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For today’s Soundbites, we discuss fixed-income investing with Terry Moore, vice president of T. Rowe Price, and portfolio specialist in the company’s fixed-income division. We talk about the impact of rate hikes, regions and categories he likes, and we started by asking about the current state of fixed-income investing.

TM: Well, as everyone knows by now, the 40-year bull market in bonds is over. Year to date, bond markets have seen their worst performance in decades, as interest rates have moved significantly higher in only a few months’ time. But the reasons for the move are understandable. You’ve got high inflation, you’ve got the Russia-Ukraine war, China’s zero Covid policy and, importantly — very importantly — central banks are going from easy policies to hawkish. Now, the good news is that inflation is likely peaking and should turn lower from here. The bad news is that it’s likely going to settle at a higher inflation rate than what we’ve all become used to over the past decade.

How fixed-income investors should approach the market.

TM: I think it’s very important for everyone to realize that the last few years were extraordinary for financial markets, and they have to normalize. The central banks’ actions of 2020 and 2021 basically pulled forward returns into those years and now we have to give some of that back. So why stick with bonds? Short-term interest rates have moved from basically 0 to 2 or 2.5%, depending on where you are on the short term. Most that pain is likely behind us, but the Fed, Bank of Canada, European Central Bank, other central banks, they all know they fell behind on inflation. As long as inflation stays high, they’re going to have to remain vigilant and continue tightening policy. So, there may be more increases in interest rates ahead of us, but it’s unlikely to be as severe as what we’ve already been through. And the higher yields you receive today can help offset some of that future risk of interest-rate increases. And don’t forget the basics on bonds too. Every day a bond accrues income for you, and that could help cushion any central volatility.

Categories sectors and the regions he likes.

TM: So, interestingly, interest rates and currencies, they’ve both repriced very rapidly. But credit spreads, while they are wider, they’ve actually not widened as much as they normally do in these types of environments. So, while they’ve had negative absolute returns, we actually would have expected even larger negatives. Now, as the central banks continue to remove liquidity, we think some corporates who’ve been used to the easy money, they could come under pressure as we look forward. Thus, we prefer duration risk today over credit risk. And we prefer investment-grade credit over high-yield credit. And then we prefer liquidity in sectors like agency mortgage-backed securities over less liquid assets like securitized credit, which would include things like asset backs and commercial mortgage backs, and non-agency residential mortgage-backed securities. And even EM — emerging markets — are starting to look more interesting to us with its 7% yield — and that 7% is even when you exclude the near-defaulted countries out of the index. You still you get a nice 7% yield. So that’s starting to look more attractive to us.

Fixed income and ESG

TM: ESG is important for fixed income. Throughout the industry, we definitely see more requests for ESG mandates, particularly in Europe, but more recently in Asia and in North America as well. There are initiatives in the industry such as the Net Zero Asset Managers Initiative, where the goal is to have net zero emissions by the year 2050. So, that’s the goal. And several asset managers, asset owners, insurance companies, and others have signed up for this initiative.

And finally, the bottom line on fixed-income investing in the current environment?

TM: Yeah, so even though the first quarter of this year was the worst quarter in the history of many fixed-income aggregated indices, we are not in a 1970s-style inflation environment. Central banks are still independent institutions who will hike until inflation is under control. Now, we can argue about supply-side and demand-side aspects of inflation and what central banks cannot control. But the reality is that the markets rely on credible institutions to help reduce uncertainty in finance companies and governments. So, yes, the party is over. The central banks are taking away the punch bowl. And there will be a few hangovers. But with short-term interest rates at 2% to 2.5% today, and longer-term rates at 3%, forward-looking returns are better than they’ve been in a long time.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Terry Moore of T. Rowe Price.

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