Why this asset class could be the "flavour" of 2023

As a millennial with, hopefully, many years of investing in my future, I have never really considered fixed-income investments for my personal portfolio... That is, until now. 

That's because, as Schroders Australia's deputy head of fixed income Kellie Wood explains, after an objectively terrible year for fixed income, there are now attractive yields on offer with much less risk compared to what continues to be an incredibly volatile equity market. 

"We've seen government bond yields move from 1% a year ago to now offering around 4%. Investment grade credit from around 2% to now yielding 6%. And asset classes like global high yield last year were offering us around 4%... it's now around 9-10%. So we have seen a huge restoration in fixed income across the whole universe," she said. 

"The year to be out of fixed income was 2022. But the year to be back investing in fixed income is 2023." 

In this wire, I'll summarise the key learnings from Schroders' latest media roundtable, as well as why the investment manager believes fixed income looks particularly attractive over the year ahead. 

Why fixed income will once again become fashionable in 2023

While Wood is the first to admit that fixed income was not the place to invest in 2022, she reveals the team at Schroders has started to increase duration in its multi-asset portfolios, as they believe the world - particularly the US - is set to face a recessionary environment over the year ahead. 

"We believe fixed income is now a better diversifier to equity risk at much higher levels, and will provide investors with low-risk income given the yields on offer," she said. 

According to Bloomberg, the 60/40 portfolio model (60% risk assets like equities, 40% defensive assets like fixed income) is on course for its worst year since the Global Financial Crisis. In late November, the 60-day correlation between the Bloomberg Global Aggregate Bond Index and the MSCI All Country World Index climbed to its highest level since 2012, with both stocks and bonds heavily being sold off this year thanks to rising interest rates. 

"This year, we have seen central banks embark on the most aggressive tightening cycle ever," Wood said. 

"It's only now that we are starting to see a peak in underlying inflation, but also cracks in terms of economic growth. The market has continued to price, over the last few months, a soft landing - that central banks will be successful in taming inflation without a recession." 

That is very unlikely to be the case, she said. Instead, inflation will likely remain stickier and higher for longer. Worse still, the risk of recession is very real in 2023.

"If you look at the level of inflation in the developed world, and you compare that to central bank targets around 2%, that gap makes it very hard, or very challenging, for central banks to engineer a soft landing," Wood explained. 

"Our recessionary indicators are suggesting a 60% chance that the US goes into a recession next year." 

So what about the RBA (and Australia, for that matter)? Well, earlier this week, our local central bank lifted the cash rate by another 25 basis points (meaning, we are now at 3.1%). 

"The RBA has struck a more cautious tone in terms of their policy path, but also a better balance between growth and inflation," Wood said. 

"The risk for the RBA here is that we are yet to see a peak in inflation and wages are starting to accelerate given the tight labour market. So there is a risk that growth holds up in Australia for longer. This means the policy path is likely to be higher for longer, compared to most other countries." 

The end of the 60/40 portfolio model

As has been well documented both on this very platform and on many other financial websites (like Bloomberg as mentioned above), the 60/40 portfolio model was unable to preserve investors' capital as it should have in 2022. 

"The 60/40 portfolio model has been under pressure for a while," Schroders Australia's CIO and head of multi-asset Simon Doyle said. 

"This year, with bonds and equities selling off, there's really been nowhere to hide except cash, so absolute returns have been quite poor. The diversification that bonds have in theory offered to equities has broken down." 

However, going forward, bonds are "very much relevant", Doyle added. In fact, with the risk of a global recession high on Schroders' radar, the team believes a 50/50 portfolio model is better suited to this challenging environment.

"This year has been one where inflation has come through, yields have had to rise, and equities have sold off to be repriced to a higher level of interest rates. It's been that interest rate story that has driven markets," he said. 

"I think next year will be about the growth outlook and the impact of those higher rates on economic output. A recession will impact profits, so I think it will be a challenging year for equities over the next 12 months." 

Bonds, on the other hand, could provide some good offset to the weakness in equities, he argued. 

"Certainly, as we move into next year, I would be overweight bonds," Doyle said. 

"The challenge in the environment moving forward is that markets will start to focus on downside growth risks over and above rising inflation," Wood added. 

"We are still negative on asset classes like equities and global high yield. We much prefer government bonds and investment-grade credit in an environment where we think there is a real risk of recession, higher defaults, much weaker growth and a recessionary-type collapse in interest rates." 

Where the team is finding opportunities 

During 2022, the bias in defensive portfolio allocations has been absolute return products and cash. However, over the year ahead, that is unlikely to be the case, Wood explained. 

"The products without a lot of duration risk have certainly been quite successful through most of this year," she said. 

"But as we enter 2023, the restoring of asset classes like government bonds, as well as high-quality corporate bonds, are probably our two favourite asset classes." 

In a recessionary environment, duration-based fixed income is where investors want to be, Wood argued. 

"Diversified fixed income products alongside absolute return fixed income products will certainly be the 'flavour' as we move into 2023," she said. 

"Today, we are seeing very attractive levels within this asset class in terms of income and the real risk of recession sets fixed income up to be an outstanding asset class for next year (in terms of performance)."