Eric Souders

Persistent inflation, elevated real yields and heavy bond issuance from the technology sector are creating a more challenging backdrop for risk assets, but the repricing in bond markets is also producing attractive opportunities for fixed-income investors, according to Payden & Rygel portfolio manager Eric Souders.

Souders said 10-year US real yields around 2.5 per cent were already approaching levels that had historically proved difficult for risk assets, particularly when combined with a stronger US dollar and higher oil prices.

“Higher bond yields, especially higher real yields, a stronger dollar and higher oil prices are all leading to slightly tighter financial conditions. That can put pressure on risk assets,” said Souders.

However, he said the rise in yields was not necessarily signalling an imminent deterioration in the US economy. In some respects, it reflected the opposite.

US earnings grew by approximately 30 per cent year-on-year in the latest quarter after excluding unusually large investment gains, while nominal economic growth was running at around 6.5 per cent.

Souders said the strength of the economy, combined with persistent inflation and uncertainty around fiscal deficits, was helping drive yields higher.

“Growth is not the problem. In fact, growth is probably too strong given the prevailing level of inflation,” he said.

“The Federal Reserve’s reaction function is becoming increasingly clear, with inflation remaining its primary concern. The market should not rule out further rate hikes.

“Our base case is that the Fed hikes within the next meeting or two, with two hikes likely by early 2027,” he said.

With close to two hikes already reflected in market pricing by early 2027, however, Souders said the risk-reward in front-end US rates had become more attractive.

“We have become somewhat more constructive on the front end of the US yield curve. Current pricing is broadly consistent with our expectation for the Fed, while all-in yields are attractive. Investors are being well compensated while they wait to see whether those hikes are ultimately delivered,” he said.

Despite the more challenging backdrop for risk assets, Souders remains positive on credit and believes fixed income continues to offer compelling opportunities. Strong household and corporate balance sheets, relatively low leverage and continued investment in AI all remain supportive.

“We like credit. Investors don’t need to take a lot of risk to generate an attractive yield. You can remain exposed to higher quality assets and build a portfolio that’s yielding roughly 6-7 per cent, which matters when the starting yield in fixed income has historically been the biggest driver of returns.”

He cautioned, however, that investors need to remain selective.

“Software is one area of particular concern, with AI challenging existing business models and making long-term revenues, margins and valuations more difficult to assess. We are comfortable sitting that one out.”

The scale of investment required to build AI infrastructure is also expected to remain an important factor for bond markets.

Souders said the major technology companies had already had a meaningful impact on bond supply and yields.

“The hyperscalers have generated a tremendous amount of bond supply this year, particularly at longer maturities, putting additional pressure on yields. We expect that supply to continue for the remainder of this year and into next year,” he said.

Financing to date has come primarily through traditional fixed-rate investment-grade corporate bonds, but Souders expects the mix to broaden over time to include securitised transactions and bank loans. Regardless of financing structure, he expects the capital requirements associated with AI infrastructure investment to remain substantial through 2027 and into 2028.

“Against an already heavy backdrop of US Treasury issuance, an outsized amount of longer-dated, fixed-rate corporate supply would leave investors with considerably more duration to absorb. All else equal, that should put further upward pressure on longer-term US bond yields,” he said.

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Eric Souders

Despite heightened geopolitical tensions, persistent inflation concerns and ongoing uncertainty around US monetary policy, fixed income continues to offer compelling risk adjusted return potential heading into the second half of the year, says Payden & Rygel managing director and portfolio manager, Eric Souders.

Markets have been forced to navigate a much more complex environment than many expected at the start of the year, Souders says.

“The US economy remains remarkably resilient, supported by strong consumer spending and what appears to be a generational upswing in investment, driven by AI infrastructure and power demand.”

While inflation has moderated from peak levels, he expects it to remain sticky and volatile in the near term.

“Our expectation is that inflation should trend lower over the next six to 12 months, but the path is unlikely to be smooth.

“The challenge for markets is determining whether inflation proves persistent enough to require a more restrictive policy response than is currently priced in.”

He believes the Federal Reserve is likely to keep rates unchanged for the remainder of 2026, despite market pricing that implies some probability of additional tightening. However, he cautions that the path is still uncertain.

“If the Fed does decide further tightening is required, it would probably involve multiple hikes, rather than a single symbolic move, to send a signal to markets.

“But our base case is that they do very little for the remainder of the year.”

Souders says attractive valuations, higher real bond yields and increased potential for monetary easing have boosted the appeal of international markets.

“We continue to see value in international (ex US) and emerging market fixed income. Beyond return potential, these markets now offer genuine diversification benefits not available to portfolios that are heavily concentrated in US assets.”

While private credit continues to offer attractive opportunities, investors should remain selective, Souders says.

“Not all private credit is created equal. The market has attracted significant capital over a relatively short period, much of it during an era of exceptionally low interest rates and optimistic growth assumptions.”

He remains concerned about quality and concentration risks within segments of the private credit market, particularly given the prevalence of lower-rated borrowers and significant exposure to technology and software sectors.

“When liquidity becomes constrained, investor anxiety can increase quickly. We believe there will likely be some challenging outcomes in parts of the market.”

