AI boom, geopolitical tensions: How unconstrained fixed income strategies are navigating volatile markets

GLOBAL markets are facing pressure from several fronts: increasing geopolitical tensions, surging energy prices, rising inflation and shifting monetary policy in major economies.

For bond investors, such an environment is testing the traditional fixed income playbook. Conventional approaches alone may no longer be enough to mitigate downside risks in portfolios and generate returns at the same time. Investors are increasingly looking for areas of the market that are backed by long-term structural growth rather than broader economic cycles.

An area gaining attention is the artificial intelligence build-out led by hyperscalers – large-scale cloud service providers that offer highly scalable and flexible computing infrastructure to businesses. Despite wider market uncertainty, these companies continue to pour billions of dollars into chips, data centres and computing infrastructure.

Explains Matthew Rees, head of global unconstrained fixed income at L&G’s Asset Management business: “Hyperscalers are increasing capital expenditures to address limitations in computing power in pursuit of strong secular growth opportunities, a trend that remains largely unaffected by fluctuations in energy prices.”

While the rapid growth has raised concerns about a bubble similar to that experienced during the dotcom boom in the late 1990s, Rees notes that the critical difference lies in how investments are funded.

Back then, companies issued equity without proven revenue models, relying heavily on external financing, he says. Today’s hyperscalers, in contrast, are funding their AI ambitions largely from internally generated cash flows. And revenue, profit margins and cash flow are projected to remain robust, making this development a robust growth rather than a speculative trend, adds Rees.

Unconstrained fixed income in the age of AI

Most investors in Singapore who seek exposure to AI tend to reach for US tech stocks. But according to L&G, there is another way.

Instead of buying into the equity rally, some investors are gaining AI exposure through the bond market. Many hyperscalers are active borrowers, regularly issuing debt to fund data centres, cloud expansion and related investments.

Despite their strong credit profiles, these companies often offer spread premiums (additional yield) over issuers with comparable ratings. In an environment of compressed credit spreads, that combination of quality and extra yield can be rare and attractive, explains Rees.

Yet many traditional bond funds have limited ability to meaningfully tap this opportunity. Hyperscalers account for just 1.5 per cent of the global investment-grade corporate bond market – comprising high-quality debt issued by governments or companies. This means that funds that closely track an index or market benchmark can only allocate a small portion of their portfolios to the sector.

This is because benchmark-focused funds are, by design, limited in how they can respond. It must hold whatever the index holds, even if some of those investments look increasingly unattractive. And when the index itself was built for a more stable world, that rigidity can become a major constraint.

Investing through an unconstrained manager, who is not restricted by such benchmarks, can change that. “As compared to investors who are tied to a benchmark, we are not required to hold onto issuers our credit research analysts do not have a positive view on,” says Rees.

He adds that capital can be directed towards AI-linked credits that offer genuine value, and away from those that do not. There is also the added freedom to move nimbly, building positions when spreads widen and trimming them when they narrow, he explains.

The AI boom is also creating opportunities beyond the technology sector itself. As the number of data centres multiply to support the AI build-out, electricity demand is surging. Utilities, as the providers of that power, are direct beneficiaries. To fund the significant capital expenditure this demands, many utility companies are now issuing subordinated debt carrying yields exceeding 7 per cent, in many cases higher than their own dividend yields.

“We consider subordinated debt (lower-ranking debt) in the utilities sector to represent a potentially defensive approach to participating in the AI boom, with the prospect of enhanced income generation,” says Rees.

Benefits of a flexible approach

The bigger challenge comes when both stocks and bonds fall at the same time – a pattern that has become more common in periods of persistent inflation and geopolitical uncertainty. Traditional portfolios are not designed to handle this, since they are built on the assumption that the two move in opposite directions.

This is where unconstrained fixed income strategies can behave differently. Rather than remaining tied to benchmark positioning, managers can actively adjust portfolios depending on what is driving markets.

One way unconstrained managers navigate volatility is by adjusting how sensitive their portfolios are to interest rate changes. This is known as duration. Benchmark funds typically hold a fixed level of duration regardless of the environment, but an unconstrained manager can adjust it actively, shortening or lengthening it depending on the risks they see ahead.

When markets deteriorate on growth fears, longer-duration government bonds can still mitigate losses as investors seek safer assets, pushing prices up and yields down. But inflation-driven sell-offs require a different response. Research by L&G shows that when inflation is projected to exceed 3 per cent, government bonds and riskier assets tend to sell off together. In those conditions, a manager who shortens duration early may well be better insulated from the damage.

L&G’s unconstrained bond strategies team also seeks to manage risk through credit default swaps and cash. Credit default swaps act as insurance against a sharp deterioration in corporate debt markets. When inflation is the concern rather than slowing growth, this can be a more effective shield, cushioning the portfolio without relying on a rate cut that may not materialise.

Cash, too, becomes more valuable in volatile markets. Unlike benchmark-focused funds, which are typically expected to remain largely invested, unconstrained managers have greater flexibility to raise cash levels when risks are rising. Holding more cash is a defensive move when markets look stretched, and it also keeps options open for when opportunity arises.

“We maintain the view that a market correction is possible, potentially influenced by developments related to AI or geopolitical tensions,” says Rees. And when that correction comes, having cash on hand allows managers to put money to work at more attractive prices.

Research is key

Geopolitical risk is not going away. Whether it is conflict in the Middle East, supply chain disruption or the energy transition, structural upheaval has become a permanent feature of markets rather than an occasional interruption.

In that context, flexibility is only part of the answer. Not all AI companies are equally well-positioned to sustain their spending, and not every utility will benefit equally from the surge in electricity demand. Picking the right ones requires careful, company-by-company analysis of financial strength, revenue models and the ability to fund growth without leaning too heavily on outside capital.

Says Rees: “Real opportunities remain present. But in a world where disruption has become the norm, getting it right requires both the freedom to act and the judgement to act wisely.”

Learn more about L&G’s unconstrained bond strategies.

Rees joined L&G in 2009 and is currently the head of global unconstrained fixed income for L&G’s Asset Management division. He has led the Global Bond Strategies team since 2019 and was the co-head of the Euro credit portfolio management team prior to this role. Previously, Rees was a Partner at Banquo Credit Management (a multibillion-euro absolute return investment manager) and has worked at UBS, Merrill Lynch and the rating agency Fitch IBCA. Rees qualified as a chartered accountant with Coopers & Lybrand in 1996 and holds a BA (hons) in English from the University of York.

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