The rise in US yields and the fear of inflation unsettled fixed-income markets in the first quarter of this year. However, yields have been rising on the back of stronger growth as economies are set to reopen, and the sharpest correction in yields that we saw in Q1 is probably behind us. That said, there is still room for yields to move higher from current levels said Mohammed Kazmi, along with other industry experts, during a recent Asset TV broadcast on fixed-income fund selection.
Indeed, contrary to what happened during the infamous “taper tantrum” in 2013, when the Federal Reserve’s then-governor Ben Bernanke unsettled financial markets by talking up the prospect of tapering asset purchases which caught investors off guard, this time around it is the financial markets that are pricing in a less accommodative approach from the Fed.
The good news here is that, by now, investors appear to have priced in much of the negative effects of higher inflation and a less supportive Fed. Additionally, while it makes sense to hedge against short-term upside inflation risks, it is worth pointing out that it is still not clear if any of the longer-term trends that have kept inflation in check over the past few years, such as globalisation and demographics, have changed. Volatility should also remain under control, given that central banks are more than willing to intervene in financial markets at the first sign of trouble, as we have previously seen on several occasions.
The main challenge for investors is that government bonds no longer provide an adequate risk buffer against equity market drawdowns in a multi-asset portfolio.
On the upside, Kazmi argues, credit spreads are exhibiting lower beta to these equity moves given the central bank backstop. In order to benefit from the expected economic rebound, higher beta segments of credit, such as high yield and AT1s are favoured, where a steeper yield curve should support financials and these parts of the market still offer adequate yield premiums over government bonds. Since the impressive vaccine efficacy results in November, he has also been increasing his exposure to corporate bonds in cyclical sectors such as autos, although he thinks one should stay cautious on areas associated with airlines and downstream refiners that may take longer to recover.
In conclusion, a further uptick in both yields and inflation is to be expected given the strong growth outlook, which has prompted Kazmi to continue to hold a short-duration bias. However, another sharp spike to the same extent that we saw in Q1 now seems less likely, which should generate an environment in which credit spreads can perform well.