CONTENT BLOCKS
FIXED INCOME STRATEGY
A COMPELLING MOMENT
April 15, 2024
IN PARTNERSHIP WITH
I

READY, RESET, GO!

Plan sponsors have a singular opportunity to rethink their fixed-income approach — and how to implement it.

Fixed Income Strategy Webinar

Our panel of fixed-income experts cuts through the market complexities to share what’s top of mind for the different types of institutional clients today. You’ll also hear what’s current in fixed-income indexing and the use of actively-managed ETFs, new developments in systematic indexing, and opportunistic segments – including private credit.

Featuring

Henry Hughes
Portfolio Manager
Fixed Income Pensions Solutions
Goldman Sachs Asset Management
Nicholas Godec
Senior Director, Head of Fixed Income Tradables
S&P Dow Jones Indices
James Palmieri
Managing Director, Senior Portfolio Manager and Head of Structured Credit for the Fundamental Active Fixed Income Team
State Street Global Advisors
MODERATED BY:
Howard Moore
Associate Editor, Custom Content
Pensions & Investments
Wednesday, April 17, 2024
2:00 p.m. ET

It’s a great time for institutions to own fixed income. Yields are more attractive than they’ve been in several years, inflation is slowing and the Federal Reserve is poised to start cutting interest rates. What’s not to like?

Given the stark difference from the environment just two years ago — rates near zero, yields correspondingly low and bonds moving in lockstep with equities — institutional allocators have a compelling opportunity to reassess their fixed-income strategy and positioning. They can pursue liability matching, income, total return and diversification, all while maintaining high credit quality with reasonable risk exposure.

The comeback story

David Furey, global head of fixed income strategists at State Street Global Advisors, cited the impact of higher yields on funding positions as a key reason why fixed income is making a comeback in the pension world.

Higher yields, particularly for Treasuries and investment-grade corporate debt, have translated into much improved funding levels for plans, he said. “Many plans are now in the enviable position of being able to shift from trying to close their previous funding gaps by investing in risky growth assets, to derisking their portfolios using liability-matching assets such as fixed income. Pensions’ funding positions are quite good, and fixed income can serve as a very effective way to match their liabilities conservatively.”

Gurpreet Gill, a macro strategist for fixed income and liquidity solutions at Goldman Sachs Asset Management, pointed to several additional factors that are making fixed income more popular. The first, she said, is that “the escape from a low-yield world has been bumpy, but it now presents investors with a new area of opportunity. You’ve got income and total return potential, which is a complete reversal from a world where there were no reasonable alternatives to riskier assets.”

She noted a couple of other interrelated catalysts. “Higher yields mean that bonds can once again cushion multi-asset portfolios against downside growth volatility, which they hadn’t been able to do for some time. That, in turn, is connected to the concept of normalizing inflation, which should allow the correlation between bonds and equities to become less positive and even return to negative. This normalization just reinforces the value of having bonds in a multi-asset portfolio.”

Positive macro backdrop

Expected changes in macroeconomic conditions are perpetually top of mind for fixed-income managers and strategists. This is particularly true today, when the environment appears set to transition from high rates and above-target inflation to a bond-friendlier regime of falling rates and lower inflation.

Many plans are now in the enviable position of being able to shift from trying to close their previous funding gaps by investing in risky growth assets, to derisking their portfolios using liability-matching assets such as fixed income.
David Furey
State Street Global Advisors

According to Nicholas Godec, head of fixed income tradables at S&P Dow Jones Indices, the economy may be entering a period of rates and inflation moving sideways, subject to some volatility.

“We think bondholders could potentially benefit from being long duration, and a lot of investors are tactically positioning themselves further out on the curve; while a downshift in rates could also support borrowers, who would be able to either borrow or refinance on better terms than they would have found not so long ago.”

Henry Hughes, CFA, a fixed income portfolio manager at Goldman Sachs Asset Management, believes that inflation is falling and financial conditions are easing from peak tightness, which should be positive for bonds.

In terms of portfolio positioning, he said, “we think this is a really exceptional time for pension schemes to be adding to fixed-income allocations. They can lock in high yields to build cash flow-matching and liability-immunizing strategies that will enable them to reduce volatility going forward. The higher-yield environment means that this is a great opportunity for fixed income from both an income and a total-return perspective.”

He added, “We haven’t had this kind of yield environment in over a decade, and it’s the first time in two years that both inflation and central-bank policy rates will likely end the year lower. There is a more predictable path for monetary policy, which is creating a more opportunistic environment for other fixed-income assets, such as securitized and corporate credit.”

