our exclusive Watchlist, we hear from managers at 8AM Global, Brewin Dolphin, Quilter, Quilter Cheviot, Tatton and Timeline. They discuss the trends and themes driving the sector and explore why:
• Investors may not need to choose between active and passive strategies • Home bias should be a thing of the past • Advisers should be rethinking how to manage investments for clients • That there has never been a better time than now to be an adviser • Read the latest on issues in the sector
odel portfolio services are projected to grow to £154bn by 2028 and their increasing popularity reflects their importance for financial advisors and their practices.
FIXED INCOME
Soft landing favours corporate bonds
banks are increasingly signaling a shift towards accommodative monetary policies, which could significantly boost bond yields and total return potential.
For Professional Clients only and not to be distributed to or relied upon by retail clients. Responsible investing is qualitative and subjective by nature and may not reflect the beliefs or values of any one particular investor. Past performance is not a guide to future performance. Opinions and examples represent our understanding of markets: they are not investment recommendations advice. All data is sourced to Aegon Asset Management UK plc unless otherwise stated. The document is accurate at the time of writing but is subject to change without notice. Data attributed to a third party is proprietary to that third party and is used by Aegon Asset Management under licence. Aegon Asset Management UK plc is authorised and regulated by the Financial Conduct Authority. Adtrax 7178075.1; Expiry 31 October 2025
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For more information about Aegon Strategic Bond Fund, please click here
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Government
Investment Grade
High Yield
Emerging Markets
0%
10%
20%
30%
40%
50%
60%
70%
80%
7%
18%
6%
11%
69%
12%
42%
1%
Average
Range
Source: Aegon Asset Management, as at 30 June 2024. Asset allocation shown for the Aegon Strategic Bond Fund.
Asset allocation range over last 5 years
US Investment Grade Index YTM vs S&P 500 earnings yield
Source: Bloomberg, as at 30 April 2024.
S&P 500 earnings yield (%)
US Investment Grade Index YTM (%)
Alexander Pelteshki and Colin Finlayson, Portfolio Managers
“A way for investors to get back into bonds and the best way to capture the return potential on offer from fixed income markets is through an active and flexible approach”
Graeme Bowden, Regional Sales Manager
Central Banks are cutting interest rates and bonds again offer an attractive yield and a more attractive total return potential after a long pause. Not only that, but we dare to say that bonds in general have not looked as attractive in a very long time. Consider the following; bonds typically carry less risk vs equities and therefore by definition offer a lower expected return (yield). This has sensibly been the case for the good part of the past 20 years, until things changed some 18 months ago. For the first time in this business cycle, investors can de-risk their overall portfolios by moving up the capital structure AND pick up yield along the way! This is a very rare opportunity that we don’t expect to last too long but is still present at the moment.
nvestor allocations to bonds have been low in recent years, with many investors preferring to hold either cash + money market funds or outright equity instead. In the period of low/rising
The main question, therefore, investors need to answer today is not whether to move cash back to bonds, but what is the best way to do that in order to maximize returns while avoiding pitfalls. Geopolitical risk, election cycle, fiscal deficits, these are just a few of the lingering uncertainties in the market today. With volatility still present, the decision on which area of the bond market to invest in can be challenging.
Therefore, the need to be active and nimble in an ever-changing environment is as high as ever. While recession odds are still low (and decreasing) we are undoubtedly in a late cycle environment too. A broad-based extension of this period would see default risks remain low and riskier borrowers benefit disproportionately more. On the other, the margin of error is thin and if the global economy tips into a more material slowdown, it would be the higher quality part of the market that would offer better risk-adjusted returns.
We believe that a way for investors to get back into bonds and the best way to capture the return potential on offer from fixed income markets is through an active and flexible approach.
The Aegon Strategic Bond fund provides a way to access fixed income market opportunities in a fund that can be held through the cycle. The fund has a number of key attributes:
The fund actively allocates across core asset classes of Government, Investment Grade, High Yield and Emerging Market bonds to seek out the best return opportunities – by focusing on the more liquid parts of the bond market, this allows the fund to be dynamic in taking advantage of opportunities and managing risk.
