Amy Xie Patrick: Finding the ‘sweet spot’ for fixed income funds

Pendal’s head of income strategies explains how her team found the sweet spot for through-the-cycle success across our fixed income funds

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CREDIT is the main income engine for most income funds.

Pendal’s income engines look to high-quality, Australian investment-grade credit to generate a core level of stable and repeatable income.

With so much uncertainty given the current macroeconomic backdrop, some credit-based income engines need a little help.

By visiting the basics of asset class behaviour, this article highlights the importance of conviction and flexibility to ensure through-the-cycle success for any income fund.

Credit likes moderation

As far as asset types go, not much beats Australian investment-grade credit for its superior risk-adjusted performance. Even private credit, with its double-digit returns over the past few years, remains untested through a real cycle.

For credit more broadly, moderation in the macro backdrop is key.

If recession becomes a real and tangible threat, government bonds start to offer greater potential for returns.

As well as a potential boost in returns from likely interest rate cuts, high-quality government bonds are the safe haven asset of choice in times of market turmoil.

On the other hand, if growth is a little too hot, equities are more likely to keep running while credit loses steam.

There are three main reasons for this:

1. Asymmetry of upside between bonds and equities

Equity prices reflect the market’s expectation of the strength and sustainability of corporate earnings, which means – in theory – unlimited upside is possible.

For corporate bonds, this upside is capped.

A hold-to-maturity bond investor’s best case is receiving all the coupons over the life of the bond and the safe return of their principal when that bond matures.

2. How companies behave as growth accelerates

Management teams tend to see more opportunities to invest or acquire other businesses, and it usually makes sense to fund these activities through issuing more debt.

If corporate bond supply is heavy, credit markets can go through periods of underperformance while the investor community tries to digest the issuance.

Even if indigestion is not an issue, the market must judge whether these companies will successfully grow into more leveraged balance sheets.

3. Higher debt-servicing costs that come with a higher interest rate environment

An accelerating economy is likely to lead central banks to adopt a tightening bias and/or raise interest rates.

Companies with floating rate debt will feel the pinch immediately. Those with fixed rate debt will incur higher refinancing costs. If earnings growth fails to keep pace, credit spreads become vulnerable to widening.

Should the economy start to overheat, and inflation hurts the performance of both bonds and equities, cash becomes king.

Competing themes

While the Santa rally failed to deliver in December 2024, both bond and equity markets are pricing in a continuation of many of last year’s themes:

• American exceptionalism: Bond markets price fewer than two cuts for all of 2025, and equity analysts see more than 10% earnings growth from the S&P 500.
• Daunting deficit: With the US deficit running at more than 6% of GDP (as at the September 2024 quarter), the bond market continues to worry about debt sustainability. This has contributed to the recent steepening of the yield curve.
• Trickling bazooka: Despite much talk of stimulus efforts from Beijing, Chinese government bond yields have continued to drift lower, signalling a lack of market optimism for a turnaround from the world’s second largest economy.
• Trump 2.0 policy uncertainty: From tariffs to immigration, tax cuts and deregulation, there is nothing but uncertainty about how this Trump administration’s policies are likely to impact the global economy. Both bond and equity volatility indices have picked up from their lows since mid-December.

It’s interesting to note that the latter three themes all pose risk to the first theme of American exceptionalism – or at the very least, American equity market exceptionalism.

To the extent that Trump policies or a high US deficit can push bond yields meaningfully higher, equity market sentiment can be de-railed. In fact, it is interesting to us that the latest march higher in yields (and real yields in particular) have largely been brushed off by the S&P 500 (Figure 1).

Figure 1: Shake it off | US real yields and S&P 500

What could knock things out of the sweet spot?

These competing themes may have been keeping each other in check, leading to a backdrop of that kind of moderation that is so well-liked by all markets (Figure 2). That is a backdrop of stable growth, supported by monetary policy that is neutral to easing in its bias.

Figure 2: The sweet spot

That’s certainly how much of 2024 played out, but the above themes point to risks that could knock things out of the sweet spot in both directions.

Growth could start to decelerate, leaving the zone of stability. This could come about from tariffs that eat into consumers’ spending power and ignite trade wars on a larger scale.

Slower growth outside of the US, including China, could also bite back on the US via various channels such as capital flows and trade. Credit spreads will come under threat if recession comes into view.

Growth could also start to accelerate and bring inflation fears back into focus. Certainly, US inflation data in the latter months of 2024 started to show signs of stubbornness once again.

While the Fed may be prepared to look through the one-off effects of tariffs, it would need to take lasting effects more seriously. One such effect could come about through draconian immigration policy which causes significant tightening of US labour markets.

On balance, we see more downside risks to growth in 2025 than a re-acceleration, simply because that seems to be the underlying direction of travel for the economy.

But we haven’t hit the inflection point just yet. Pandemic savings are far from being rundown (Figure 3), but we do note that the liquidity position of the poorest half of Americans has come off its peak.

Figure 3: Cashed-up and spending

More than just coupons

With the “sweet spot” covering a narrow range of economic environments, income funds need more than just corporate bond coupons to successfully navigate the economic cycle.

It is tempting to reach for higher coupons (i.e. higher default risk), but that will mean a higher risk of large drawdowns, defaults, and loss of income at the economic extremes.

Similarly, if growth stays robust or picks up, income funds could benefit from having more ways to participate in the upside. Investment-grade corporate bonds won’t get you there.

That’s why Pendal designs its income solutions with the entire spectrum of economic and market scenarios in mind. Our funds can access levers outside of just credit, and our investment process actively exploits opportunities conjured up by market themes.

In portfolio terms, this translated into a strong 2024 return outcome.

By actively positioning into and away from interest rate exposures throughout the year, Pendal was able to benefit from bond-favourable market themes of “benign disinflation” and “Sahm rule breach” (where recession fears came back into view), while also avoiding any tantrums relating to Trump and inflation fears.

We also actively positioned into and away from return boosters such as equities and emerging markets, which allowed us to further benefit from the optimism around rate cuts and China stimulus and avoid the disappointment relating to both.