Fixed income in a volatile world

For decades, bonds were seen as stability, dependable income and diversification in portfolios. They rarely generated the headlines that technology stocks or speculative alternatives generated.

That is, until the COVID-19 pandemic brought the sharpest global inflation surge in decades and one of the fastest interest-rate tightening cycles on record. Government bonds declined alongside equities, liquidity evaporated in parts of the credit market and securities once viewed as defensive experienced significant price swings.

This experience serves as a reminder that while fixed income remains an essential asset class, it is no longer the simple “buy-and-forget” allocation many investors remember. Instead, today’s bond market has become broader, more sophisticated and increasingly dependent on active decision-making. The days when bonds could simply be viewed as the “safe” portion of a portfolio have largely passed.

The days when bonds could simply be viewed as the “safe” portion of a portfolio have largely passed.

This article shares insights from experts Jeff Carter, CFA, portfolio manager, deputy chief investment officer and chief risk officer at Canso; Gary Morris, CFA, president and chief investment officer at Cidel Asset Management; and Leanne Ongaro, CFA, vice-president, portfolio manager – fixed income at CI Global Asset Management. Increasingly, success depends not on whether an investor owns bonds, but on which bonds they own, how they interact with one another and whether they are positioned for the market environment ahead.

Why the old bond playbook no longer works

For much of the last 40 years, declining inflation and steadily falling interest rates created a supportive environment for bond investors. Coupon payments generated regular income, while falling yields boosted bond prices, creating an additional source of capital appreciation. Investors could achieve attractive returns in a passive portfolio without any complex portfolio decisions.

That environment has shifted. Persistent inflation, shifting central bank policy, geopolitical uncertainty and changing patterns of global capital flows have introduced new sources of volatility into fixed income markets. While many segments of the bond market generally exhibit lower volatility than equities, they are not immune to significant drawdowns.

Fixed income is not one asset class

Fixed income itself has become something of a misleading term. The modern universe encompass a wide ecosystem of securities whose risks, return drivers and portfolio roles can differ significantly.

Traditional government bonds remain an important foundation for many portfolios, but they now sit alongside investment-grade corporate debt, high-yield bonds, preferred securities, private credit, floating-rate loans, structured products and convertible securities. Some behave more like equities during periods of economic expansion, while others are designed to perform during market stress.

The growing diversity of the asset class has created opportunities for investors, but it has also added complexity. Consider two hypothetical investments during the pandemic period: a bond issued by a highly leveraged hotel real estate investment trust and a bond issued by a large technology company. Both securities are labelled bonds, but their outcomes differed heavily. Hotels faced shutdowns, collapsing travel demand and severe cash flow pressure, while many technology companies benefited from the acceleration of digital adoption during the pandemic.

Let’s also explore private credit. Once largely confined to institutional investors, private credit has become increasingly accessible to retail investors seeking enhanced yields. This can also be seen in the numbers, where global private credit assets under management grew from roughly US$1.2 trillion in 2020 to nearly US$2.0 trillion by mid-2024. Yet those higher yields often come with trade-offs, particularly around liquidity. Unlike publicly traded bonds, private credit investments may be considerably harder to sell during periods of market stress – a characteristic that can become particularly important precisely when investors need flexibility most.

Further, securities that appear similar on paper can produce vastly different outcomes. A callable bond and a convertible bond issued by the same company may have similar maturities and identical underlying credit quality, yet one may be driven primarily by interest rate changes, while the other behaves more like an equity investment because of its conversion feature.

The takeaway is that sector exposure, credit quality, maturity, duration and embedded features all matter. Treating fixed income as a homogenous category can lead to surprises during periods of stress.

Looking beyond yield

For many investors, the word “risk” in fixed income means interest rates. But interest rate sensitivity is only one piece of a much bigger puzzle. There are five risks that deserve attention:

• Interest rate risk – bond prices generally move inversely to interest rates; when yields rise, bond prices fall
• Duration risk – longer-maturity bonds are typically more sensitive to rate changes than shorter-maturity bonds
• Credit risk – the risk that an issuer’s financial condition deteriorates or it fails to repay its debt
• Liquidity risk – the risk that an investment cannot be sold quickly at a reasonable price during stressed markets
• Reinvestment risk – the risk that future income must be reinvested at lower yields

For professional managers, understanding these nuances is essential. For individual investors, it highlights why fixed income deserves more attention than it often receives.

