By Richard Westlund
For fixed-income investors, 2015 may be the right time to go global. Adding foreign bonds or other securities can diversify the portfolio and provide exposure to new types of return opportunities.
“We have seen a shift toward more global mandates as investors seek to diversify their fixed-income holdings away from their home countries,” says Valerie Shey, director, Fixed Income Product Management at Wellington Management. She adds that this trend is more pronounced outside the U.S., because the U.S. has been a relatively high-yielding market. “But we think having a global perspective is important when considering a fixed-income strategy for 2015, even for U.S. investors, because of the significantly larger opportunity set,” she says.
Daniel Janis, III, senior managing director and senior portfolio manager at Manulife Asset Management, has also seen a shift in fixed-income approaches. “Many institutional investors are moving from a U.S. centric core strategy to a more global portfolio that may include emerging market and high yield securities,” he says. “But there have been a lot of new products issued in the past six years, so you have to be careful about what you buy.”
Stephen Liberatore, managing director/lead portfolio manager, SRI Fixed-income, TIAA-CREF Asset Management, notes that the U.S. fixed-income aggregate is becoming more global in nature. “Since the world’s economies are becoming more integrated, you need to have a global view and consider the implications for an increasingly correlated fixed-income market,” he adds.
Tracking monetary policies
While institutional investors have been slower than retail investors in making allocations to global fixed-income markets, Chris Molumphy, CIO, Franklin Templeton Investments, believes this sector offers a very good relative opportunity in the year ahead. “The benefits include diversification as well as potential alpha generation,” he says.
However, investors will need to chart their course carefully and track the monetary policies of central banks in the U.S., Europe and Japan. “Their biggest concern today is what happens as the Federal Reserve changes its policy of quantitative easing (QE),” says Shey.
Liberatore believes a Fed rate hike is more likely to occur later in 2015, rather than earlier in the year, because there is still no pressure from inflation. While the U.S. job market has improved, there has been only a slow return to wage growth, and that is weighing on the Fed, he says.
Molumphy adds that the risk of a significant rate increase may be less than the market perceives, considering the amount of global liquidity from the central banks in developed markets.
“One of the biggest challenges for fixed-income investors in 2015 will be the growing divergence of central bank policies in the major economies,” says Michael Taylor, associate director, Fixed-income Product Management Group, Wellington Management.
While the Federal Reserve is winding down its asset purchase program and considering a rate hike, the European Central Bank and the Bank of Japan are engaging in much more accommodative policies to stimulate those economies, according to Taylor. “Relatively higher U.S. interest rates have already had the unintended effect of spurring global capital flows into the U.S. bond market, thus holding down U.S. yields,” he says.
But Taylor points out that this “push-pull tension” among central banks may open the door to active global fixed-income strategies. “When all central banks were leaning in the same direction in the aftermath of the global financial crisis, there was little return dispersion across issuers,” he says. “Active returns were hard to generate for that reason. Now, managers will have more opportunities to add value through sector rotation and security selection based on fundamental research.”
Addressing volatility and liquidity risks
Along with the prospect of a Fed rate hike, investors are also concerned about greater volatility in the fixed-income markets. “We expect to see more episodes of high volatility, as was the case in 2014,” says Taylor. “They are not harbingers of doom, but a reflection of the new market environment.”
A related trend is an increase in intraday volatility in the past year. “There have been multiple days when Treasury levels were down a point in the morning and up a point in the afternoon,” Liberatore says.
In 2015, fixed-income investors will also need to consider strategies to address liquidity risk. “Broker-dealers are no longer major participants in the secondary market for bonds,” says Taylor. “As a result, market liquidity is much narrower and shallower than was the case pre-crisis, and no one wants to sell into an illiquid environment where prices are falling.”
Investors who are planning to make asset allocation shifts within their fixed-income allocations may find it makes sense to change positions gradually over an extended period, rather than trying to adjust the portfolio at once, adds Taylor. “Because of reduced liquidity, exiting sizeable positions can trigger adverse market impacts.”
Searching for opportunities
In a low-rate environment, many fixed-income investors are moving away from core products and seeking out higher-yielding assets, says Janis. “But this needs to be done with caution,” he says. “You need to be sure you understand the nature of these higher-yielding assets before adding them to your portfolio.”
Looking beyond the bond markets, Molumphy says the fundamentals look positive for other fixed-income asset classes, particularly corporate credit. “We like investment grade and high yield, as well as leveraged bank loans, another asset class that has been underallocated institutionally,” he says.
Liberatore notes that slow growth and low inflation offer a good global environment for spread products. However, valuations are very tight across the board. “Investors need to be more nimble and be willing to reposition and trade more frequently to take advantage of valuation opportunities,” he says. On a strategic basis, certain corporate securities, leveraged loans, taxable munis and esoteric ABS products look attractive, he adds.
“Investors have also shown more interest in unconstrained rotational strategies that may include securities such as bank loans or collateralized loan obligations (CLOs),” says Shey. “These present opportunities for bond managers to add value by accessing sectors beyond the purview of many core bond (and even core plus) mandates.”
While seeking return opportunities, investors also need to understand that some types of fixed-income securities may not perform as well as others under specific market conditions. For example, Shey says that investing in lower-quality credit has been “a good call” in the years following the 2008 crisis, but that may not be the case today.
“Many credit managers are running higher-beta (more volatile) portfolios in seeking to outperform their benchmarks,” she says. “If the macro environment turns less favorable to risk assets, those portfolios will suffer. Lowering the quality of a credit portfolio to get more return may be the right strategy for some investors, but if you ‘go for the gusto’ you have to understand the risks.”
In a world with emerging opportunities and significant risks, fixed-income investors may benefit from an overall diversification strategy that includes an active approach to the global market.
As Molumphy says, “Diversification has been a critical element for fixed-income investment over the years. Given the current dynamics of the market, diversification will continue to be a crucial consideration in 2015 and beyond.”
