Fixed income markets have changed dramatically post pandemic, according to Schroders’ fixed income investment team, and that means a new investment approach is required for this asset class.

“Fixed income did not perform well in 2022 but 2023 was the complete reverse of that. In 2023, the more risk you took the better your return,” co-portfolio manager of the Schroder Absolute Return Income Fund, Adam Kibble, says.

Schroders expects to see continuing volatility in the fixed income market this year due to the ongoing uncertainty surrounding inflation and the economic cycle. That uncertainty is translating into higher volatility rates and greater dispersion between different parts of the fixed income market.

“We've simply entered an environment where we have more macro volatility, and more variability around growth and inflationary outcomes. And in that environment, we will see more variability around asset class returns.” Schroders’ deputy head of fixed income and co-portfolio manager of the Schroder Fixed Income Fund, Kellie Wood, says.

“This requires an active approach to investing and a more dynamic approach to asset allocation. It's also an environment where the correlation between bonds and equities could become quite unstable,” Ms Wood says.

In the post GFC decade, the correlation between bonds and equities was firmly negative, but bond markets have now entered an era where that correlation could oscillate between positive and negative.

“That really requires us to be looking for higher risk premium when we're investing in bond markets or investing in asset classes. What we've also seen play out is a dispersion between regions, countries, and sectors and to be able to invest for that really requires a global capability, where those opportunities can be accessed, especially when we see misevaluation,” Ms Wood says.

“What's great at the moment, and different, is the dispersion in valuations. Some fixed income assets are really expensive, while others look really cheap. And the benefit we've got in our global platform, is we can pick and choose from that, we don't have to be in expensive assets,” Mr Kibble adds.

This means, for example, that Schroders is exiting exposures to US corporate securities which are currently in the most expensive quintile in the history of their spreads.

“What we're holding instead is European investment grade, Australian investment grade and we also like Tier 2 Australian subordinated debt from the major banks as it is cheap relative to its history. The other asset class that we really like is US securitised assets,” Mr Kibble says.

“These are mortgage-backed securities, asset backed securities, which are delivering about 1 per cent above US investment grade, and they've got a high credit quality,” he adds.

A bottom-up stock selection process is also important in an environment where the government is employing more active fiscal policy. When the government has more control over resources more winners and losers are likely.

“And this is where active bottom-up stock selection can really help us in avoiding the losers and certainly avoiding the defaults,” Ms Wood says.

Given this outlook, and the potential for a number of both economic and inflationary possibilities, Ms Wood says Schroders approaches bond market investing by considering a number of different scenarios and positioning its fixed income portfolios so they can outperform, via a mix of both capital and income returns, in any of these conditions.