Despite ongoing economic uncertainties, Souders believes the current yield environment presents one of the strongest opportunities for fixed income investors in years.

“Starting yield is one of the best indicators of future returns, and today’s yields are attractive across several segments of the market,” he says.

He nominates BB-rated US high-yield bonds, infrastructure, power, utilities, energy and commercial real estate debt as sectors he is bullish on.

Looking ahead, Souders believes investors should prepare for greater dispersion across markets and sectors rather than broad-based directional moves.

“There are reasons to be optimistic and reasons to be cautious. What matters now is identifying the areas where investors are being adequately compensated for risk.

“In this environment, active management is likely to be the key driver of outcomes, rather than relying on broad market exposure.”

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Nigel Jenkins

In recent years, many investors have shifted towards passive fixed income strategies, seeking lower fees. However, passive approaches have often lagged behind active fixed income strategies. Active management offers the potential for higher returns and can add value through agility.

Active managers can respond to market events with adjustment in asset positioning, a capability lacking in index-tracking approaches. This agility is crucial in today’s uncertain economic environment in our view.

Bond markets have become increasingly volatile over the last couple of years, as interest rates have been raised from ultra-low levels. The market has gone from the certainty of very low and stable interest rates and inflation to an environment where very little seems certain anymore. As a result, the active management of bond investments is highly relevant.

In recent times, we have seen a sharp turnaround from solid expectations that the US central bank would cut interest rates this year to investors questioning whether any rate cut will come at all. As a result of stubbornly high inflation in the US, Treasury yields have jumped. Most recently, a higher-than-anticipated US inflation report for March delivered a dent to bond prices and to market hopes of the dialling back some of the past year’s interest-rate increases. While US inflation is down after cooling in the second half of 2023, it still seems stuck at over 3 per cent.

On top of the uncertainty about inflation, multiple elections around the globe this year add complexity to the bond market outlook. The outcomes of US presidential and congressional elections in November, could be very influential on financial markets. We are watching for potential fireworks. Even before then, there could be other fireworks and surprises from European Central Bank policy decisions, from inflation releases in developed countries and other elections around the world. And that’s all apart from jolts that could come from geopolitical hotspots around the world, especially associated with Russia-Ukraine and the Middle East, but plausibly also from other zones of tension like China-Taiwan for example.

Need for quick action

This uncertainty underscores the need for nimble management. Investors need to be fleet-footed to best preserve their capital and take advantage of opportunities in the bond market, where they emerge.

Importantly, while passive funds offer low fees, they more or less guarantee net of fees underperformance versus their index. Active management, on the other hand, can prioritise risk management and seek to protect investors’ principal.

An absolute return strategy is untethered from traditional benchmarks, so managers can invest where they see the best risk-adjusted returns in the bond market. In addition, active managers have several tools that can help produce alpha and offset downturns, such as varying bond duration, carefully selecting sectors and securities, as well as geographic and currency exposures. Active managers can also use derivatives, the new issue market and other strategies to cushion portfolios during bond market downturns and uncertain environments, such as those currently prevailing.

Contrast that to passive managers, where a manager must work with a given bond benchmark and allocate investments in a rigid fashion; returns of a passive fund are almost entirely driven by the performance of that benchmark. Managers are not able to reallocate portfolio assets across different sectors and respond to market developments very quickly. They are stuck with fixed choices.

If investors are seeking an efficient allocation of capital to the best risk-adjusted return opportunities, it makes much more sense to give discretion to fund managers who can choose the best opportunities rather than simply invest in a portfolio of bonds determined by a market benchmark. Passive funds give you beta, but in bond land, you’ve got nowhere to hide in terms of duration if interest rates start rising. Almost all bond prices will be pushed down.

An active manager can lower duration to reduce sensitivity to interest rates. In a passive fund, investors are essentially rolling the dice with the future and their capital is in no way over the short term, and sometimes not even over the longer term. Whilst the fees might be low, passive funds can lock in underperformance or loss of capital.

Additionally, for fixed income, as opposed to equity allocation, if you are investing in the bonds of corporations in proportion to the amount of their outstanding debt (that is after all how bond indices are constructed – more debt means a higher weighting), you are at risk of locking into the idea that the more debt a company has, the more of it you will own. That is different from passive investing in the equity of a successful company. It grows and you invest more as a passive investor because of that growth. In bond land, you are investing more because a company has got more debt. Is that an implicitly attractive proposition? Not at all, and in extremis it can even expose investors to a greater risk of default.

As active managers, before we consider the direction of markets or the value opportunities that are presented, our first responsibility is to protect an investor’s principal against the potential for loss. Risk management is paramount.

Given that opportunities in fixed income will shift over time, asset allocations should not remain fixed during a credit cycle. The active manager can recognise and add value by identifying opportunities across a broad spectrum of perspectives across multiple bond sectors and issues, and add alpha when dispersion is elevated. While absolute return fund fees will likely be moderately higher than those of passive funds, that can be a small price to pay for the prospect of better capital protection and superior performance over time.

By Nigel Jenkins, managing director

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