Investors tempted by more exotic fixed income flavours
The theory goes that one of the major benefits of holding fixed income in your portfolio is to act as a diversifier against equity markets. That when stockmarkets are booming, bonds remain quiet, but come into their own when equities experience a downturn.
But 2019 turned out to be very different, with all asset classes correlated to the upside. Everything did well.
In large part this was down to the shift in central bank policy, with concerns over global growth and trade tensions at the beginning of the year causing the Fed and others to move from a tightening cycle back towards looser monetary policies.
“Normally those kind of risks would have weighed on equity markets and the higher risk parts of fixed income, but those markets took the cue that because central banks were willing to inject liquidity to support the global economy, there was greater optimism,” says Steven Oh, global head of credit and fixed income at Pinebridge Investments.
But it is extremely unlikely that 2020 will continue in a similar vein. Valuations, in all asset classes, are stretched and have much less room for a continued rise, he says, while central banks have indicated they are likely to be on hold, unless some meaningful risks emerge.
So investors can expect bonds to return somewhere around coupon, says Mr Oh, which for large parts of the market is not much at all.
“By lowering yields across the board, central banks are inducing investors to take more risk exposure,” he explains. “But there is concern you are not getting paid particularly well to take on that risk. Investors are facing a dilemma, do I get more defensive, or do I maintain an aggressive posture? A lot of that depends on time horizons.”
The need for diversification, and a balance between risk and safe haven assets, does not go away simply because the market is where it is, says Mr Oh. But government bonds may not be the safe havens they once were, particularly for European investors dealing with negative yields.
Instead he points to cash, or cash substitutes, as ballast in a portfolio, as well as extending risk profiles by trying to get more yield in credit.
“I know there is a lot of concern around that, but our feeling is we are not in a recessionary environment, more low growth and low inflation,” says Mr Oh. Those conditions tend to be supportive of corporate credit risk.
“Spreads are quite tight, but maintaining corporate credit exposure is a better place to be than extending your government bond duration,” he adds.
Firm ground
Back in early 2019, fixed income was relatively cheap, says Tom Claridge, senior portfolio manager at Julius Baer, which explains why performance was so strong. “Now it is at fair value, but if you look at what is on the horizon, it is hard to see anything that will disrupt it any time soon, though of course things can change quickly.”
There is unlikely to be a compelling case for central banks to either hike or cut rates, he says, and while credit is not cheap, it is difficult to make a case that there will be a big move higher in spreads. “We think there is fairly firm ground to invest,” concludes Mr Claridge.
He expects 2020 to be a year with positive equity market returns, hopefully because earnings growth comes through, and one where bonds deliver the yield they are showing, rather than yield plus capital upside, which is what happened in 2019. Mr Claridge highlights investment grade corporate credit, emerging market hard currency debt and also high yielding securities.
“The outlook for those looks fairly stable, so why not pick up the available risk premia?”
Assuming inflation remains in the modest channel seen over the last decade, central banks will not be tightening for a long time, believes Catherine Matthews, global product specialist at Western Asset, an affiliate of at Legg Mason. They are much more likely to be quick to ease on weaker economic conditions, but very slow to tighten, she says, meaning low government bond yields are likely to persist.
“In a slow growth, low inflation, yield-starved environment, investors are forced to extend duration, reduce credit quality or move overseas to increase yield,” explains Ms Matthews. “This is likely to continue to provide a strong tailwind for the higher-yielding developed market and emerging market government bonds as well as corporate bonds.”
Even though these segments performed exceptionally well last year, the odds favour further outperformance versus core government bonds, with global bonds overall likely to produce low but positive returns over the medium term, she adds.
Private bank Coutts is underweight bonds. It leans away from lower yielding government bonds, although it does have an allocation to form ballast in portfolios, and is underweight investment grade bonds, favouring higher yielding areas where it sees compensation for the risk.
Emerging market debt and financial credit are two areas the bank finds interesting, says Monique Wong, multi asset investment manager at Coutts.
“In emerging market debt we own both hard and local currency. Hard currency is effectively investment grade with a little bit more yield, while in local currency we effectively have a bet that emerging market currencies will appreciate against the dollar.”