Active managers can adjust duration, rotate between sectors and shift exposure as valuations change.

Why active management has returned to centre stage

For much of the long bull market in bonds, passive strategies benefited from declining interest rates and broad market exposure. Today’s environment demands something different.

Inflation expectations shift. Central banks adjust policy. Credit spreads widen and contract. Liquidity can disappear overnight.

Passive indices also allocate more capital to issuers with the most outstanding debt – meaning investors may unintentionally concentrate exposure in the largest borrowers, not necessarily the strongest ones.

Active managers can adjust duration, rotate between sectors and shift exposure as valuations change. This flexibility has become increasingly valuable, because opportunities rarely emerge uniformly across the fixed income market. Perhaps the biggest fallacy in today’s fixed income market is that a higher yield automatically represents a better investment. The reality is considerably more nuanced. Experienced credit investors often begin by asking a different question: Why is this bond offering a higher yield in the first place?

Higher yields often compensate investors for greater risk, whether through weaker credit quality, lower seniority, embedded options or reduced liquidity.

Occasionally, markets become overly pessimistic. Periods of heightened volatility can create pricing dislocations where fundamentally strong issuers trade at yields that exceed their underlying risk. Identifying these opportunities requires detailed credit analysis and a deep understanding of how individual securities are structured. Conversely, securities that appear attractive based solely on their yield may carry risks that are not immediately obvious. Private credit illustrates this balance particularly well.

As Ongaro notes, “If a yield appears too good to be true, there is often an underlying reason.” For investors, the lesson is simple: yield should be the beginning of the analysis, not the end.

Security selection matters more than ever

One theme emerged consistently among all three experts interviewed: security selection has become a defining characteristic of successful fixed income investing.

Two bonds can offer nearly identical yields while presenting very different risks. Even two bonds issued by the same company may offer very different levels of protection. Beyond the issuer itself, investors should consider factors such as credit quality; maturity and duration; liquidity; seniority within the capital structure; covenant protections; embedded options such as calls, puts or conversion features; and expected recovery values should financial conditions deteriorate.

Market volatility can also create opportunities. Periods of stress frequently produce indiscriminate selling as investors seek liquidity or reduced risk exposure. During these episodes, prices can temporarily disconnect from underlying fundamentals.

Active managers often search for these dislocations by examining unusually wide credit spreads; pricing differences between comparable securities; inconsistencies along an issuer’s yield curve; securities with stronger fundamentals than current market prices imply; and sectors where market sentiment has become overly pessimistic. These dislocations can create opportunities, but only for investors who understand the underlying structures.

The evolving role of bonds in portfolios

Despite recent challenges, fixed income remains relevant. If anything, today’s higher yields have strengthened the case for bonds within diversified portfolios.

Higher interest rates have restored much of fixed income’s traditional income-generating role. While volatility remains a consideration, today’s yields provide investors with a stronger foundation for long-term returns than the ultra-low-rate environment that followed the global financial crisis.

Technology is also reshaping the market. Advances in electronic trading, data analytics and artificial intelligence are making increasingly sophisticated strategies accessible to a broader range of investors. As Morris notes, however, “Technology is unlikely to replace experience. Understanding how different risks interact will remain essential as the market continues to evolve.”

A different way to think about bonds

For investors, the implication is clear: successful fixed income investing is increasingly about understanding what you own, why you own it and how it fits within your broader portfolio.

The last five years have shown that fixed income is no longer the quiet corner of the investment universe. It is broader, more dynamic and more nuanced than ever before. For investors willing to understand that complexity, it may offer more opportunities than at any point in recent memory.

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Written by

Angha Gupta, CFA, is an associate director at Fitch Ratings. She holds an MBA from Ivey Business School and is an FSA Credential Holder from the IFRS Foundation. She is the features editor on the Editorial Committee at CFA Society Toronto and events director at Ascend Canada