Fixed income themes for the next decade

The AI-driven bull run in equities markets may have celebrated its second birthday in October 2024, but the picture had been a little more mixed for fixed income investors. We want narratives in fixed income, too. Yes, numbers matter, but what really helps us understand something is a story – what’s really going on, how the world is changing, and why.

It doesn’t always lead to the correct conclusion of course – often, we end up with what Nassim Nicolas Taleb, of ‘Black Swan’ fame, refers to as ‘narrative fallacies’¹, whereby we fit all incoming data points to a preconceived story, often after the fact.

For fixed income investors, it’s difficult to avoid a narrative that isn’t dominated by interest rates and inflation. There’s no denying market conditions have changed, with a record global tightening cycle and fiscal uncertainties leading to something of a fixed income reset in 2022. Then there’s yield curve dynamics, with the curve moving wildly to defy some of the traditional rules of fixed income.

Still viewed by some as a harbinger of recession, an inverted yield curve – as has been the case since April 2022 – can encourage investors to favour short-term bonds due to higher yields, even if this increases exposure to reinvestment risk if rates fall, and often prompts a reassessment of duration strategies. After all, if a recession or slowdown isn’t on the cards, why take additional interest rate risk for no commensurate increase in yield?

Nevertheless, it remains rates that really count. And while the decline in short-term rates might already be underway, the trend for long-term rates seems much less clear – partly because of the uncertainty over inflation. After a sharp decline from May to September 2024 – from 4.70% to 3.60% for the 10-year yield – US long-term rates rose in October, on the back of better-than-expected economic data and rising consumer prices². However, debate continues about the theoretical equilibrium level of long-term real interest rates, or the so-called R* or ‘neutral rate’.

This matters. Since 2022, while real rates and potential growth have largely converged, nobody knows if this is sustainable, or where R* lies for sure. Some economists argue that the underlying reasons for the situation in the 2010s of so-called ‘secular stagnation’ – when real interest rates had to remain very low in order for economic growth to hold and unemployment to fall – are still present; others describe a new regime of structurally tighter employment, higher fiscal spending, higher nominal growth, and higher neutral rates.

Budgets under pressure

Whichever scenario is true, public debt is certainly one area that is being watched closely by François Collet, Deputy CIO and Portfolio Manager at Paris-based DNCA Investments, who believes it could pose a greater threat over the long term. He commented: “Debt is a topic we have spoken about at length and it remains a concern and not just to us. A number of significant markets now boast a fiscal deficit greater than 3% of GDP³. And recently the IMF warned that deficits have stoked inflation and pose ’significant risks’ to the global economy⁴.”

Meanwhile, many of the structural transitions related to ageing populations, de-globalisation and climate change are likely to continue to foster inflationary tailwinds and higher real rates. Matt Eagan, Head of Full Discretion Team and Portfolio Manager at Boston-based Loomis Sayles also points to security concerns stemming from the geopolitical risks of a multi-polar world and the intense rivalry between China and the US. He commented: “In this landscape, secure supply chains trump low-cost production. Nations, companies, and even individuals seek to reduce their vulnerabilities. And the result is a re-ordering of trade and capital flows into less-than-optimal areas.”

Beyond the impact on inflation and rates, the structural transitions also have a bearing on fixed income’s place in a long-term investor’s portfolio. Xavier-André Audoli, Head of Multi Asset Expertise for Insurance at Paris-based Ostrum AM, said: “When it comes to asset allocation, deglobalization means decorrelation between countries and geographical areas. A more geographically diversified portfolio is a source of opportunities for our clients."