Future of fixed income

The fall in headline inflation in the last quarter of 2023 led many market participants to expect central banks to cut interest rates as early as the first quarter of 2024. Those expectations did not materialise due to the persistent nature of underlying inflation and, more specifically, inflation in the services sector, which didn’t weaken.

Meanwhile, heightened geopolitical risk has increased volatility and, at the same time, there’s been the realization that deglobalisation and the energy transition will be both complicated and costly. In this environment, with risk levels and investor uncertainty high, diversification remains essential from an asset allocation standpoint.

• Over the past 30 years, following the bond market has often been a successful strategy¹. However, the return of inflation, rates volatility and geopolitical uncertainties mean today’s markets demand a more active approach.
• Debt levels weigh on investor minds. The IMF has warned that deficits have stoked inflation and pose ’significant risks’ to the global economy². Given this, many countries will have to walk a tightrope, especially given high foreign ownership of their public debt and any missteps could soon be punished severely by so-called ‘bond vigilantes’. Fiscal dominance is also likely to mean higher rates over the long term, as investors come to terms with a new paradigm of stronger fiscal driven growth, economic uncertainty, and higher ’neutral rates’.
• Many market participants have never experienced this sort of market. Indeed, one of the key challenges facing investors in today’s market is their lack of understanding about bonds, interest rates, and fixed income investing. Our 2023 survey of individual investors showed that as rates were rising, only 2% knew what it meant for bonds³ – current value went down, while future income potential went up. That lack of knowledge, plus attractive rates on cash, made it difficult to move clients back into bonds.
• In other research, of the 2,700 advisers surveyed, 89% said one of their key challenges is to increase fixed income allocations in client portfolios. Perhaps unsurprisingly, at the top of the list of challenges is the uncertainty around interest rate policy. This sentiment may be changing, as inflation reaching target levels in many countries has resulted in rate cuts, and the assumption is that there are more to follow⁴.

Over the medium and longer term, flexibility will continue to be the watchword for fixed income investors. The frequency and number of rate cuts, in a cycle that began in 2024, will determine to what degree investors can take advantage of both rising and falling rates. In short, starting points matter – and if they are too expensive, even great ideas can turn out to be bad investments.