As Fed battles inflation, fixed-income investing regains popularity, purpose

As Fed battles inflation, fixed-income investing regains popularity, purpose
Experts advise taking advantage of higher bond yields while bracing clients for the near certainty of a recession.
OCT 03, 2022

For the first time in a long time, financial advisers and portfolio managers can say with a straight face that allocations to fixed income represent the biggest area of opportunity.

While inflation is still seen as the biggest risk facing the financial markets, the Federal Reserve's efforts to slow the pace at which prices are rising without pushing the economy into a severe recession have increased the appeal of bonds.

“Over the last several years, a lot of pundits have talked about not having a high degree of income and ballast in fixed income, but today you can create a portfolio north of 6% yield with the who’s who of North America,” said Gautam Khanna, head of the U.S. multisector fixed income team at Insight Investment and manager of the BNY Mellon Core Plus fund.

“When you consider the kind of macroeconomic uncertainty we’re living in right now, that’s a lot of ballast,” he said.

Khanna was part of a panel discussion on fixed-income investing hosted by InvestmentNews last week.

While the panelists had an easy time justifying allocations across the fixed-income spectrum, they're keeping a watchful eye on Fed policy.

“One of the core risks for managers is thinking you can do a set-it-and-forget-it strategy,” said Haley Wood Bates, a financial adviser with Signature Estate & Investment Advisors.

“Our goal with clients is to make sure we’re nimble and flexible,” she said. “The greatest risk is stretching for yield and not being mindful of credit risks.”

Stuart Katz, chief investment officer at Robertson Stephens, agreed that now is not the time to be sitting on one’s hands when it comes to fixed-income investing.

“Valuations are not necessarily cheap in fixed income on a broad basis, so the need for active management will be critical here,” he said.

In terms of opportunity, Katz cited tax-loss harvesting and “stepping up in quality.”

“We haven’t seen this kind of opportunity in fixed income in decades,” he said.

But the situation is nothing if not dynamic, which means advisers will need to keep track of a moving target linked to the rate of inflation, which has been hovering stubbornly above 8%.

“Historically, once inflation goes above 5%, it’s never come down until the Fed funds rate has risen above CPI,” Katz said, suggesting the Fed will continue to push interest rates higher.

“We think the inflation journey from 8% to 5% will be much easier than from 5% to 2%,” he said. “The other key aspect is that once inflation is above 5%, it’s never been tamed without a recession.”

Khanna agreed that Fed policy is heading toward 5%, but he isn’t giving up hope that what the Fed has done already won’t start making a dent in inflation at a 40-year high.

“Monetary policy takes time for the effects to be felt in the real economy, and we don’t know how much effect monetary policy has already had, but we still think they will get to 4.5%,” he said. “The Fed is not in the business of deliberately causing recessions, but with monetary policy the way it is, the likelihood of recession is quite high.”

The current Fed funds rate is around 3%. Bates said the financial markets are already pricing in a Fed funds rate of 4%, but she isn’t sure about 5%.

With that in mind, her firm has been adjusting client portfolios, including allocations to fixed-income alternatives including structured notes, middle-market lending and real estate.

“We moved swiftly into these spaces,” Bates said.

She has also advised clients to take advantage of the Treasury's inflation bonds, which have been gaining appeal for their high yields, even though they come with some lock-up commitments.

“I have been recommending I bonds to clients,” she said. “Certain clients are feeling antsy and want to do something. This is a place where you can park a bit of cash.”

Regarding the outlook for a recession, Bates described it as “very probable.”

“It will be a very challenging pathway to a non-recessionary event,” she added.

Khanna said that parts of the economy are already in recession and that the odds of an overall economic downturn are “quite high.” In the meantime, he said investors should be taking what the bond market is giving them.

“Right now, I think smart money would suggest that you want to own fixed income, especially if you think a recession is in the cards,” Khanna said.

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