Fixed income may be making a slow recovery from one of the worst sell-offs in decades, but institutional investors are still pessimistic about the performance of the asset class over the next year. Many are not seeing the opportunity yet.
Sixty-two percent of 100 institutional investors surveyed by Aeon said they expect to reduce their exposure to fixed income in 2022, with only 11 percent planning to increase their bond holdings. About 48 percent of respondents said they expect to cut their investments in fixed income by more than 10 percent this year. Oumar Diallo, CEO of Aeon, said money is moving into assets that can hedge against inflation, such as commodities, or can provide attractive yields in relatively low risk sectors like structured credit.
But, Michael Contopoulos, Richard Bernstein Advisors’ director of fixed income, warned that over-selling fixed income could prove costly to investors as the market begins to recover from the macroeconomic volatility of the first half of the year.
In a recent report, Contopoulos reminded investors that “returns are greatest where capital is scarce.” Contopoulos wrote that the Federal Reserve’s next step is likely to tame inflation by dampening demand. Growth — not inflation— drives longer-dated bond yields, which means that yields are likely to increase. In fact, Contopoulos noted that while 10-year yields haven’t reached their peak, they are closer now than they have been in the last two years.
“If one were to buy a 10-year Treasury note today, yields would have to increase to 4.3 percent over the next two years before realizing a mark-to-market loss,” Contopoulos worte. “Although this is possible, if we enter a recession between now and then, and yields fall to 1.5 percent, the returns stand to be 17 to 23 percent. Clearly the upside-downside has shifted, creating an opportunity for us that we have not seen in some time.”
In the report, Contopoulos warned that the market will most likely overshoot between now and when this would occur, which is why the firm is now overweight non-index, floating rate products and added investments with targeted credit exposure. For instance, the firm moved investments into floating rate investment grade corporate bonds and AAA-rated collateralized loan obligations. Contopoulos said these are a better use of capital and offer the potential for far better returns than cash in the current environment.
Contopoulos also pointed to opportunities in agency mortgage-backed securities and credit.
“Having an active portfolio that can shift from being conservatively positioned for lower yields to being aggressively positioned to capitalize on credit spread tightening, will ultimately be the path to strong fixed income performance over the coming years,” he wrote.