The expected returns from cash vs bonds are no longer compelling: Central Banks are cutting interest rates and bonds again offer an attractive yield and a more attractive total return potential. In allocating back into bonds, investors should favour a strategy that can deal with changing market conditions: allowing them to select one fund rather than having to switch between different fixed income markets. Investors need a strategy that can be consistent in capturing the upside from bond markets though a diversified range of alpha sources and by switching from top-down drivers to bottom – up factors through the market cycle. This approach in our opinion is essential in the coming period and the Aegon Strategic Bond Fund is well placed to capture the opportunity.
I
Concurrently, the other main alternative that investors have flocked to, cash (or money market funds), is past its prime time too, we reckon. Interest rates have peaked; Central Banks are now set to cut interest rates and deposit rates, in turn, are also set to decline. At the same time bond yields are at attractive levels again, offering the opportunity for both income and capital appreciation. So on one hand, you have the expected yield pick up by moving from cash to bond funds, while on the other, you also face the increased technical demand for fixed income in general as cash migrates from money market funds to generic fixed income.
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The key question for investors now isn't whether to shift funds from cash to bonds, but how to do so strategically. Given the current geopolitical climate, election cycles, and fiscal deficits, market volatility remains a concern. Choosing the right bond market segment to invest in can be tricky under these circumstances, say Portfolio Manager's Alexander Pelteshki and Colin Finlayson.
For more information about Aegon Strategic Bond Fund, please tap here
the period of low/rising bond yields and high deposit rates, this made perfect sense. Now, as we enter the next phase of the interest rate cycle, this is no longer the case. Bonds look as attractive as they have been in over a decade. Being flexible will be key.
nvestor allocations to bonds have been low in recent years, with many investors preferring to hold either cash + money market funds or outright equity instead. In
2
bond yields and high deposit rates, this made perfect sense. Now, as we enter the next phase of the interest rate cycle, this is no longer the case. Bonds look as attractive as they have been in over a decade. Being flexible will be key.
For more information about Aegon Global Short Dated High Yield Climate Transition Fund, please click here
“Although there are few high yield companies leading the transition today, many companies are taking credible steps. For that reason, high yield bonds present an intriguing opportunity to invest in companies that are critical to the transition”
Thomas Hanson, Head of Europe High Yield Mark Benbow, Portfolio Manager
Exhibit 3: Aegon AM's Climate Transition Categories
Leader
Ready for a low carbon future and actively driving the net-zero transition
Prepared
Policies, targets and actions aligned toward progress on net-zero
Demonstrating awareness of transition but a mixed degree of alignment
Policies, targets and actions misaligned or unaware of required transition
Unprepared for low carbon future or actively working against climate goals
Transitioning
Unprepared
Laggard
Exhibit 2: Income (not price) is the main driver of high yield returns
-20%
-10%
-30%
Dec 16
May 17
Oct 17
Mar 18
Aug 18
Jan 19
Jun 19
Nov 19
Apr 20
Sep 20
Feb 21
Jul 21
Dec 21
May 22
Oct 22
Mar 23
Aug 23
Jan 24
Jun 24
Sep 24
Price return
Income return
Total return
Exhibit 1: Short-dated high yield offers enhanced yields
Source: Bloomberg and ICE BofA. 30 September 2024. Exhibit 1 includes the following indices: Bloomberg Global High Yield Corporate 1-5 Year; ICE BofA Global High Yield; ICE BofA Global Government Index; and the ICE BofA Global Corporate Index. Exhibit 2 is based on the ICE BofA Global High Yield Index.
7.00
1.00
2.00
3.00
4.00
5.00
6.00
0.00
0.0
2.0
3.0
1.0
4.0
5.0
6.0
7.0
8.0
Yield to Worst (%)
Duration
Global Government
Global Corporate
Global High Yield
Global High Yield 1-5 Year
As a result, climate-oriented investors may initially avoid high yield bonds. However, achieving net-zero requires action from companies at all levels. Although there are few high yield companies leading the transition today, many companies are taking credible steps. For that reason, high yield bonds present an intriguing opportunity to invest in companies that are critical to the transition.
