The future of fixed income as an asset class was the subject of a hotly-debated roundtable dinner held recently at the FT’s headquarters in London, co-hosted by PWM and SPDR, the ETF business of US asset manager State Street Global Advisors.
While the views of 14 professionals involved in investment management and consultancy in the fixed income sphere often clashed, there were several threads common to the representatives of both wealth and asset managers that contributed to the evening discussion.
Among topics on the agenda were the macro and political factors influencing the fixed income market, the role of fixed income in private portfolios, current fixed income challenges and trends, and innovations in trading practices and products.
Macro trends
Speakers quickly agreed there was a long future ahead for fixed income and that there were key drivers behind the story, but the sticking point was around how bright this future might be, how challenges would affect the health of bond issuance and what the shape of investors’ fixed income portfolios would look like as a result.
One key speaker memorably described a new world of low and falling interest rates, following recent central bank moves to loosen monetary policy in order to boost weak growth. “There is a school of thought that QE1.0 was about making rich people very rich,” said the speaker. “But QE2.0 is going to be about helping the poor people catch up.”
This could take the form of huge debt monetisation, increased public expenditure across many countries, with early signs of these trends signalled by Democratic candidates in the US, the Labour Party in the UK and many voices across Europe. Speakers agreed that increasing populism, coupled with politicians trying to control central banks in order to get elected, would lead to implementation of “modern monetary theory”, by printing money to finance infrastructure.
But the panel was not in full agreement about whether a continued prolonged period of low interest rates could curtail the bull market for bonds or when this would happen.
“It could all blow up spectacularly,” predicted one major global asset manager. “But this could still be three or four years down the road.”
The concept of “secular stagnation” was also identified early in the debate, with suggestions that many market-based economies were entering a long period of low or negligible growth, with even those economies that appear to have recovered from the 2008 financial crisis only firing on two or three cylinders. A lot of spare capacity was identified in leading economies, with the US seen as probably “the best house in a bad bunch”.
These factors may combine, argued speakers, to strike fear into the hearts of investors, witnessing an aggregate total of close to $13tn of zero or sub-zero interest rate debt, unthinkable 10 years ago, but a reality today.
This trend may be further fuelled by falling inflation, not just due to lack of demand in our economies, but also brought on by the transformative power of technological progress. This was not however embraced by all, as another camp in the room forecast inflation rather than deflation taking root for the next decade, leading central banks to re-examine their targets.
Countries such as the UK, in their “run-off phase”, need fixed income to plug pension deficits. But high net worth investors, it was argued, are not necessarily wedded to investing in bonds, can be more selective about investing in emerging markets, high yield or private debt, and are becoming more and more nervous about liquidity.
Portfolio role
Yet this view was far from unanimous across our range of speakers, with a very vocal continental European private banking investment boss claiming exactly the opposite was true among the bank’s clients, who wish to maintain massive bond allocations, increasingly skewed to riskier assets in emerging markets and high yield in order to boost returns.
This led to a heated discussion between our banks and asset managers, who sparred over the true role of fixed income: should it be an anchor allocation, ensuring a particular, though low, guaranteed rate of return, or should it be gradually changing into a high returning asset, offering improved yields?
Our panellists clashed repeatedly about whether such yield chasing goals could really be expected of bonds or whether they should be confined to equity markets. Interestingly enough, even those banks seen as traditionally conservative, were prepared to include various fixed income tranches in the higher risk buckets of their clients’ portfolios.
One private banking portfolio construction expert told the gathering: “You inevitably see the risk profile of the fixed income portfolio gradually mutate and you end up building in more risk to the portfolio. So, your investment grade investor has become a high yield investor and your high yield investor has started to look at private debt and your private debt investor is being pushed out into the world of private equity.”
Other voices contributed the view that fixed income has long lost its “shock absorber” quality, now that the world has been changed by the experience of quantitative easing.
The role of private banks and asset managers in educating investors about unrealistic yields for fixed income was also stressed, even though this conversation often pushed these customers into chasing yield in previously unheard-of portfolio allocations, such as frontier markets.
Another group of managers did not see their private clients going into higher-risk fixed income instruments, preferring instead sovereign bonds. Again, this was aligned to the education process about risk and reward.
One major manager drew attention to a cultural divide, which he believed separated continental and UK managers in the room.
“The way the Europeans think about fixed income is very different to how the UK does,” said the manager.
“In Europe, it’s all about yield. They’re buying high yield and going into emerging markets, anything that will give them income. They think they have 80 per cent of their portfolio in bonds, so they need income out of that, so they will go wherever they can. In the UK, they’re thinking of it as a shock absorber.”
Major challenges
Much debate ensued throughout the evening about the tradability of fixed income instruments, particularly in a distressed environment, with a lack of investment banks and other banking institutions, who were market makers, or buyers of last resort, prior to 2008.
Panel members were presented with research suggesting these concerns now mean it takes eight times longer to carry out a fixed income transaction compared to 2008, leading to a flight to quality and heightened concerns around selectivity of assets. This could, for example, lead to doubts around emerging market bonds, previously a firm favourite among clients of private banks and wealth managers, as they fit into the story-telling thematic favoured by this sector.
