Amy Xie Patrick: How to position for income when bond yields are moving fast

In an environment where yields can move sharply and inflation risks can re-emerge quickly, income positioning is less about stretching for the last basis point and more about preserving flexibility. AMY XIE PATRICK explains

• Oil shocks fuel inflation fears; yields jump
• Importance of staying flexible
• Find out about Pendal Dynamic Income Fund and Pendal Monthly Income Plus fund

EXOGENOUS shocks tend to do two things.

First, they reveal and force the unwind of extended positioning, particularly where prices have drifted too far from fundamentals. Second, they force markets to confront risks that were easier to overlook when volatility was low.

Since early March, the geopolitical escalation in the Middle East has done both.

The immediate market focus has quite naturally been on oil. Disruption to key shipping routes and the risk of a prolonged impairment to energy flows have pushed crude sharply higher and introduced a new layer of uncertainty into every major asset class.

But the oil shock has not landed on a clean slate. It has collided with a market that was already carrying crowded trades, complacent assumptions and a willingness to extrapolate benign outcomes too far.

That was visible first in precious metals. We understand the structural desire to own gold and silver in a world where traditional safe havens no longer feel as safe as they once did. But the scale of the move had begun to imply something more extreme: not merely caution, but a broad loss of faith in money itself.

Recent price action has challenged that view.

As real yields have risen and the US dollar has strengthened, gold and silver have looked a little less lustrous. In periods of real stress, investors often rediscover their preference for cash, liquidity and instruments with a known nominal value.

The more important adjustment, however, has been in bonds.

The rise in yields has been a classic 1–2 punch.

The first blow came from the oil shock itself. Higher energy prices immediately raise concern about headline inflation, especially when supply disruption appears geopolitical rather than cyclical.

The second blow came from something more uncomfortable: the shock has forced markets to reckon with the fact that, in the US at least, the disinflation story had already become stuck well before the latest escalation.

Core inflation has not been convincingly falling for some time. So rather than being treated as a short-lived nuisance, the oil move has landed on top of an already fragile inflation narrative.

This, however, doesn’t explain why real yields have risen just as hard if not harder than breakevens. The former usually tells us how the market feels about future growth prospects, while the latter tells us about the market’s inflation expectations.

I can’t explain why yields have moved in this way. One theory might be the market fearing greater government bond issuance to help consumers with higher prices at the pump. Nevertheless, this current picture is certainly not pricing in a material growth hit, let alone recession.

As for what the read-through ought to be on inflation, the jury is out. There are times when surging oil prices feed through into core inflation – the inflation in central banks’ targets, but unlike the 2022 episode, this oil shock is not coming at a time when real policy rates had just been deeply negative and there had been a massive fiscal response to a global pandemic.

The RBA chose to bring forward the May hike to March, citing the oil shock as one of the reasons that tipped the finely balanced voting scales.

This move was likely about managing inflation expectations, rather than fearing a more severe and direct pass-through from oil to inflation. Nevertheless, the market prices another 3.5 hikes to the end of 2026.

At the same time, this has not been a one-way market. Volatility itself has become part of the story. Investors have repeatedly de-risked into weekends for fear of gap risk, only to find that by Monday, selling had exhausted itself and asset prices were recovering on the slightest hint of de-escalation.

The swings in bond yields, equities and credit have at times looked disproportionate to the flow of genuinely new information.

That is often what exogenous shocks do: they magnify investor behaviour. Fear, liquidity preference and positioning can dominate fundamentals for a period of time.

For disciplined investors, that can create opportunity — but only if position sizing is sound and one is careful not to mistake violent relief rallies for genuine clarity.

The 1–2 punch also applies to private credit, although the shock was the fear of ‘Saaspocalypse’.

The first punch came from AI and software-related repricing. It reminded investors that not every business model is equally durable, and that parts of the market had been assuming a smoother earnings and refinancing path than was realistic.

The second punch has been the exposure of how much capital had already migrated into riskier parts of sub-investment grade debt, often in structures where liquidity is intentionally limited.

The issue is not that AI disruption, by itself, suddenly invalidates private credit as an asset class. It is that the shock has illuminated something that was already there: a global credit cycle that is long in the tooth, increasingly vulnerable to weaker credit metrics, and more fragile than zero-volatility marks had suggested.

Public credit has responded accordingly. Higher beta segments such as US high yield and emerging markets have been whipsawed as investors have chased hedges, reversed them, then rushed back out again on the next constructive headline.

By contrast, Australian investment grade credit has been notably resilient. Higher all-in yields have continued to attract demand, both domestically and offshore. Even so, resilience should not be confused with immunity.

Physical credit markets, especially in Australia, can feel liquid until they do not. In a more extended stress scenario, high-running yield alone will not prevent spreads from widening, nor will it guarantee buyers when investors suddenly want cash.

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How we are positioning right now

Against that backdrop, our portfolio decisions have become more cautious.

In the income portfolios, we have reduced duration to 0.5yr from 1.5yrs earlier in the month. We had thought that Australian yields hitting their 2023 highs provided insulation as the monetary and fiscal policy backdrop now differs materially to the 2022 oil shock.

Still, momentum pushed on, helped by the global repricing described above. We continue to think there will come a point where bonds offer better convexity than they do now.

If the conflict drags on, markets should eventually have to pay more attention to the growth damage, not just the inflation impulse. And if the Strait of Hormuz reopens and oil normalises, at least part of the recent rise in yields should reverse.

We await more clarity to add more duration back into the portfolio, including whether oil can find its way out of the region via other routes.

It is worth keeping an eye on the Baltic shipping indices for clues. For now, the Baltic Dirty Tanker index (oil tankers) has come off its recent peak, but not nearly enough to restore confidence to the market.

On riskier assets, the profitability backdrop for equities still looks reasonably supportive in the medium term, but that has been overwhelmed in the short term by macro sentiment. In Monthly Income Plus we currently hold 12% in equities, around 4% above our usual minimum.

At the end of February, we overrode our process signals to stay at 20% and reduced our allocation to 8-10%, choosing to bank a very favourable reporting season in Australia. We have added to that allocation slightly intra-month as risk-reward signals turned more favourable after the first leg of the correction.

In Dynamic Income, we have exited our exposure to emerging markets and high yield, albeit having weathered some of the recent widening in global credit spreads.

Our bias remains cautious. We are increasingly focused on liquidity, asymmetry and the possibility that complacency in investment grade credit may yet be tested if stress in private credit begins to spill over into the broader demand for cash.

For now, we have been using bouts of positive market sentiment to reduce credit exposures in our income portfolios.

If conditions settle quickly, there will be many ways to rebuild risk. Primary markets may prove especially attractive in that scenario. But where the downside involves a rapidly narrowing window to de-risk, building and maintaining healthy cash balances remains the more valuable option.

Cash remains the greatest source of portfolio flexibility in this dynamic market environment.