Commentary: ‘Abandon fixed income’? 3 reasons not to do so

Recent pronouncements by certain marquee investment names would have you believe that bonds and other debt instruments are not the places to invest today and that insurance companies and others who continue to invest in them face a bleak future. From the esteemed Warren Buffett in his annual letter to shareholders to LinkedIn posts by Ray Dalio, bonds are vilified as possibly stupid, and certainly not the place to be for investors.

We understand the possible motivations for that sentiment. These market gurus are not wrong when they point to the remarkable economic recovery, both globally and in the U.S., up from the depths of the pandemic-induced downturn of 2020. They see that central bank largess and fiscal profligacy, while helping the recovery, threaten inflation. They worry about the persistently low interest rates that seem to be starting to creep up. Rising rates mean negative price returns from fixed income, and with the low coupons in today's fixed-income markets, it will not take much to get to negative total returns overall.

But here is where we part company. There are several good reasons why insurers and other income-seeking and liability-focused investors, such as pension funds and endowments, should not fear, but in fact, welcome fixed-income opportunities in today's environment.

‘Lower for longer’ might finally be coming to an end

For more than a decade, insurers' earnings and investment income have been pummeled by financial repression. Higher rates, i.e., opportunities to buy quality at a better price and increase general account book yield, are welcome.

‘The carry trade is back’

As rates rise and yield curves steepen, financial institutions of all kinds — banks, pension funds and insurers — will find more ways to build a "yield advantage" over their implied cost of funds.

‘Liability-driven investing/asset-liability management trumps short-termism’

As an example, insurance companies manage their portfolios to support a complex and cash flow-oriented business. Short-term price fluctuations are far less important than adequate liquidity over long market cycles. Fixed-income securities are tailor-made for this.

For thoughtful investors, there are a variety of strategies for risk-adjusted investing in fixed income that may provide much-needed ballast for portfolios in today's frothy equity markets. Below we note three areas of current interest for insurers and fixed-income asset classes that may help them achieve their goals.

1. Quality and stability in longer-duration assets

Fundamentals are strong in the municipal sectors and we expect this to remain the case as the broader economy continues to recover and $350 billion of direct aid from the American Rescue Plan is made available to state and local governments. Taxable municipals are one of our largest overweights and they aim to provide diversification and high-quality long-duration exposure. While valuations in tax-exempts are less appealing at this time, we are monitoring the space closely as the tax-reform debate may provide an attractive entry point this year.

2. Benefits of diversification

We continue to find value in private placements as we see many deals coming to market with valuations quite favorable compared to public corporate bonds of similar quality and duration. While less liquid than public bonds, these investment-grade securities seek to offer geographic, industry and issuer diversification at attractive spreads. A sector traditionally known for longer maturity offerings and thereby a better fit for life companies, we have seen an increasing number of new issues with short and intermediate maturities, creating opportunities for property and casualty companies to participate.

Our structured product team has been identifying opportunities both in select commercial mortgage-back securities and esoteric asset-backed securities. In CMBS, we see value moving down in credit in seasoned deals that have proven resilient through the pandemic. Particularly for ABS, there are solid fundamentals across many collateral types, allowing for good diversification and modest duration exposure.

The housing market remains well supported as the U.S. economy reopens. While agency mortgage-backed securities appear to be fairly priced vs. corporates and Treasuries, non-agency residential mortgage-backed securities spreads have widened recently as issuance volumes weigh on the market. The sector offers a sizable pickup to corporates and similar duration assets, while providing investors with a more stable duration profile vs. their agency counterparts.

3. Durable opportunities with more risk appetite

Fear that swept through the markets was even higher for lower-rated portions of the bond market in mid-2020 as high-yield default expectations rose beyond 10%. However, accommodative policy response combined with fiscal stimulus led to a more rapid economic recovery, limiting actual defaults to 6.71%, and expectations for 2021 are ratcheting down with most now well below the long-term average of 3.4%. As the prospects for growth rise and fundamentals continue to improve, this provides insurance companies with an opportunity to participate in lower-rated credits.

High-yield bond spreads are, like high grade, historically narrow, but a case can be made for them to grind a bit tighter. When coupled with the backup in Treasuries, this provides an attractive all-in yield for income-oriented portfolios. We maintain an overweight in high yield, seeing value vs. many weak BBB credits as well as fundamental improvements continue.

For collateral loan obligations, similar default concerns existed for the underlying collateral of bank loans but they did not materialize to the extent expected. An asset class that historically has proven durable through challenging market environments, the CLO structure offers an opportunity for investors with varying appetites for risk. Current concerns regarding inflation and rising interest rates have pushed demand for CLOs as their coupons will reset higher along with market rates, potentially providing an additional benefit in owning these structures.

We completely agree with Mr. Buffett's sentiment expressed at the end of his letter: Investors should never bet against America. We would add: nor against the broad, diverse and innovative U.S. fixed-income markets.

Rich Sega is global chief investment strategist and Cindy Beaulieu is a managing director, portfolio manager and chairwoman of the investment policy committee at Conning in Hartford, Conn. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.