For example, consider a metals company that focuses on recycled aluminium while also demonstrating strong emissions reduction. Or a packing company with aggressive emission reduction targets, a robust net-zero roadmap and dedicated capital investments for climate projects. If you look closely, there are many high yield companies supporting the net-zero transition whilst offering compelling investment opportunities.
By allocating capital to companies that are transitioning their businesses, we can help accelerate change. The path forward may be fraught with challenges, but investors have a unique opportunity today to pursue attractive financial returns in short-dated high yield bonds while also aligning with net-zero goals.
While aligning portfolios with climate goals sounds intriguing, the gap between current reality and global ambitions remains wide. Many companies are early in their net-zero journey, with varying commitments and mixed progress. High yield issuers typically aren’t trailblazers when it comes to emission reductions and climate ambitions. In reality, many lower-quality companies lack commitments, disclosures and resources dedicated to sustainability initiatives.
The critical role of high yield companies
To uncover investments that support a real economy climate transition, we believe it’s critical to combine emissions data with a forward-looking assessment. As a result, our responsible investment specialists developed a proprietary climate transition research framework. We evaluate companies from various perspectives – climate ambitions and targets, emissions and disclosures and management, governance and alignment of company strategy – and categorize issuers based on their readiness and net-zero alignment using a 1 to 5 scale (Exhibit 3). Utilizing our climate research, we design portfolios that follow a climate transition pathway to shift allocations to companies taking action towards a net-zero transition.
Elevated yields and income are only part of the puzzle. Many investors are increasingly focused beyond financial returns as they pursue climate goals. After all, climate change presents a global threat, and significant action is needed to reduce emissions. However, aligning fixed income portfolios with net-zero goals is not straightforward. It requires a pragmatic, multi-dimensional approach to build net-zero aligned portfolios.
Uncovering opportunities to support net-zero
Within global high yield, short-dated bonds offer enhanced yields (Exhibit 1), with lower expected volatility. Importantly, investors don’t need to stretch for the riskiest bonds to increase yield. Many higher-quality bonds offer enhanced yields and high coupons. In our view, adding yield while reducing risk is a win-win trade.
Some investors are hesitant to add high yield exposure given tight credit spreads and macro headwinds. While caution is warranted, we mustn’t underestimate the power of income. Over the long term, income (not price) has been the largest driver of total returns for high yield bonds (Exhibit 2). As the saying goes, it is time in the market, not timing the market that matters. For income-oriented investors, we think short-dated high yield bonds look attractive.
For income-oriented investors, now is the time for bonds. Elevated rates have led to rising yields and increasing coupon rates, offering income opportunities rarely seen in recent years. Although rates are expected to decline as central banks shift to monetary easing, inverted curves still present short-dated investment opportunities.
The right climate for bonds
nvestors today face many challenges. From slowing economic growth and geopolitical risk to climate change, the market is fraught with a plethora of headwinds. The path forward is
Investing in companies undergoing net-zero transition can drive positive change. While the journey may be complex, short-dated high-yield bonds offer a promising way for investors to achieve both financial gains and climate goals, say Thomas Hanson, Head of Europe High Yield and Portfolio Manager, Mark Benbow.
with...
David Hood
For more information about Aegon Global Short Dated High Yield Climate Transition Fund, please tap here
path forward is anything but a straight line. However, these dynamics present opportunities. As investors balance financial returns and climate goals, high yield bonds can play a key role.
nvestors today face many challenges. From slowing economic growth and geopolitical risk to climate change, the market is fraught with a plethora of headwinds. The
anything but a straight line. However, these dynamics present opportunities. As investors balance financial returns and climate goals, high yield bonds can play a key role.
