Volatility presents prime alpha opportunity for investors

While challenging for many investors, increased volatility in global markets this year and into 2025 has made risk assets – and by extension credit or bond markets – more attractive for active strategy investors, presenting them a golden opportunity to gain from alpha, according to fixed income and credit specialist firm Insight Investment.

“Credit cycles have turned,” Insight wrote as part of its 2024 Annual Investment Update. “We are now living in a more supportive environment for credit spreads, leaving behind below-trend growth, above-target inflation, and tight monetary policy.”

While spreads are “no longer cheap” the firm noted, “the absolute level of yields have risen dramatically over recent years, while the risks needed to generate target returns have fallen substantially”.

The firm predicts that, following aggressive policy rate hiking through 2022 and 2023 (as central banks globally battled surging inflation), the neutral interest rate is expected to remain higher in the coming decades.

However, Insight argued that bond markets do not need aggressive rate cuts to perform well.

“In an economic environment characterised by high interest rates, government bonds are once again being recognised for their diversification properties,” the firm wrote.

While it did note the potential of a rate drop, exposing shorter-duration positions to increased pricing risks, bonds in longer maturities, “appear close to fair value and offer attractive absolute yields”, Insight said.

These can also be further enhanced by investments in investment grade credit.

Eyes on East Asia bonds

“The economies of China and Japan are likely to play a role in the direction of global bond markets in the years ahead,” Insight wrote.

With China’s producer price index still in negative territory, investors in the country are likely to be watching for “a potential further disinflationary pulse”.

Nevertheless, Insight predicts that this exported disinflation “is likely to be much smaller than it has been in the past”.

Japan, meanwhile, could offer a boon to fixed income investors, should Japan’s central bank shift away from longstanding negative interest rates – an outlier in the developed world.

“[If] the central bank [hikes] rates, the yield curve will likely steepen, potentially attracting the attention of domestic investors who have deployed considerable capital around the world in the search for yield.

“Global fixed income markets have done little to price the risk of a significant return of capital to Japan and may therefore be impacted by this shift.

“This could become a key theme in 2024.”