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Fixed income investors might be taken by surprise if inflation rears its head this year.

That’s because an Invesco study finds that 58% of fixed income investors interviewed aren’t concerned about rising inflation.

Although most believe the global economy is on the path to recovery (again, 58%), those interviewed say the recovery isn’t via the typical normalization process of increased growth and rising interest rates and inflation, which has historically occurred after an economic slump.

Rather, they believe a secular shift has occurred resulting in a new normalization of moderate growth, gradually rising rates and little risk of global inflation.

Read: End-of-cycle positioning for portfolios

“The big risk for investors is that they are underestimating inflation risk in a strong global economy,” says Rob Waldner, chief macro strategist at Invesco, in a release.

Read: Get ready for more volatility

The study also uncovered a strong appetite for alternative credit, such as bank loans and real estate debt.

Alternative credit provides fixed income investors with the opportunity to diversify portfolios away from traditional return drivers, such as rates and term, toward alternative drivers, such as illiquidity and manager skill, as well as to pursue absolute-return strategies unconstrained by traditional benchmarks.

“While traditional core fixed income assets continue to play a foundational role in many fixed income portfolios, alternative credit is expected to increase in institutional fixed income investors’ portfolios,” says Waldner.

On average, the investors interviewed allocate 19% of their fixed income portfolios to alternative credit strategies, with the largest appetite in North America, at 26%.

Larger investors (AUM greater than US$15 billion) typically have higher allocations to alternative credit than smaller investors, who aren’t able to exploit alternative credit strategies to the same extent as their larger peers.

A return to core bonds

That study finds that, over the past three years, investors have been reducing allocations to core fixed income portfolios; however, the majority of investors surveyed (63%) expect to rotate back to core fixed income over the next three years, funding this predominantly from equity portfolios.

Read: What happens if bonds become more appealing than stocks?

Investors still expect to allocate to alternative credit but at slower rates as appetite becomes constrained by higher prices and a reduced set of opportunities.

One area of alternative credit which remains notably in favour is emerging market debt. While respondents currently allocate 3% on average to emerging market debt, 29% expect to increase this allocation over the next three years, because of improving economic fundamentals, shrinking current-account deficits and the lesser direct impact of rising U.S. interest rates.

Download the full study.

About the study: Fieldwork was conducted by NMG Group’s strategy consulting practice, with 79 fixed income specialists worldwide interviewed. In Canada the study was restricted to accredited investors as defined under National Instrument 45-106.

Originally published on Advisor.ca
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