03 Feb 2023
Bond investors’ loyalties were truly put to the test during 2022 as traditional safe havens exacerbated portfolio drawdowns. Fidelity Strategic Bond Fund co-managers Tim Foster and Claudio Ferrarese reflect on these recent challenges and highlight the themes we expect to impact returns across global bond markets from here.
Key points
This article is a summary of a longer 2022 Fidelity Strategic Bond Fund review. You can access the full version here.
The Fidelity Strategic Bond Fund is a one stop shop fixed income solution that seeks to generate attractive risk-adjusted returns over the cycle, while aiming to deliver on the core pillars of bond investing: namely a steady income, low volatility and diversification from equities. Our pursuit of these objectives means there are some structural defensive biases in the portfolio relative to peers the IA £ Strategic Bond sector.
The last year was a period where a traditionally defensive approach like ours was challenged. By now, it will be no secret that high quality assets did not fulfil their usual role of diversification and providing safe haven in a bear market. A key difference we saw last year relative to previous market downturns is that credit sold off across the risk spectrum, driven by outflows on the back of concerns about duration in a rising rate environment.
We see the trend of high quality underperformance reversing into next year as investors begin to differentiate between higher and lower quality issuers. Those at the lower quality end of the spectrum (with less shored up balance sheets) are most at risk in the current challenging economic backdrop from increased defaults. With a huge amount of uncertainty to come, we expect high-quality bonds and diversification more broadly to play an even more vital role in investors’ portfolios.
Duration and interest rates were the primary driver of the negative total returns from bonds in 2022. Relative to peers, we tend to have a longer duration bias and we believe it is important not to lose sight of the benefits that duration provides. Extending duration provides investors with additional yield. The two primary sources of risk in a high-quality bond fund are interest rate and credit risk. If you reduce or even eliminate interest rate risk, you are left with a concentration of credit risk. This significantly increases a portfolios correlation to equities and reduces diversification. We maintain it is important to preserve some balance between the two risks, with value to be added through tilting the balance at the right times.
In a year like 2022, this approach was questioned as the rates shock dominated in every way and ended the multi-decade sovereign bond bull run. Persistent inflation across the world led central banks to pursue aggressive rate hiking, despite the potential to induce a recession. Government bonds experienced a larger drawdown than the S&P 500 - which is not a phrase traditionally found in bond investor’s lexicon - as a result of the severe re-pricing of yields. According to Deutsche Bank, longer-term data showed that it was the worst year for 10yr Treasuries on a total return basis since 1788.
Our longer-than-peers duration positioning was therefore challenging last year, on the back of such extreme moves in government yields and explains the drawdown of the fund. We currently hold a long duration position of 6.0 years but are of the view that yields may go higher still before they fall. Central bank hikes are happening at a slower pace and will eventually stop, at which point yields will rally. As the Fed squeezes in additional hikes in the coming months, we will look to increase duration, especially if yields continue to rise.
This most recent, aggressive hiking cycle will be the positive catalyst investors need to meaningfully shift portfolio allocations back to fixed income. As a result, long bonds versus equities is the consensus trade going into this year, which could lead to strong total returns.
Central banks have come a long way
Source: Fidelity International, Bloomberg, 31 December 2022. Peak rate priced by the market derived from Bloomberg consensus.
We think central banks are now at peak hawkishness and rate hikes will ease as we head into a recession. With inflation numbers falling in the US and UK and surprising on the downside of expectations, the backdrop for a reduction in the pace of hikes is positive and lowers expectations for short term rates. It would be a mistake to structurally under allocate to duration at this point in the cycle, where usually there is on average just eight months between the last hike and the first cut. We especially like UK duration here. Homeowners form an important part of the economic make up and consumer spending and rising mortgage rates will become and increasing issue.
Interest rates across developed markets are now higher than they have been in nearly two decades, which suggests to us that most of the pain in rates is behind us (as illustrated by the chart above). Yields are high and we expect positive total returns for the asset class this year, but it remains to be seen how bumpy the ride will be.
Our favoured part of the market remains investment grade credit, which will have two large tailwinds in 2023. Firstly, the outright yield levels on offer are highly attractive. Investors can now buy yields with similar levels to that of the dividends offered by blue chip companies, with a fraction of the risk they’d take in equities. Secondly, the flight to quality will continue to play out and we have seen this recently with the bifurcation between lower and higher quality parts of the market. We think now is the time to focus on selective alpha opportunities within the high-quality space and also on downside protection.
More generally, we remain positioned to deliver on the attributes of a high quality, flexible, core bond fund, endeavouring to deliver an efficient mix of income, low volatility and diversification from equities.
Performance summary
.png)
Past performance is not a guide to the future.
Source: Fidelity International, 31 December 2022. Basis: bid to bid with income reinvested. Performance relates to the W Inc share class.
This article is a summary of a longer 2022 Fidelity Strategic Bond Fund review. You can access the full version here.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.