Flexing duration: strategies for a shifting global bond market

A consistent theme across the majority of US policies to date under President Donald Trump’s leadership is their likely inflationary impact. In response, fixed income allocators need a dynamic approach to managing duration to hit their target return goals in global bonds.

The reason? A mix of US-led fiscal expansion, trade protectionism and immigration restrictions. Considering tax cuts and infrastructure spending set to boost aggregate demand, as well as expectations of higher tariffs on imports raising input costs for US producers and consumer goods prices, plus a tighter labour supply, especially in low-wage sectors – while the Trump era is a potential source of higher short-term growth, it looks set to come at the cost of persistent inflation and elevated bond yields.

Yet the US isn’t alone in shaping global bond markets. Many other Western governments are running elevated fiscal deficits, leading to increased sovereign issuance and, therefore, upward pressure on yields.

At the same time, central banks are diverging in policy amid a complex environment of moderating inflation and uneven growth. In turn, this is driving currency and bond market dislocations.

Combined with volatility stemming from ongoing geopolitical frictions and trade tensions, the bond market is in flux. 

Against this backdrop, how can asset allocators in Asia balance resilience and vulnerability, to capture potential opportunities from rate volatility while aiming to mitigate downside risks? We believe the key is actively adjusting portfolio duration. 

Agility in allocations

Being flexible is looking like a viable route to enhance risk-adjusted returns in global bond portfolios. Put simply, it can balance capital preservation with the potential for income and price appreciation across market regimes.

This approach can work for several reasons:

• Firstly, higher yields create flexibility to take or reduce duration risk without sacrificing total return.
• Secondly, portfolios can dial up duration when the biggest risk is a ‘hard landing’, but when inflation concerns flare up like we saw on Liberation Day, we believe the most appropriate risk management strategy would be to quickly cut government bond exposure.
• Thirdly, with varying rate sensitivity across sectors ranging from US Treasuries, to corporate credit, to securitised and emerging market (EM) debt, tactical tilts between them can addvalue.
• And finally, liquidity is promising, especially in US rates markets, allowing portfolio managers to adjust exposures efficiently.

Yet dynamic rates management is easier said than done in today’s evolving global bond landscape. Unpredictable rate movements at the hands of central bank divergence and geopolitical uncertainty complicates pricing models and risk assessments.

Strategies to source returns

While credit spreads are already tight across sub-asset classes in the fixed income universe, they could go tighter. This is driven by yield-related demand and weaker government bond markets. 

The potential for spreads to become even tighter, meanwhile, could suggest there is some merit to focusing on segments and names that benefit from elevated yields, such as subordinated bank debt

Global aggregate bonds are a case in point. They could appeal to medium-term investors as the so-called ‘Trump trade’ keeps yields higher for longer.

Investment grade (IG) credit is another potentially attractive source of income, along with its relatively low default risk, especially as central banks begin easing and credit spreads remain supportive. 

Meanwhile, the five-year to seven-year part of the yield curve is potentially more attractive now than the longer end, in our view. That can be an effective plan for fixed income exposure amid the current fiscal, tariff and inflation situation. 

At the same time, in managing duration dynamically, curve flatteners are worth exploring, and potentially outside the US – in the UK, Japan and Germany, for instance, as steepening may be unjustified. ‎

A distinct lens

Ultimately, global bond allocations in today’s macro environment require a broad perspective. And being flexible in allocations requires certain ingredients to explore effective exposure. 

The starting point is a macro-thematic investment process with an objective of delivering stable through-the-cycle returns.

With this in place, regional specialists armed with tactical relative value insights can then seek diversified alpha – perhaps most likely to come from credit allocation on the back of active duration management.

 

Read more about L&G active fixed income expertise. This article was first published on AsianInvestor.net.