Fixed-Income Allocation of P&I Top 1,000 DB Plans
Source: Pensions & Investments Top 1,000 Plan Surveys (https://researchcenter.pionline.com/rankings/plan-sponsors/summary)
All data as of Sept. 30 of the respective year.

Watch for headwinds

Despite the good macro vibes, fixed income could face meaningful headwinds that could knock the positive trend off course. SSGA’s Furey said he is most concerned with any potential reacceleration of inflation, which alongside strong GDP growth is “the obvious elephant in the room.”

If it were to happen, “there would need to be a reassessment of the rate cuts that have already been priced into the market. If inflation starts misbehaving again, then we’re also into credibility issues with the Fed, which can take a long time to overcome,” he said. Other things that might undermine investor confidence are federal budgetary issues and the potential for a significant increase in U.S. Treasury issuance, both of which could push Treasury yields higher.

SPDJI’s Godec sees default risk for the lowest-rated credits resulting from higher rates as a significant possible headwind. Illiquid markets and speculative-grade high yield present concern, he believes, because elevated rates are especially costly for the most speculative ratings tiers or the riskiest borrowers within those tiers.

To GSAM’s Gill, the biggest potential dangers could come from technical factors, geopolitical uncertainty and anything that might persuade central banks to maintain their respective rates at current levels. “Sometimes technical forces can create fundamental moves in markets. We’re very focused on the interaction of central banks’ quantitative tightening programs and the withdrawal of liquidity alongside new bond issuance,” she said. “There will always be end demand for government debt, especially with the liquid markets like U.S. Treasuries, but what really matters is, at what price?”

In addition, Gill continued, “one of the biggest risks is that the hopes for an economic soft landing may, unfortunately, conflict with a geopolitical hard landing. There’s a lot of geopolitical uncertainty out there, and we have to be alert to the potential inflation risks when there are renewed supply-side disruptions.”

Beyond that, she said, “the market is quite jittery about the reaction function of central banks, and anything that disrupts that could force the banks to keep rates more elevated for longer. That is a key risk for bond markets this year.”

Read: Controlling Risks in Systematic Active Fixed Income Portfolios

Investors are also looking to enhance returns using multi-sector credit strategies that invest across the credit spectrum: investment-grade and high-yield bonds, bank loans, emerging market debt, securitized debt.
Henry Hughes
Goldman Sachs Asset Management
II

WHERE THE OPPORTUNITIES ARE

With auspicious conditions across fixed income, plan sponsors can seek out several attractive segments.

Fixed-income professionals have varied perspectives on how to best position portfolios for the expected macro environment. One thing they agree on is that institutions should focus on high-quality instruments, especially Treasuries and investment-grade corporate debt.

In the view of SPDJI’s Godec, “Investment-grade corporates tend to have strong benefits in terms of their overall yield profile and relative credit safety. Triple-B issues, for example, currently yield 5.8%, which is around 30 basis points higher than the overall corporate index, and they also represent the largest segment of the investment-grade corporate market — around 45% of total issuance.”

Commercial real estate: Time for reappraisal?
Source: S&P Dow Jones Indices. Data as of March 5, 2024.

Seek out potential upside

Godec also comments on emerging markets corporates: “The iBoxx USD Emerging Markets Corporates Investment Grade index yields 5.8% at the moment, with a duration of 4.3 years. In other words, emerging high-grade corporates have nearly half the duration exposure of the developed-markets U.S. dollar investment-grade corporate market with a credit profile similar to that of overall investment-grade corporates,” he said. “Triple-B issues account for about 40% of the EM investment-grade corporate market. This means that the 5.8% yield from triple-B U.S. corporates is also available from emerging corporates, but with a broader credit exposure of triple-Bs plus some in the single-A range.”

Commercial real estate-related securities don’t check the quality box these days, given the continuing post-pandemic impacts on office space, rising costs and stressed valuations. However, Godec observed: “Rising interest rates and and increased vacancy rates have driven most of the widening in spreads for commercial mortgage-backed securities,” he said. “If rates were to fall, that would be beneficial for commercial real estate borrowers. Their debt costs would go down and they’d be able to refinance on better terms. We’d also point out that falling rates would make real estate more cost efficient for commercial tenants, meaning that occupancy rates could potentially rise.”

Regarding spreads, Godec cited the Markit iBoxx Trepp CMBS Office index as a measure of commercial real estate with the greatest exposure to the office sector. The index’s spread, he noted, currently is around 66 basis points higher than its five-year average but it has narrowed thus far in 2024.