On the financial credit side, she likes subordinated bank debt, or CoCos, something Coutts has held in portfolios for four or five years and can yield around 5 per cent.
“Although bank profitability is still challenged in a low interest rate environment, banks have deleveraged and recapitalised, solvency isn’t an issue and default risk is remote,” says Ms Wong.
Emerging market debt is of increasing interest to a large number of investors searching for both yield and diversification, says Marshall Stocker, director of country research for Eaton Vance’s global income team. In his experience, many are turning to the asset class for the first time, with the biggest obstacle up until now having been their “misperception” of volatility.
“A lot of the volatility concerns around emerging markets are built off poorly constructed indices. In equities you have almost 60 per cent in China, Korea and Taiwan, three export-oriented economies, trading off one beta, so you are going to get volatility, and it is not much different on the debt side. There are more indexes but you see the same thing.”
Rather he insists active management is essential in managing that volatility, and indeed using it to your advantage, while a diversified portfolio needs to have a fairly wide universe of countries. Mr Stocker sees opportunities in countries where economic policy is likely to improve.
“In the fixed income space, countries that enforce the rule of law, make government expenditure more efficient, simplify the regulatory environment or address inflation, will all see their discount rates come down and sometimes see cashflows, tax revenue collection for example, go up. That is where we start. Governments that have good ideas that lead to good policies, because that leads to good outcomes.”
He highlights Ukraine, where the government has a mandate to enact change, carrying out land reform and dealing with corruption. Meanwhile Pakistan is making an effort to improve governance and revenue collection, while Egypt is bringing its fiscal deficit down.
Wider net
Almost anyone who buys a fixed income mutual fund is either buying either credit risk or interest rate risk, says Adam Smears, global head of fixed income research and portfolio manager of Russell Investments Unconstrained Bond Fund, and right now they are not getting rewarded for taking that risk.
The aim of his fund is to deliver a positive return better than cash, while aware of drawdown risk and diversifying the portfolio as much as possible. In order to do that he attempts to capture as many other risk premia as possible, while putting in active strategies to hedge those risks.
One example highlighted by Mr Smears is prepayment risk premia, and especially the interest only and inverse interest only strips part of the mortgage market. These are created when borrowers with long term mortgages choose to refinance at a lower rate and pay a fee for doing so, which is then packaged up and sold as securities.
“It is not a well-trodden part of the market, but it is out there and is one that has a decent amount of return potential and is not as overstretched as things like credit and interest rates,” says Mr Smears.
Prepayment might be considered too small for some managers but the current environment is forcing investors to find new ways of generating returns, making niche areas like this more appealing.
“The vast majority of managers out there will be buying corporate credit,” says Mr Smears. “And when spreads get tighter they get chased into buying riskier credit to keep yields higher. And I don’t think that is the right thing to do. You shouldn’t take on more risk to earn the same amount of return. That just makes the end result for the client more volatile.”
Indeed a volatility strategy is one of the hedging techniques he employs. “This strategy tends to not do very much most of the time, but whenever you have a sell-off, it makes money,” says Mr Smears. “And that is a beautiful complement to having credit in the portfolio. Both make money at different times, giving you much smoother return streams.”
At global investment adviser Cambridge Associates, the approach is also focused on avoiding the traditional areas of the market and trying to identify niche areas which better compensate investors.
“With the growth of the private market, it has become less about fixed income as a defensive asset class where I get the yield I need, and am expecting it to protect me on the downside, rather the focus is now more about growth and accessing niche ideas that you can’t get exposure to through other asset classes,” says Mark Wilgar, investment director at Cambridge Associates.
The firm’s clients tend to be people who look at fixed income for more than just its defensive properties, he says, and warns investors to avoid a “halfway house” – if they want to be defensive then go very vanilla, if they want yield, avoid traditional high yield, which can be anything but, and look further afield.
He points to things like collateralised debt obligations, or CDOs which many investors are scared of after the way they behaved in the financial crisis. But Mr Wilgar explains that the regulated market we have now is very different to back then and instruments like this may therefore be worth a second look. Likewise there are new innovations in things like trade receivables or ways of using financial company balance sheets to leverage risk.
