Salman Ahmed looks at the issues facing fixed income investors.
- Many investors do not realise the far reaching implications of low yields
- Some investors are moving down the credit spectrum in search of yield
- However, they need to adapt their approach by building quality-driven portfolios and trading less
We face a problem of too much debt in advanced economies. Central banks are now policy makers, asset owners and regulators, and through ultra-easy monetary policy and unconventional methods have back-stopped the system, delaying the necessary adjustments through default and debt re-structuring.
Central banks in advanced economies are likely to maintain very low or negative rates for much longer. This policy is having significant intended and unintended consequences for fixed income portfolios. We believe there are three told and untold challenges facing fixed income investors in light of this new paradigm of fixed income.
Widespread or low yields
It is not a surprise to investors we have widespread low and negative yields but many investors don't realise the far reaching implications this scenario causes. It is estimated that around $10trn (£8trn) of government and corporate bonds are now yielding less than zero. Across Europe, with the exception of mainly peripheral countries, more than 50% of available government bonds have negative yields.
Any asset owners with a reasonable quality developed government bond portfolio is earning negative carry on their fixed income portfolios. It is important to recognise that as interest rates move deeper into negative territory, the question of economic (rate at which further negative rates become counter-productive) and physical (rate at which economic agents flee deposits for cash) will become paramount.
It is hard to see how the yield compression-driven capital gains we have witnessed over the last five years can continue unabated going forward given the reality of this binding constraint.
Increased market risk
Negative yields have forced the majority of investors to undertake a search for yield by taking on more duration in their government bond portfolios to maintain positive carry. However, as investors have materially extended duration to achieve return targets, a key consequence has been the flattening of yield curves across all major bond markets.
Through a heightened sensitivity to interest rate moves, we estimate that just a 50bp increase in rates globally would create significant and damaging mark-to-market losses across portfolios as over the last eight years duration of outstanding sovereign debt in Europe has increased from less than six to more than seven years.
In addition, the risk/reward facing investors in advanced economy government bond markets has deteriorated sharply. For instance, using German government bond yield data since 1840, the volatility is actually higher than its long-term median, while yields are at all-time low levels.
As the direct risks investors face from their fixed income portfolios are rising rapidly, there has also been a worrying shift in the correlation between bonds and equities.
Over the last few years bonds in Europe have tended to correlate positively with equities. This means bonds now amplify the market-driven moves in the return-seeking part of portfolios, rather than acting as an offset.
Simultaneously, an indirect consequence of the ongoing search for yield is forced herding of investors into the same positions, a situation exacerbated by the overuse of market cap-based allocation schemes, which is due to their perceived liquidity.
Investors should be under no illusion that liquidity has fractured across fixed income markets. Central bank domination represents a paradigm shift in fixed income markets, because they do not play by the same rules as traditional investors.
From a market-liquidity perspective, it is critical to consider the impact of price-insensitive nature of central-bank involvement in fixed income markets, particularly as the more-or-less permanent nature of their balance sheets implies a significant reduction in the free floats available to traditional investors. Once central banks have bought their bond positions, they do not need liquidity unless their policy stance shifts.
What should fixed income investors do?
We believe investors need to continue to source yield and move down the credit spectrum into asset classes like corporate credit and emerging local debt but they need to adapt their approach to account for a new paradigm in fixed income markets by building quality-driven portfolios and trading less.
In order to tackle some of these challenges, we recommend investors trade less and build safer portfolios that exhibit quality. To achieve this, investors should install explicit default risk mitigation at the heart of their portfolio construction process. Therefore, investors need to consider fundamental-driven portfolio construction within a low turnover framework that focus on credit default mitigation.
Salman Ahmed is chief investment strategist at Lombard Odier Investment Managers
Morningstar Investment Management (MIM) has launched a range of three multi-asset funds that will blend active and passive strategies to offer advisers low-cost solutions.
The government will set up an infrastructure bank to support investment and to co-invest alongside investors including pension funds.
The Retail Prices Index (RPI) will be reformed and aligned with the housing cost-based version of the Consumer Prices Index, known as CPIH, by 2030, the Treasury has confirmed.
Estatee agent denies a shareholder’s absence from voting is an issue, finds Minerva Analytics.