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EM versus other asset classes
Chart 1: Credit rating relative to yield
Chart 2: Duration relative to yield
Source: JPMorgan, BofA, Bloomberg. as at 28 June 2024.Note: EM Corporate (USD) = JPM CEMBI Diversified; EM Sovereign (USD) = JPM EMBI Global Diversified; EM Local Sovereign = JPM GBI-EM Global Diversified USD unhedged; US High Yield = BofA US High Yield Master II; US Corporate = BofA US Corporate Master; Euro High Yield = BofA Euro HY Index; Euro Corporate = BofA Euro Corporate Index; EM Corporate HY = JPM CEMBI Diversified HY, and EM Corporate IG = JPM CEMBI Diversified IG.
Polina Kurdyavko, Head of BlueBay Emerging Markets
“A benchmark agnostic – aka ‘unconstrained’ – strategy can open a portfolio to a wider opportunity set, offering a potentially value-additive approach”
“Although the EMD universe benchmarks are generally robust and suitably diversified, off-benchmark investments can often provide attractive value and enhance returns”
As a result, there has been a proliferation of new unconstrained, total return, and absolute return strategies in the EMD universe – each one with its own philosophy and unique portfolio construction approach, but all promising a smoother return experience.
Historically, we have seen most investors allocating to EMD via benchmarked solutions – either through single sub asset class exposure or through a multi-asset, well-diversified approach. While there is merit in each of these solutions during certain parts of the economic cycle, a benchmark agnostic – aka ‘unconstrained’ – strategy can open a portfolio to a wider opportunity set, offering a potentially value-additive approach.
n uncertain macro backdrop in recent years, and the resulting volatility, has led to investor nervousness around investing in the EMD market. This includes the
challenges surrounding the timing of capital deployment and understanding how to best capitalise on opportunities within the four sub asset classes. Consequently, there has been higher interest amongst investors seeking strategies that can deliver returns whilst navigating volatility through asset allocation.
The asset class also serves as a store of value. The current attractive yield premium is apparent when compared against developed market instruments with similar rating and duration risk profiles.
The sub asset classes have differing sources of returns, for example, interest rates and spreads for hard currency sectors versus local rates and FX for the local currency sectors. These are driven by a diverse set of idiosyncratic fundamental and technical factors and can result in a broad range of return profiles at any given time.
However, EMD is also prone to periods of meaningful devaluation, pushing up yields with the potential to incur significant short-term losses during periods of asset price volatility, driven either by idiosyncratic events within EM or by the global macro backdrop. Asset prices can also be driven by technical factors, such as positioning or liquidity, to a greater extent than in other core fixed income asset classes. As EMD generally accounts for a much smaller proportion of institutional investors’ strategic allocation, non-dedicated investors often shift in and out of the asset class tactically, which can add to the volatility in the price action.
Therefore, a long only benchmarked solution targeting any EMD sub asset class can prove successful during certain parts of the economic cycle, but the overall success of such investments depends as much on the timing of investment as it does on manager skill and selection of underlying beta. For this reason, a strategy that explicitly targets downside protection while capturing most of the upside can smooth out the volatility of portfolios and still deliver attractive returns over the cycle.
As a result of this dispersion of returns, active asset selection across and within sub asset classes is key. We believe that through active asset allocation and judicious security selection, it should be possible to produce superior returns throughout the cycle. In our view, because an unconstrained strategy can consistently exploit the full spectrum of opportunities, it provides a compelling solution for investors.
EMD can be an efficient portfolio diversifier, rich in idiosyncratic return drivers ranging from highly-rated investment grade companies in large Asian economies to the local currencies of various frontier markets, such as those of Sub-Saharan Africa.
1. Value and volatility create opportunity
Four reasons why an unconstrained approach to EMD investing makes sense
EMD comprises four main sub asset classes, which exhibit broadly high inter-correlation over the long term. However, during periods of drawdown, this correlation can weaken.
2. Flexibility in asset allocation permits a nimble portfolio
Although the EMD universe benchmarks are generally robust and suitably diversified, off-benchmark investments can often provide attractive value and enhance returns. Whilst some of these investments can be held on an off-benchmark basis in traditional benchmarked portfolios, an unconstrained strategy can capitalise on the opportunities with statistical significance, due to potentially larger position sizing.
