Data & Analytics Insights

The worst is behind us, with better times ahead

Jack Fischer

Senior Research Analyst, Lipper

Are we finally coming to the end of interest rate hikes and what will today’s higher-for-longer mean for fixed income allocations?

  • Inflation risk is the main factor that determines the movement of long interest rates and the net flows of fixed income funds.
  • Market reactions and fund flows hinge on perceptions of inflation coming under control and an economic soft landing.
  • Higher for longer could see investors favour short-duration, floating rate, and Treasury funds.

Looking back, fixed income funds suffered their worst year on record during 2022 . The average annual returns for taxable and tax-exempt funds were negative 10.2% and negative 9.12%, respectively. The historical pace at which the Federal Reserve increased interest rates choked the bond market dry and sent investors running for the sidelines as a record-breaking US$695.9 billion piled into money market funds since the start of the year.

With only three modest and widely expected rate hikes through the first half of the year, fixed income funds got off to a strong start with back-to-back quarters of gains. The party ended in the third quarter as yields jumped and longer-duration investments struggled – Treasury funds fell hardest with Lipper General US Treasury Funds realising negative 6.40% on average.

The key to strong performance in 2023 in the bond markets was finding oneself in a floating rate fund or one with short-end exposure – Lipper Loan Participation (+8.54%) and Short High Yield Funds (+4.94%) have reported the highest year-to-date returns through October month end.

To be inactive or not to be, that is the question

Although Q3 was a rough quarter for fixed income funds, actively managed funds outperformed their passive counterparts for the sixth quarter in seven. At year end, actively managed fixed income funds had close to 8.0% in cash on average and as the year progressed, they saw that allocation drop to an average of 4.7% as of their most recent reporting date.

With their cash positions falling, the average duration of active funds increased with fixed income managers suddenly moving to own duration – for reference, passive funds have seen their cash and duration steady around 3.0% and 5.2%, respectively.

Exhibit 1: Actively managed fixed income fund outperformance

We have seen tremendous volatility in fixed income markets and what tends to beat beta during these times is actively managed investments.

While passive flows have been dominated by investors looking to take advantage of short-term Treasury yields and capital preservation, active inflows this year have been into Lipper classifications that allow portfolio managers more leeway to manage their funds.

The top three in year-to-date inflows are Core Bond Funds (+US$48.1 billion), Multi-Sector Income Funds (+US$17.5 billion) and Core Plus Bond Funds (+US$16.8 billion). These three classifications have average durations of 6.11, 4.29 and 6.14 years, respectively, with Multi-Sector Income Funds increasing their duration by 32 basis points (bps) since the start of the year.

Exhibit 2: Top 5 inflows/outflows year-to-date by lipper classification

Ongoing inflation risk

The risk in that lies in long interest rates is our old nemesis, inflation. If the market believes inflation has been subdued and a soft landing is likely, then we will continue to see these three classifications lead in active net flows throughout the start of next year.

Is it possible the effects of rates have not yet been fully realised? Student loan payments have just begun, the commercial real estate market is struggling, credit card balances are soaring and geopolitical tensions remain high. If we see short-term rates stabilise and market uncertainty continue to grow with fear of oncoming recession, short duration, floating rate and Treasury funds may will be the focus for investors.

Year to date we have seen 62 newly launched actively managed funds, with 21 coming in Q3 – most falling under either securitised debt or floating rate funds.

With market uncertainty comes market opportunities– but will the opportunities be long- or short-dated?

It is my opinion that if we stay higher for longer and recession is likely, investors will favour short-duration passive fixed income. If inflation is indeed handled and a soft landing becomes the prevalent outlook, longer interest rates may fall faster than anticipated leading to actively managed intermediate to long fixed income funds reigning in 2024.

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