Examining the Fixed-Income Puzzle

September 15, 2016

Oksana Aronov

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Only time will tell if central banks are able to find creative solutions to normalizing interest rates without a disastrous side effect like a bond panic or a yield curve inversion. In the meantime, investors have been allocating away from equities and into bonds all year, with bond funds adding $189 billion in assets year-to-date.

Within bond strategies there is a flood out of alternative credit and more nontraditional areas of the market into the lowest-yielding — even negative-yielding — high-quality areas. The bond pile-up is alarming for several reasons, and one needs to examine all the pieces of the puzzle to see the bigger picture.

The first piece is the commoditization of fixed income. Warren Buffett’s quote comes to mind here: “The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you. ...” Today negative-yielding bonds more closely resemble commodities.

Bonds have long served as the anchor in a conservative portfolio: a safe haven asset with an income component designed to produce a consistent return stream. As the amount of negative-yielding debt exceeds $10 trillion globally, bonds increasingly cease to trade based on fundamentals, such as yield, in favor of what someone else will be willing to pay for them in the future. For a prime example, look no further than 4 percent Swiss government bonds maturing in 2049. Today these bonds trade above par at more than $130, giving them a negative yield. With premiums of this magnitude, bonds are effectively commodities, and investors are using the greater fool theory as an investing strategy.

The next piece of the puzzle is the false perception of a high-yielding U.S. Treasury market. Compared with the negative nominal yields in Japan and parts of Europe, the yield on U.S. ten-year Treasuries appears attractive, trading at about 1.6 percent. Treasuries also look attractive compared with government bonds from other developed markets such as Canada, with 1.1 percent, or the U.K. gilt’s 0.7 percent or the 1.5 percent in South Korea. On a real basis, however, these yields are significantly negative as well. Adjusting for inflation, they range from –1 to –0.1 percent. Furthermore, at a real yield of –0.7 percent, the ten-year Treasury isn’t even the best house in what appears to be a very dangerous neighborhood for investors. From an endowment whose return target includes inflation to individuals planning on spending their retirement savings, this circumstance has significant implications for many investors.

The final piece is the question of how much control central banks really have over the situation. In our view at J.P. Morgan Asset Management, it is tenuous at best. Whereas central banks have shown they are extremely capable of driving rates lower, they have yet to show their ability to drive market rates up. Should we see more hikes from the Fed, what is to prevent a further flattening of the yield curve? Last year’s hike has already led to significant flattening. The difference in yields between ten- and two-year Treasuries is a mere 80 basis points. To put this situation in perspective, this figure was close to 300 basis points in early 2010 and, since the beginning of 2009, has averaged almost 200 basis points, which makes the current spread two standard deviations below the recent average.

So the Fed’s — and other central banks’ — choices are either to continue to push rates lower, a strategy that is proving to do nothing for economic growth and actually hurts financials, or to push rates higher with little impact on market rates and the added risk of creating panic in the bond markets.

Perhaps this is one reason why we’ve seen the Fed managing in accordance with market sentiment: interpreting essentially the same constructive stream of economic data differently, depending on where markets are at the time of a meeting. The bottom line is that in the wake of unprecedented quantitative easing, central banks have painted themselves into a corner and lost their ability to alter market rates.

So where does this leave us? One way or another, market forces will eventually prevail and return the income component to bonds. In the meantime, investors should consider diversifying into strategies with a much broader toolbox across traditional, alternative and private markets. This recommendation is because a long-only, best-ideas approach focused exclusively on public fixed-income sectors looks very limited on the upside and is acquiring a meaningful downside as the incongruence between economic data and central bank policy grows. A more constructive approach would be to allocate to strategies, not sectors: strategies that target a specific risk-return profile and take a relative-value approach across traditional, alternative and private markets from both a long and short standpoint, as well as lend liquidity in exchange for yield. This approach may be investors’ best bet at continuing to find attractive, risk-controlled returns while waiting for market normalization.

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