Iain Lindsay, co-head, global lead portfolio management, fixed income and currency at Goldman Sachs Asset Management, looks at how flexible investment strategies can improve risk management and income generation
The global financial crisis and its aftermath are bringing fundamental changes to the bond market. These changes involve new risks as well as opportunities, and we believe fixed income investment strategies must adapt. Traditionally, investors have allocated a portion of their portfolio to fixed income to manage their portfolio’s overall risk and to generate income. However, we believe traditional fixed income strategies may be less able to provide these benefits in the future and that more flexible investment strategies may be called for.
More Risk for Less Reward?
Traditional fixed income allocations tend to be benchmarked to indexes dominated by government-sector debt, which currently provides very low yields. For example, the Barclays Global Aggregate Index currently has approximately 75% of its constituents yielding 2% or less.1
While the yield on government-related securities is historically low, we believe the risks have increased. Many developed governments are already running severe budget deficits and still face the difficult choice of increasing fiscal stimulus or risking slow growth, either of which could raise investor concerns about debt sustainability. Thus, even if central banks keep policy rates near zero, credit concerns could still lead to higher interest rates, and declining prices, on government-related bonds.
The total return on a bond portfolio has two components: income and capital gains. At higher yield levels, income can provide a significant cushion against the risk of falling bond prices. For example, the Barclays Global Aggregate generated a capital loss during four of the last 10 one-year periods from 2000 through 2009, but meanwhile the index’s total return were positive in all 10 of those years as the income more than offset the price decline. Today, that income cushion is much smaller, approximately half of what it used to be five years ago, with bond yields now only needing to rise 0.5% to cancel the income advantage, as compared to closer to 1% a few years ago. Meanwhile, yield volatility has not changed appreciably.
Finding a Better Balance Between Risk and Reward
We believe many sectors of the global bond market offer a more attractive balance of risk and return potential.
For example, emerging market sovereign bonds denominated in the local currency offer substantially higher yields compared to their developed-government counterparts. At the same time, many emerging countries offer stronger growth to support their debt and budget situations that are strong and improving rather than weak and deteriorating. Corporate credit is another example, in our view. Investment-grade and high-yield corporate bonds offer yields in the area of 3.5% and 8% respectively. In our view, these yields more than compensate for likely default risk, and corporate balance sheet fundamentals are steadily improving.
In some cases, securities are trading at significantly discounted prices, resulting in yet higher yield potential. For example, US non-agency mortgage securities have yields in the area of 10%, even after making severe losses assumptions on the underlying mortgages pools.
We believe all of these sectors offer higher incomes to cushion against the risk of rising bond yields and yet supported by more robust credit and economic fundamentals than those of government bonds today.
From Threat Comes Opportunity
The high level of uncertainty surrounding the outlook for growth, monetary policy and fiscal policy, seems likely to continue for the foreseeable future. As a result, we think that fixed income market are susceptible to abrupt changes in yields and periods of elevated volatility, as evidenced during August by the steep decline in major government bond yields. The less certain macro economic outlook presents new opportunity to add value from active management of interest rate, currency, sector and security level exposures set within a total return framework.
Adapting to Today’s Fixed Income Markets
For investors seeking the traditional benefits of a bond allocation, we think the new reality in global bond markets argues for a more flexible approach to fixed income investing. Many of the sectors we view most favourably, both in terms of fundamental risk and return potential, have little or no weighting in traditional multi-sector fixed income benchmarks. We believe that investors will be rewarded for their efforts exploring the more attractive credit, mortgage and emerging market debt sectors and from adopting a more total return approach to their fixed income management.
1 Source: Barclays, as of August 31 2010
Iain Lindsay, co-head, global lead portfolio management, fixed income and currency at Goldman Sachs Asset Management