3. Off-benchmark opportunity set can enhance returns
For an EMD investor, it is possible to select hedging instruments that offer asymmetric return profiles. Due to the inefficiency of the asset class, well-recognised risk factors can be notably underpriced, offering an efficient way of hedging some of the risks.
Hedging strategies, such as single country CDS, EM FX, and futures and options, can therefore be implemented systematically to provide downside protection and help preserve returns for investors during market drawdowns.
4. Asymmetry of hedging allows for downside protection
Given the many twists and turns of the EMD asset class – its technical nature, vast opportunity set and inefficiency, all of which can lead to asymmetry of returns – we have found that, delivered correctly, an unconstrained strategy is well placed to meet the needs of clients looking to achieve optimal returns in a risk-adjusted manner. Our EM Debt team has long experience of harnessing the dispersion of the asset class, capturing upside potential across the universe, while smoothing volatility and limiting the downside.
Summary
The emerging market universe is so diverse that geopolitical headwinds are part and parcel of the investment landscape. This often drives the same volatility that can be used to generate returns, says Polina Kurdyavko, Managing Director, Head of BlueBay Emerging Markets, BlueBay Senior Portfolio Manager.
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includes the challenges surrounding the timing of capital deployment and understanding how to best capitalise on opportunities within the four sub asset classes. Consequently, there has been higher interest amongst investors seeking strategies that can deliver returns whilst navigating volatility through asset allocation.
n uncertain macro backdrop in recent years, and the resulting volatility, has led to investor nervousness around investing in the EMD market. This
Four reasons why an unconstrained approach to EMD investing makes sense.
Discover more about RBC BlueBay's Investment Grade specialism here
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“We remain of the view that this golden period for European banks will play out for a lot longer than the market is currently pricing”
Marc Stacey, BlueBay Senior Portfolio Manager
Andrzej Skiba, Head of US Fixed Income
“Active management allows managers to exploit dislocations, benefit from uncertainty and deliver strong returns when clarity emerges”
Cumulative gross relative performance since inception (USD)
Source: Bloomberg and ICE BofA. 30 September 2024. Based on ICE BofA and Barclays index data.
Bloomberg Global Aggregate Corporate Bond Index (hedged to USD
BlueBay Global Investment Grade Corporate Bond Fund
Same with growth, you would normally prefer IG debt from regions with a superior growth trajectory, however that’s not always a recipe for strong bond performance. You could have exposure to IG issuers from a country with a weak growth profile, where aggressive central bank accommodation spurs positive investment returns. Our task as fixed income investors is to consider all these factors when making investment decisions. Balancing short-term considerations with longer-term drivers is not an easy task, but one that is deeply rewarding and fosters a rigorous debate within our teams.
Andrzej: There is no easy answer to this question. You could argue that fixed income assets in low-inflation jurisdictions should do better than those in higher inflation regions. The former is likely to experience rate cuts, while the latter a tightening of financial conditions. However, what matters as well is short-term inflation momentum. Downside surprises to inflation in a high inflation economy could lead to an aggressive rally in fixed income prices as investors reassess severity of the inflation problem.
Q
How can investors benefit from regional divergence (growth/inflation outlook) when assessing IG bonds?
Andrzej: Soft landing, assuming inflation also cooperates, means continued rate cuts by the Federal Reserve and other central banks over the remainder of 2024 and well into 2025. This backdrop is likely to steer investors further out the curve, leading to inflows into credit products. So far, we have seen a limited shift of assets from money market accounts towards longer duration alternatives. Even a small reallocation could have a significant positive impact on valuations in the corporate bond universe.
Moderation in growth, rather than a recession, also implies continued resiliency of corporate balance sheets and only a marginal deterioration in credit metrics. While growth sensitive sectors are likely to see more pressure, the bulk of our investment universe is expected to traverse relatively unscathed through a soft landing economy.
What can we expect from corporate bonds in a soft-landing scenario?
