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David Riley, | Vasiliki Pachatouridi, | Tom Coleman, |
According to recent research published by Vanguard, which manages the world’s biggest bond mutual fund, global bonds generated median returns of 5.4 percent between 1926 and 2015. In the more recent past, between 1970 and 2015, they returned an even more impressive 7.7 percent.
Until further notice, bonds won’t be generating anything like these returns. At the end of February, the yield on the flagship Barclays US Aggregate Bond Index stood at about 2.2 percent. That yield looked generous compared to those available across large swathes of the sovereign bond market in Europe and Japan. By the end of February, about $7 trillion of bonds globally were trading at negative yields.
In this environment, says David Riley, Head of Credit Strategy at BlueBay Asset Management in London, many investors in Europe have effectively given up on generating income from the core bond markets that used to provide them with such dependable yields. Little wonder that many of these investors, he adds, are looking across the Atlantic for respite. After all, as Tom Coleman, Senior Investment Specialist at Standard Life Investments (SLI) in Boston, points out, in this distorted global environment, 10 year US Treasuries yielding 1.75 percent are increasingly looking like high yielders.
“The average yield on German government bonds is now around zero,” says Gareth Isaac, Fixed Income Fund Manager at Schroders in London. “But there is still plenty of demand from insurance companies and pension funds that have to buy high quality assets for regulatory reasons.”
Some of this demand is also being driven by currency expectations. For international investors, a negative yield on a Japanese government bond does not look quite so unappetizing if it is offset by a 5 percent appreciation in the yen.
At Schroders, Isaac says that he believes the experiment of QE is nearing its end, which will hearten those who say it has conspicuously failed to deliver on its objective of re-igniting growth. Brooks Ritchey, Senior Managing Director, K2 Advisors of Franklin Templeton Solutions says, “It is fair to say that neither Europe nor Japan nor the United States for that matter have seen much of a significant economic recovery post-2008,” says Ritchey in a recent blog.
Whether or not central banks have a Plan B for addressing stagnant growth and the risk of deflation is open to debate. But Schroders’ Isaac believes they will have little choice but to explore alternative options for breathing life into the global economy. “There has been a recognition from central banks that interest rates alone can’t do the job,” he says. “They may now need to move on to the next stage, which could be some form of helicopter drop or expanded infrastructure spending program financed by government debt.”
Either way, says Isaac, the likely consequence would be rising yields as the supply-demand dynamic in government bond markets shifts, which would increase the risk of benchmarked investors sustaining losses.
This would also suggest that inflation is likely to pick up from its current lows, but not by enough to turbocharge interest rates to anywhere near the levels of the 1980s and 1990s.
By happenstance or design, institutional investors have already gone some way towards readjusting their asset allocation to address the lower for longer challenge. At a global level there has been a long-term diversification away from fixed income among pension funds, for example. According to data published by Towers Watson Willis in February, over the last 20 years pension funds in Australia, Canada, Japan, the Netherlands, Switzerland, the UK and the US (which account for over 90 percent of global pension fund assets) have collectively reduced their fixed income exposure by 7 percent. Over the same period, their allocation to alternative assets--led by real estate, but also including hedge funds, private equity and commodities--rose from 5 percent to 24 percent. Among US pension funds, this allocation increased from 17 percent to 27 percent.
Reappraising Fixed Income’s Role
This reallocation is not to suggest that fixed income has lost its relevance for institutions. Nor should it. It does, however, mean that investors may need to reassess their fixed income strategies based on the role they see bonds playing within their portfolios. As Vanguard advised in a recent update, “We encourage investors to evaluate the role of fixed income from a perspective of balance and diversification rather than outright return. High-grade or investment-grade bonds act as ballast in a portfolio, buffering losses from riskier assets such as equities.”
At SLI, Coleman agrees that fixed income will retain a key role, but that its function within portfolios probably needs to be reappraised depending on investors’ individual mandates. “The challenge facing fixed income investors in this environment is two-fold,” says Coleman. “The first is that in a world where achieving annual returns on a fixed income portfolio of 2 percent or 3 percent now looks aggressive, they are having to readjust their risk-adjusted return expectations.”
“The second challenge for fixed income investors is that they are increasingly being forced to abandon benchmarks that they have followed for years,” says Coleman. “Out of which has come the popularity of unconstrained or non-traditional fixed income strategies.”
So-called unconstrained fixed income strategies are defined by BlackRock as those that “can look across the entire global fixed income market for opportunities and adapt quickly to changing market conditions.”
In the case of BlackRock’s $8.35 billion Fixed Income Global Opportunities Fund, this means offering investors exposure to a diverse group of asset classes, as well as investment grade and high yield credit.
