February 2024 | 

Fixed-Income Investing: Seizing a Lucrative Opportunity

Fixed Income Investing: Seizing on a Lucrative Opportunity

Higher interest rates and market volatility are bringing renewed attention to fixed-income investments, with some institutions and investors taking a closer look at the asset class for the first time in decades. Wharton@Work recently sat down with finance professor Michael Roberts, who heads up the new Fixed Income and Credit Market Investing program, to discuss those investments, which he calls some of the most important but least understood. Roberts explains why investors, asset managers, capital allocators, and corporate executives should know more about fixed-income products, including the risks and “seriously good opportunities” they can bring to a portfolio.

Wharton@Work: Conventional wisdom says investors should turn to fixed-income vehicles like bonds when stocks become volatile and there are higher levels of uncertainty. Is that still true?

Michael Roberts: That’s exactly what I was told when I was first introduced to fixed-income investing: bonds were safer than and largely uncorrelated with stocks. You balanced your portfolio between them, with stocks going up and down and bonds being the safe bet, generating interest income. But the reality is that bonds — even so-called safe ones such as treasuries — can be risky. In other words, the conventional wisdom that bonds are safe — just allocate some money and don't worry about them — is misguided. In fact, many events have shown it to be greatly misguided.

W@W: But debt instruments like bonds, and the concept of fixed-income investing, aren’t new. Why do so few executives and institutional and individual investors seem to understand these risks and how better to leverage these investments?

MR: Fixed-income investing feels new because it's been a while since we've seen interest rates high enough to make it attractive. Ironically, it’s one of the most important asset classes in the world regardless of interest rates because of its size and scope. Fixed-income markets are more important to economies than stock markets. When the stock market gets in trouble, people get upset. When debt markets get in trouble, people panic because that's when economies experience systemic problems.

For about 40 years, interest rates have been declining — falling from 15 percent to zero — and they were at or near zero until about two years ago. With the recent rise in inflation, rates have shot up like a rocket. This introduced risks that we hadn't seen for quite some time, and those risks played out very publicly, with bank failures and with retirement funds that lost an enormous amount of value. We've also seen them play out with savers who suddenly recognized that the coupon payment from the bond fund they got didn’t look great anymore, and if they started selling any of the bonds, they lost a lot lost value. It’s been a real wake-up call for managers, investors, allocators, and others who are now realizing that understanding fixed income investing and risk management are really important.

W@W: Debt instruments include more than just bonds, though, correct?

MR: Yes. There has been an explosion of opportunities in the credit space over the last 20 years that are more recently growing beyond their niches. We’ve seen dramatic changes and growth in structured products, as well as the rise of private credit. Additionally, bond ETFs are now making available to retail investors opportunities that were historically only available to institutions and high net-worth individuals. The issue now is understanding and navigating these new markets and securities.

W@W: Because of the various risks involved when you are investing in debt?

MR: Yes. I don't think most people appreciate those risks, and because some of these products are new or haven’t been considered for some time, a baseline understanding has become even more important. There are different instruments to consider, including simple U.S. treasuries, corporate credits, mortgages, private credit, and structured products, let alone fixed-income derivatives. But to make informed decisions about which instruments make sense for particular situations, you need to understand some fundamental concepts and be able to use tools to analyze their risks.

W@W: Who needs a better understanding of fixed-income investing?

MR: For executives at financial institutions where fixed-income instruments play a central role on both sides of the balance sheet, this knowledge is critical for asset liability management, as well as investment decisions. I’m talking about banks and credit unions, insurance companies, finance companies, etc. But, even beyond financial institutions, corporate financial executives also need to understand fixed-income markets for asset liability management, as well as for capital raising activities, capital budgeting financing, and acquisition considerations.

Professional investors such as hedge funds and capital allocators at family offices, sovereign wealth funds, and endowments also need a deep understanding of fixed-income markets and investing. Understanding concepts such as portfolio construction, indexing, and benchmarking, and risk metrics such as duration, default, prepayment, etc., are central to their business model.

Finally, fixed-income investing is important for individual investors because it offers additional diversification and risk mitigation, when done properly.

The reality is everyone needs to understand fixed-income investing, albeit possibly different aspects of the topic and to varying degrees. But the beauty is that, like all areas of finance, fixed-income investing rests on the same fundamental principles of cash flows and discount rates. This is just another application of those principles.

W@W: Getting back to those nervous investors and business leaders watching interest rates and inflation, is there good news?

MR: Higher interest rates bring higher costs to companies, but also new opportunities to investors. When you're earning one or two percent, it's not terribly exciting. But when you can earn almost six percent risk-free, or double digits with higher risk credits, investing gets more interesting and potentially lucrative. You just have to know how to take advantage of these opportunities, and that’s what the new program is in part about.