One investment head at a major private bank shared his practical concerns about liquidity, especially when it comes to trading high yield bonds, on which he can sometimes be forced to take a three per cent haircut meaning that he has to hold for the longer term. His heartfelt concerns about liquidity were clearly genuine and widespread through the investment community, even if several other banks denied having this problem.
“These are high street bonds, not complex difficult names, but there are no sellers,” said the banker, leading to another speaker referring to the fixed income market described by the International Capital Markets Association as “a mile long and an inch deep”. This illiquidity means that unlike the fast trading permitted by equity market conditions, it was generally impossible for investors to combine buy and hold strategies with opportunism.
“This doesn’t seem to be evident on the fixed income side,” commented a consultant.
Another challenge identified by our fixed income experts was that of managing huge amounts of data and separating them from general “noise”.
Creating products for the next generation and conducting a fruitful dialogue with younger investors was also a crucial, if challenging, goal for the participants. Several talked about the need for products linked to ESG criteria, especially within the fixed income sphere, with much of the demand driven by regulatory requirements, especially in the Netherlands and France, where both companies and investors are increasingly expected to declare their carbon footprints.
Products and services
The role of exchange traded funds (ETFs) as wrappers was keenly debated throughout the evening. Strong recent flows into ETFs investing in investment grade core and high yield bonds were identified.
The change in dynamics of conversations around ETFs was also highlighted, with the active versus passive debate of 2008 now having given way to how ETFs can be occasionally, strategically used to reposition portfolios, by bringing in shorter or longer duration weightings or adjusting credit exposures. “I think the tools are now there to tweak whatever you’ve already got in your portfolio,” said one practitioner. “That’s how we’re seeing things today.”
There was little doubt about growth potential in this area, with fixed income indexation representing just 3 per cent of fixed income fund assets globally in 2007, up to 12 per cent today, while equity has more than doubled from around 12 per cent to 25 per cent over the same period.
Private banks, now staffed up with teams of analysts to choose funds and assets from the bond and equity universe, conducting asset allocations themselves, are increasingly populating these either directly, or using ETF or other passive vehicles.
All of our private banks and asset managers were clearly regular users of fixed income ETFs, but like their view on bonds as an asset class in general, they also differed on the role of ETFs in portfolios and the risks which they may pose as exposure increases.
“What worries me in the fixed income market is the potential for systemic risk here,” commented the head of fixed income at a major global manager. “If ETFs are massively successful and take up 60 to 70 per cent of the market trading volumes and you suddenly get money coming out of there, you are going to have huge tracking errors. And because you are not going to be able to sell the underlying assets, you are going to have massive mark to market risk and that has not been tested.”
This speaker feared that ETFs could potentially be oversold on the promise of their ability to trade the secondary market, allowing investors to exit when needed. However, the compelling nature of the ETF story and its cheaper cost of entry to fixed income markets was also acknowledged.
The ETF business model, combined with a low-cost approach, provides a core building block, on top of which an in-house manager can super-impose an asset allocation, which can then be populated with ETFs, suggested one proponent of passive products.
“It’s certainly no magic wand,” said the ETF supporter. “It’s still subject to the vagaries of the same underlying fixed income market. But there are other properties which many investors are finding useful.”
All the speakers clearly had huge respect for both active and passive management of fixed income, with one speaking for the gathering when suggesting: “We’re all in the same boat, trying to deal with bonds, but get our hands on those bonds in a different way.”
The widening of bond portfolios to incorporate as yet unused asset classes was also highlighted, with Chinese bonds identified as a potential fixed income game changer, perhaps even in 10 years replacing US Treasury bonds, suggested one key speaker.
Others rallied to this view, with a major UK wealth manager favouring the broader category of Asian bonds issued in dollars, advocating major Asian allocations in current dollar investment grade portfolios as a “great place to pick up yield”.
The larger, more international banks were the keenest on investing in emerging market fixed income, even identifying a new “sub-asset class” of emerging market corporate debt, expected to gain increasing traction.
The notion of finding “alternative bond proxies”, especially with the end of the fixed income bull market looming, was also raised.
Participants also lamented the primitive state of technology in fixed income trading, compared to equities, with the $10tn US Treasury market still relying on manual systems, awaiting innovative technology such as Blockchain to fix bottlenecks, although there are still many legal and regulatory issues to consider around this.
Despite all the challenges of dealing with fixed income investments, our speakers agreed there were many opportunities and innovations which made this particularly intriguing asset class worthwhile.
“Everybody wrote off equities after the 2000 bear market and equities went into a long ice age,” commented a consultant among our participants, warning there may be trouble ahead for fixed income, which was agreed by most speakers, who were pondering how the “bond bubble” would end.
“But the bit of equity that caused the problems has fallen by the wayside and the quality equities have survived. I think the same thing will happen with fixed income. As an asset class, it’s here to stay.”