Read: 2023 Fixed Income Index Products Annual Report

Use a quality lens

GSAM’s Hughes is positive on the outlook for high-grade bonds. “Yields are close to their highest since the financial crisis, which allows pension plans to generate attractive levels of income and match cash flows while taking less credit risk. They are focused on high-quality, liquid fixed income to meet these investment objectives,” he said.

Hughes made the case for broader quality exposure. “Investors are also looking to enhance returns using multisector credit strategies that invest across the credit spectrum: investment-grade and high-yield bonds, bank loans, emerging market debt, securitized debt. A key benefit is that you can dynamically allocate to where the best opportunities are, based on the market environment.”

[Fixed income indexing] can be used to manage cash flows and as a liquidity sleeve for quick beta exposure for macro and relative-value trading. There are many different ways that active investors can use these tools, and they are driving growth today.
Nicholas Godec
S&P Dow Jones Indices

Duration is paramount

While duration positioning is always important, one could argue that it’s especially critical now — given the inverted Treasury yield curve and the Fed seemingly poised to cut rates.

SSGA’s Furey said he favors taking duration in the intermediate segment of the curve — from the three-to-five-year range to 10 years — but he would reevaluate this positioning if the market begins to price out currently expected rate cuts. He also sees the potential for a slight steepening bias in the five-to-10-year portion of the curve, as the shorter end could potentially outperform the 30-year part.

“We would prefer to allocate risk to duration now, rather than to curve positioning,” Furey said. “We think that long duration can provide hedging benefits versus some of the late-cycle credit concerns that could manifest themselves. These concerns can hit high yield and the lower rungs of investment grade. If that happens, then owning Treasuries with a bit of extra duration can help to offset the risk.”

GSAM’s Gill, however, noted that pension plans are placing less emphasis on duration at the moment. “Broadly speaking, our pension clients are looking to immunize their duration risk, and that’s both from an overall and a curve perspective,” she said. “They would prefer to add value in their fixed-income portfolios through corporate credit, earning carry and corporate security selection, rather than active duration. Duration is not their primary driver of returns.”

Public vs. private

Much is made about the popularity of private credit these days — as well as its merits versus public fixed income. While private credit enjoys generally higher yields and often provides the ability to create bespoke lending terms, public markets offer trading liquidity and much greater transparency.

But plan sponsors don’t have to choose one over the other. As GSAM’s Hughes sees it, each can play a role in fixed-income allocations, depending on the needs of the asset owner. Some require significant liquidity, while others can take a longer-term view to generate additional returns, he said.

“Our institutional clients have a broad approach to liquidity management,” he said. “On one hand, property and casualty insurers need a high degree of cash flow to pay claims, often with lower predictability. They tend to manage short-duration, high-quality, highly-liquid portfolios.”

For pension plans, Hughes added, “it’s critical that their cash flow-matching portfolios factor in options for liquidity management, particularly when they’re managed alongside derivatives that are used to hedge liabilities. Collateral management is very important to these investors.” To help meet these portfolio needs, GSAM deploys reverse-repo transactions in government bonds and corporate credit, as well as other tools to embed liquidity management options into the broader portfolio construction.

Life insurers and pension plans with longer-dated liabilities are on the other end of the liquidity spectrum, Hughes said, noting that private markets present an appealing opportunity. “If you’ve got a longer investment horizon, you can afford to provide liquidity to markets and harvest the illiquidity premium. That’s where we’ve seen huge interest and opportunity in strategies such as private credit, particularly the senior direct-lending space and open-ended private credit funds.”

SSGA’s Furey expressed some caution regarding the public-versus-private debate. He observed that the current environment is one of the first instances of a potential cycle slowdown — SSGA forecasts U.S. GDP growth to cool a bit in 2024 — in which investors have significant allocations to private credit. “Investors appreciate that private credit isn’t as liquid. But it is credit at the end of the day and will be affected by the public markets’ credit cycle. Investors understand this, but there’s just much greater transparency and liquidity in public markets.”

“It’ll be interesting to see how those private assets play out if we do have a material downturn,” Furey continued. “It calls for managers to exercise vigilance and scrutiny. That said, I’m not sure investors should be overly concerned about liquidity issues with private credit, because they already know that those assets are illiquid.”

public and private credit strategies offer wide investment universe
Source: Goldman Sachs Asset Management. For illustrative purposes only. As of September 2023.
III

MOMENTUM BUILDS FOR INDEXING

Fixed-income indexing picks up speed as allocators seek new ways to add value and use passive as a complement to active management.