“Credit markets, both public and private, have been on a 10 year bull run. The more risk you have taken in credit over the past few years the better you have done,” says Mr Wilgar. “Some are dialling down risk, and you are less well compensated. But those who had made that call in the last few years would have rued it the year after.”
Fool’s yield
But not everyone is convinced that this is what fixed income markets should be used for. Bonds offer genuine diversification, are relatively simple asset class, and should be a core holding in most people’s portfolios, believes John Patullo, co-head of strategic fixed income at Janus Henderson Investors, but he warns that yields that appear to too good to be true are more than likely to be a dangerous investment.
“Beware ‘fool’s yield’, or those so high that you are a fool if you buy it. You are asking to lose your capital,” he says. “Bonds are meant to be boring, dependable, reliable, and not let you down.”
Those investors going into products which promise anything up to 12 per cent are making a mistake, he believes. It is much better, in his opinion, to get 3 or 4 per cent and keep your capital intact than get 6 or 7 for a couple of years and lose half.
VIEW FROM MORNINGSTAR: Mixed start to year after bumper 2019
In 2019, fixed income markets recorded strong returns thanks to a wide range of factors across regions.
The dovish shift in US interest rate policy resulted in the first rate cut since the global financial crisis and a total of three rate reductions during the year. The progress in the US-China trade discussions also boosted risk sentiment.
Investors’ appetite for yield led to strong inflows and significant spread tightening across investment grade, high yield and emerging markets hard currency bonds. Other supportive factors were better than expected employment and economic growth data in the US and strong corporate earnings. The victory of the Conservative Party in the UK election alleviated concerns over a “Hard Brexit”. High yield markets further benefited from supportive new issue technicals and strong performance of equity markets.
However, markets also experienced short spells of risk aversion, mainly in May and August. Tariff hike announcements in the US-China trade negotiations, concerns over weakening global growth and country-specific issues such as Hong Kong-China tensions and an unexpected result in Argentina’s primary election led to spread widening during these periods.
US government bonds yields fell in 2019 as the Federal Reserve initially adopted a more accommodative stance and then announced rate cuts in July, September and October. Core European government bond yields also fell as the ECB announced additional monetary stimulus. Germany issued negatively yielding 30-year government bonds for the first time in August 2019.
Fixed income markets had a mixed start to 2020. Government bonds and investment grade continued posting positive returns, however high yield was flat and emerging market bonds weakened as the coronavirus negatively impacted risk sentiment in the second half of January.
PIMCO GIS Glb Bd Fund E Class USD (Currency Exposure), has been managed by Andrew Balls, Pimco’s CIO of global fixed income, since September 2014, and is aided by co-managers Sachin Gupta and Lorenzo Pagani. The process is based on Pimco’s top-down views, driven by the investment committee on which Mr Balls sits. The fund has historically held up to half of its assets in corporate bonds, and up to a third in emerging markets debt. It can invest up to 10 per cent in below-investment grade bonds. During Mr Balls’ tenure the fund has comfortably outpaced its average peer group but slightly underperformed the US dollar-hedged Bloomberg Barclays Global Aggregate Index. Over the first three quarters of 2019, the fund benefitted from its selection within high-yield corporates, non-agency MBS, and ABS, as well as from currency trades.
iShares Overseas Govt Bd Idx (UK) A Acc is managed by experienced portfolio manager Francis Rayner and the wider EMEA Portfolio Solutions Team. Its investment process is highly automated, with a key focus on minimising trading costs. It is using stratified sampling to replicate the performance of the JP Morgan Global Government Bond Ex UK Index. The exclusion of the UK is statistically significant as it can represent up to 10 per cent of a global developed sovereign bond index. This also results in a more volatile risk/return profile relative to peers, both passive and active. UK investors simply looking for an efficiently managed strategy to gain tactical exposure to developed government bonds other than those issued by the UK should find that this ETF fits the bill.
Evangelia Gkeka, Senior Manager Research Analyst, Morningstar
