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Bond market volatility to rise, high yield attractive

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Fixed-income investors, all investors for that matter, should be prepared for ‘higher market volatility’ for the remainder of 2021, according to independent asset manager Neuberger Berman.

The comments come from their recently published outlook report for the September quarter of 2021, titled ‘Course Correction or Policy Framework Change’, in which heir extensive fixed income team outlines the outlook for every major sector of fixed income markets.

Whilst widely known in institutional and pension fund circles, most advisers will know the firm primarily for their listed investment vehicle, the Neuberger Berman Global Corporate Income Trust (ASX:NBI). NBI offers investors diversification into the massive Global corporate credit market, but represents only one part of the diverse expertise the group has built since 1939.

It is over this period that the group has built an understanding of the importance of separating the ‘signal’ and the ‘noise’ of markets, but particularly when it comes to the communication of central banks including the US Federal Reserve. In their view, whilst many may pass the Fed’s more recent ‘hawkish’ comments about inflation off as ‘noise’ it should in fact be treated as a ‘signal’ for a long-term change in direction.

The result is that fixed income investors ‘should be prepared for higher market volatility’ and an ‘upward bias in interest rates’, neither of which are comments that traditional long-duration, buy and hold or ‘balanced’ investors would be happy to hear. Traditionally the low risk portion of portfolios, the need for flexibility, diversification and an understanding of relative value across and within asset classes is likely to be more important than ever.

Hawkish comments from the Fed clearly suggest that the ‘the period the economy will be allowed to run hot may be shorter than expected’ something reiterated by the clear change in the Fed’s approach to inflation. As highlighted extensively, their new decision making framework will ‘emphasize inflation directly’ rather than relying on unemployment or NAIRU as a potential indicator of future price increase.

Despite the hawkish tilt of the latest meeting, Neuberger highlight that the US is now in quite a difficult position with employment growth ‘relatively disappointing’ but both wages and inflation surprising to the upside. They make four conclusions from the meeting, the first being that one way or another ‘market volatility is set to rise’ as both the Fed and European Central Bank are expected to taper bond purchases before the end of 2021.

They also expect markets to be increasingly responsive to economic data, rather than brushing it aside quickly as has been the case in recent years and months. Similarly, the highlight the risk that rate rises can and will be steeper than markets currently expect.

On the positive side for investors of all stripes ‘right tail outcomes’ or those in which inflation spikes and remains elevated for an extended period of time are unlikely, with the probability having reduced in light of the Fed’s latest commentary.

Turning to the investment opportunities, the group remains broadly neutral towards high quality Government and corporate debt, noting that the economic recovery and signs of inflation may actually be supportive to a ‘deleveraging’ of the corporate sector and ensure ‘defaults’ remain muted. That said, investment grade credit and government bond spreads remain ‘relatively tight’ with carry the major source of return.

The greatest conviction lies within high yield or sub-investment grade credit, where the group has specialised for decades, noting that any volatility around ‘taper talk’ from the Fed should be seen as an opportunity to increase exposure. Expanding they confirm that the sector ‘has generally performed well in prior periods of rising inflation and steepening yield curves’.

Finally, turning to emerging markets, the group is constructive on the opportunities afforded by an expected, albeit slow, normalisation in interest rates and elevated commodity prices. They suggest that local currency debt is still ‘largely undervalued’ with emerging economies likely to be ‘less vulnerable’ to Fed-induced policy volatility than in previous periods. They cite the lower external funding needs, competitive exchange rates and generally higher rates, as being the key differences.

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