A good example of this dynamic occurred in early August. Fear and loathing spread across the markets as weaker than expected jobs report prompted a major risk unwind across a variety of asset classes. As normally tends to be the case, many extrapolated this price action to suggest an imminent recession and demand an emergency rate cut from the Fed. We felt strongly that investors were overreacting.
Firstly, the payroll report was likely impacted by Hurricane Beryl, so adjusted for that, could have been easily within market expectations. Secondly, as demonstrated by ISM Services release around that time, conditions in the broader US economy remained solid. Finally, much of the sell-off was, in our opinion, driven by the “machines”. CTAs and quant investors got themselves overextended and that triggered a washout of positions across a range of markets ranging from Japanese stocks to AI darlings. All this led us to take advantage of the dislocation, add exposure to credit risk and, shortly afterwards, to benefit from an aggressive rally in spreads as conditions normalized and market panic abated.
Andrzej: We passionately believe that volatility enables alpha generation. Active management allows managers to exploit dislocations, benefit from uncertainty and deliver strong returns when clarity emerges.
With uncertainty around growth, inflation, and government policy, what does ongoing volatility mean for corporate bonds? What are the benefits of active management here?
Marc: The biggest driver for markets in Q3 was without doubt the Fed cutting rates by 50 basis points (bps), and Fed chair Jerome Powell delivering a dovish pivot, though he was at pains in his press conference to underline that the economy remains healthy, assessing risks to the outlook as broadly balanced. He also noted that the 50bp cut is not meant to signal the new pace, guiding listeners to the dot-plot forecasts, which continue to embed less monetary easing than the market expects. Powell reiterated that the Fed was likely to cut by 50bps by year-end if the economy performs as expected. The European Central Bank lowered rates by 25bps to 3.5% at its last meeting, and further rate cuts are expected in coming quarters as inflation comes closer to its 2% target.
What have been some of the key drivers of market returns in IG bonds?
Marc: Q2 was another stellar quarter for European banks from a fundamental perspective. The underlying strength of the sector was underlined by the fact that the beats were driven from multiple sources - rates stayed higher and deposit costs levelled out driving strong net interest income, fee & commissions recovered as activity picked up, asset quality remained benign with cost of risk remaining at historic lows and capital continued to move higher despite increased shareholder returns.
We remain of the view that this golden period for European banks will play out for a lot longer than the market is currently pricing. Central bank rates have stayed meaningfully higher than the market expected and we remain convinced that net interest income is going to remain much more resilient to rate cuts than the market is pricing as we look forward to Q3 results in the coming weeks. After a benign period of economic activity we also see loan volumes starting to pick up, which will accelerate with any rate cuts from this juncture. At some stage we may see cost of risk and non performing loans pick up but for now the outlook remains constructive and we see no reason for this to change in the short term.
With interest rates on the decline, what can investors expect from the banks sector?
Marc: The fundamental resilience of banks is not being fully reflected in valuations but one we are confident should correct over time. Even in light of a possible hard landing, the sector would be coming into any economic downturn from a position of strength and perhaps the best position it has ever been in at this point in the cycle. Bank profitability has increased by +70% over the last 3 years and it is this revenue tailwind that should go some way in shielding any deterioration in asset quality should that occur in the months and quarters ahead.
In fact, 2024 is looking to be an even more profitable year than 2023. Capital levels remain close to all-time highs while the stock of NPL’s are close to the lows. Although we are conscious that these factors are often overlooked in times stress, fundamentals always reassert themselves eventually, and we believe European Bank spreads offer investors better risk adjusted returns.
What sectors could have attractive entry points as rates fall?
Here Andrzej Skiba, Managing Director, Head of US Fixed Income, Senior Portfolio Manager and Marc Stacey, Managing Director, BlueBay Senior Portfolio Manager, emphasise the importance of active management to navigate market volatility and capitalise on regional divergence in growth and inflation outlooks.
Andrzej Skiba & Marc Stacey
In a soft-landing scenario with continued rate cuts, corporate bonds are poised to benefit from increased investor interest and resilient corporate balance sheets. Meanwhile, banks are expected to maintain strong performance, but investors should consider other sectors with attractive entry points as rates fall.
