Fixed income and AI: Active risk-taking amid higher rates

Davis: In either a positive or a pessimistic AI scenario, the future may be ripe for active risk-taking in the fixed income market. We’re likely to see a rate environment that’s very different from what we saw from 1983 to 2020. That period provided a strong tailwind to all fixed income investors. In a higher rate environment, active risk-taking has more room to add value. 

Davis: Our research points to a higher neutral rate over the coming decade, relative to the low-rate environment that pervaded pre-Covid, in part due to factors such as an aging population and rising structural deficits.

So, our outlook is that interest rates above pre-pandemic levels are here to stay. In both our positive and negative AI scenarios, we expect the federal funds rate to stay above 4%, but for different reasons. In the positive scenario, the 4% rate reflects higher economic growth. In this scenario, the yield curve may remain flatter than some think, creating opportunities for active risk-taking along duration. There may be similar dynamics around credit as well.

In the pessimistic scenario, it indicates growing structural deficits and financing pressures on the U.S. government. There may also be greater inflationary pressure in this scenario. This would likely be a very different environment, one in which rates may be rising and the curve is getting steeper, possibly creating an opportunity for active risk-taking.

Higher rates would mean less return would come from price appreciation, and more return would come from reinvesting at higher rates. Generally, we’d be entering an era where bonds offer greater value in a portfolio than they did in the low-rate environment that followed the global financial crisis.

Davis: Neither environment sounds as “easy” as it may have been during the few decades with a secular downtrend in interest rates that began in 1983. There will be many sources of volatility to navigate to either mitigate potentially adverse price effects of a rising yield environment or take advantage of price dislocations. The coming decade seems ripe for active risk-taking in the sense that there are likely to be sources of volatility to navigate or take advantage of.

It seems particularly important if AI disappoints. In this scenario, being underweight in equities and overweight in fixed income could be beneficial because in that environment, you’d expect to see lower growth, disappointing earnings growth, and higher interest rates. Within fixed income, investors may benefit from an overweight to corporate bonds (including high yield) relative to U.S. Treasuries. That’s because Treasury prices could come under pressure if investors become concerned about the sustainability of the national debt.

• Concerns with fiscal deficits in a lower-growth future: If AI disappoints, investors could potentially benefit from an overweight to fixed income, particularly corporate bonds.

• With interest rates rising, either scenario seems ripe for active risk-taking: Whether AI delivers or disappoints, we are likely to see a higher rate environment. This presents an environment ripe for active risk-taking in fixed income.