Building resilient portfolios within fixed income has structurally changed in the post-pandemic era, where portfolio construction has had to evolve in step. A higher inflation backdrop coupled with a growing stock of government debt has increased the need for building more balanced portfolios made up of both corporate and sovereign risk.
This comes in contrast to traditional investment grade where tight credit spreads have meant that the majority of the yield is made up of government bond risk. Instead, we believe that a core allocation to fixed income should be taking both credit and interest rate risk more evenly, especially at a time when corporate fundamentals have remained in check.
In this respect, our portfolio strategy has been designed to capture a still-supportive growth backdrop, whilst mitigating political and macroeconomic risks. We are executing this by targeting diversified income streams across segments of credit markets that stand to benefit from the high nominal growth backdrop that both central banks and governments are incentivized to maintain. In addition, we view the erosion of trust in traditional institutions as likely to sustain investor preference for tangible and alternative assets.
Whilst the conflict in the Middle East remains unresolved, attention has instead refocused on resilient fundamentals. A key component here remains the AI revolution, which is a profound, multi-year structural shift. This technological transformation is reshaping industries, driving unprecedented demand for specific raw materials and hardware, all creating long term investment opportunities. Crucially, its benefits are also being seen within the latest earnings season which was one of the strongest in recent years amid accelerating AI infrastructure investment.
The strong physical demand for both precious and industrial metals, combined with their safe-haven appeal reinforces our positive outlook on this asset class. We therefore see continued upside potential for select emerging market currencies, which offer an attractive carry profile and serve as a diversified source of income amid the backdrop of geopolitical uncertainty and fragmentation. Finally, to capitalise on the AI theme and the broadening out of earnings, we are focusing on long tech positions through convertible bonds, focusing on critical hyperscaler partners. This strategy provides the opportunity for equity-like returns while offering the downside protection of a fixed-income instrument.
Within credit, areas in which we have a particular focus would include High Yield through CDS indices which offers a yield pick-up for enhanced liquidity relative to cash bonds. Quality income segments including AT1s, BB bonds and CLOs also offer an attractive premium without added default risk and provide diversification from both a sector and geographical perspective. BB bonds, for example, historically give you a yield pick-up of about 100 basis points over BBBs, despite having practically the same, very limited default risk. These corporate names in the US provide one with exposure to a resilient economy despite the energy shock also.
Other areas include the AT1 market, focusing on national-champion banks with very strong balance sheets. This is really a European and UK story, where there is very strong regulation protecting this asset class. We also invest in high-quality CLOs, which give you exposure to the leveraged-loan market, with default protection coming from the equity tranche. And EM local-currency sovereign debt, where countries such as Brazil, South Africa and Mexico which benefit from elevated real rates today. When you blend all these areas together, you should be generating yields around two percentage points above traditional investment grade, in a very diversified manner.
In the shorter term, we view this as a market pricing in the inflation shock that comes from higher energy prices, without taking into account the demand destruction that would inevitably also appear. We therefore do not expect central banks to deliver on the extent of hawkishness that is priced in, especially given the weak domestic growth outlook for the likes of the eurozone and the UK. As such, whilst credit spreads have recovered given the positive risk backdrop, we view government bond yields as being towards the top-end of the range, increasing the attractiveness of the asset class from an all-in yield perspective and providing investors with the opportunity to earn the carry available. Recent years have proven that it is time in the market that is paying off within the higher-income segments of the asset class given this carry, rather than attempting to perfectly time the market.