Indexing has long been a fixture in the equity market, but much less so in fixed income. This is changing, though, as fixed-income indexing strategies gain volume and momentum.

SPDJI, which focuses on the adoption of index-based products and tools, sees strong activity in exchange-traded funds, which historically have favored indexing strategies. “We saw continued adoption of fixed-income ETFs in 2023,” Godec said, “with assets under management ending the year at around $1.9 trillion, versus about $1.5 trillion at the end of 2022. Putting that into perspective, fixed-income ETF AUM was around $817 billion five years ago. So AUM for fixed-income ETFs has more than doubled in just the past five years.”

Godec is optimistic about the continued growth of fixed-income indexing, with demand coming both from institutional and non-institutional investors, such as digital wealth platform and model portfolio users. The key driver for institutions is “to understand that these are not just passive investment vehicles, but rather tools for an active investor’s toolkit,” he said. “They can be used to manage cash flows and as a liquidity sleeve for quick beta exposure for macro and relative-value trading. There are many different ways that active investors can use these tools, and they are driving growth today.”

As for non-institutions, said Godec, “we see fixed-income indexing ETFs increasingly adopted by model-based portfolio strategies and digital-wealth platforms due to their liquidity benefits and to index-based ETFs’ ability to standardize key market exposures.

Godec added that he expects growth in actively managed fixed-income ETFs. “Active managers are looking to take advantage of the ETF wrapper, which includes benefits like liquidity, broad diversification, and trading and tax efficiency. Several active managers launched active strategies in fixed-income ETFs in 2023,” he said. “There was also an upsurge in creating new fixed-income ETF products that systematized nonlinear exposures.”

Read: Bear (Market) Necessities: The Case for Core Fixed Income

Disaggregating benchmarks

SSGA’s Furey said he sees the disaggregation of fixed-income benchmarks as a growing source of institutional demand for passive strategies — and it can provide the customization that allocators need to meet their portfolio targets. Essentially, this involves breaking benchmarks into their smaller sectoral components — he calls them “building blocks” — and reweighting the components as needed to best execute the institution’s strategy.

Demand for SSGA’s disaggregation capabilities is high, as plans become more outcome oriented in the individual parts of their fixed-income portfolios. Furey also noted that the use of indexed building blocks facilitates asset allocation and enables investors to gain market access more efficiently and quickly. “I’m not just talking ETFs here, as they account for about a quarter of [SSGA’s] $600 billion or so in indexed fixed-income strategies.” he said. “Our indexing book is dominated by institutions looking for more customization of their fixed-incomes exposures or benchmarks.”

“We also see the case for indexing alongside active management because certain parts of the fixed-income markets are good for active and others are not,” Furey added. “Other indexing areas of growth that we see are also in the more complex parts of the market, such as U.S. high yield and emerging market debt.”

Looking ahead, Furey is bullish on fixed-income indexing. “The allocation of fixed-income AUM currently is about 90% to active strategies and 10% to indexing. While the indexing share may never get to 40% or 50%, as with equities, it could certainly double to 20%. We estimate that there’s about $3 trillion in indexed fixed-income assets globally, and we could see that increase significantly over the next five years.”

A different active approach

SSGA takes a balanced view on active management versus indexing in fixed income, seeing important roles for both styles. Institutions should take the active route in sectors where managers have demonstrated that they can add value, Furey said, noting that he has observed a structural decline in managers’ ability to add alpha consistently.

Systematic fixed income management: a data-driven, rules-based approach
Source: “Building a Portfolio: A Closer Look at Our Process,” State Street Global Advisors, August 2023.

Improvements in the breadth and frequency of pricing fixed-income instruments are improving the transparency and information efficiency of the fixed-income markets, he added. SSGA has developed a quantitative active strategy known as systematic investing. The firm implements the strategy and the Barclays Quantitative Portfolio Strategy group provides the research for it.

“Our systematic credit approach builds portfolios by scouring the entire credit market and evaluating securities based on several factor signals that have been shown to drive returns,” Furey explained. “These factors include value, or whether a bond is cheap versus its peers; momentum of the issuer’s equity, which correlates with the performance of its bonds; and sentiment, which analyzes shorting activity in an issuer’s stock.”

Furey added that SSGA’s indexing heritage, which has strengthened the firm’s bond-trading skills, has also helped it to innovate in systematic investing. “Our trading is highly granular. We have a lot of daily flow, and we manage it very efficiently,” he said. “Electronic trading has been a huge boon for index managers, and it has paved the way for systematic. We have a lot more insight and data points intraday on a bond than we’ve ever had before. Investors have certainly benefited from this.”