However, the performance of some unconstrained fixed income strategies has been disappointing over the last 18 months, with several of the largest funds generating negative returns. “Unconstrained or absolute return fixed income funds have been serial underperformers over the last 12-18 months,” says Isaac at Schroders. For investors willing and able to ride out these short term bumps in the road, he says, unconstrained bond funds may now offer increasingly compelling value. “Over the short term, returns will remain volatile, but there are myriad opportunities within the fixed income market today,” he says. “Investors building an unconstrained portfolio which can take a three- to five- year view should be able to generate some very attractive returns.”
“The question investors should be asking themselves is, can they live with higher volatility tied to many traditional benchmarks in today’s low yield world?” adds Coleman. “I think the answer is no--which means investors should be building unconstrained portfolios, not necessarily adding more risk,” he says.
That is easier said than done, for several reasons. One of these is that it calls for investors to build an entirely new range of research and analytical capabilities. Some of these can be developed in-house, while others will often need to be mandated to external managers. Either way, they add another layer of costs that need to be factored into overall investment returns.
Another is that against the backdrop of a fragile global economy, views are polarized on where value is to be found in the fixed income market today, and where risks can be avoided. Take the example of the US credit market. Some international as well as domestic investors see the US corporate bond market as an increasingly attractive source of risk-adjusted returns. “We have seen an uptick in interest in US public and private corporates from international investors seeking both diversification and higher yields in today’s low-rate global environment,” says Chris Lyons, Managing Director and Group Head, Private Credit, Voya Investment Management.
“Building a portfolio that includes both public and private corporate credits can help fixed-income investors gain the benefits of diversification,” adds Travis King, Head of Investment Grade Credit, Voya Investment Management. “Other advantages to combining these two asset classes include greater tactical flexibility and potentially higher return opportunities.”
BlueBay’s Riley says, “US corporate bonds are an attractive option, given that reasonable investment grade issues are yielding 3 percent or 4 percent, whereas investors would be earning 1 percent or so on an average comparable European corporate.”
The high yield market is also attracting growing interest from yield-starved investors eager to unearth value in a market that was one of the most notable casualties of the risk-off sentiment that prevailed in the first six weeks of 2016.
Pimco agrees that US corporates are offering increasingly appealing yield. “Today, investment grade corporate bonds, select high yield bonds and select bank loans offer investors the potential to earn near equity-like returns with significantly less historical volatility than equities,” Pimco advised in March. “We believe the US economic expansion is right around mid-cycle, which should help keep defaults low (excluding the energy sector) and remain supportive for credit.”
Societe Generale’s Global Strategist, Albert Edwards, has a very different view on the outlook for US credit, which is likely to send shivers down the spine of investors overweight in US corporate bonds. “With the US corporate sector up to its eyes in debt, the one asset class to be avoided – even more so than the ridiculously overvalued equity market - is US corporate debt,” Edwards advised his clients in a devastating note published in early April. “The economy will surely be swept away by a tidal wave of corporate default.”
Emerging market debt is another example of an asset class which plays an important role in unconstrained portfolios. It is also an area where investors remain deeply divided as to whether this is the right time to return to the market, given concerns about the outlook for China, commodity prices and US monetary policy. Some investors fear that they would be catching a falling knife if they stepped back into the market today. Others are already advising investors to switch from lesser-rated US corporates to those in less developed markets where they argue default rates are likely to be lower. According to research published by the London-based emerging market specialist, Ashmore, in the first three months of 2016 default rates among high yield issuers in emerging markets improved by nearly 2 percent relative to those in the US.
With yields in developed markets so unattractive, it is small wonder that investors are reassessing their exposure to emerging regions. “Our emerging market managers are starting to ask if we’re reaching a point where we should be taking on a more significant EM position given that currencies and commodities are both at very low levels,” says Coleman at SLI.
By tearing up the old rule-book for fixed income investment, and pushing managers well beyond their traditional comfort zones, rising demand for unconstrained strategies is opening up considerable opportunities for portfolio managers with the wherewithal to identify relative value and pricing anomalies. At the same time, it is an unforgiving environment for those without the necessary resources.
As BlueBay’s Riley explains, this is because performance across asset classes – and within individual asset classes – is becoming increasingly diverse. “During the period after the global financial crisis, QE was the tide that lifted all boats,” he says. “Correlation across all asset classes was so high that as long as you were fully invested, you could make money. We’re now in a very different investment regime where those correlations are breaking down and there is much greater dispersion in performance. In the US high yield market, for example, investors need to do very thorough homework in terms of the default risk of individual issuers and recovery rates in the event of default.”
The Liquidity Challenge
Alongside diminishing yields, illiquidity is probably fixed income investors’ main concern today, with Pimco advising that there are two notable drivers of reduced liquidity across mainstream fixed income markets. Stiffer regulation reduces the capital that banks can allocate to proprietary trading and market-making. At the same time, the growing popularity of systematic or program trading strategies tends to exacerbate large market moves.
Whether or not exchange traded funds (ETFs) are the answer to investors’ misgivings about liquidity has been a topic of animated debate. BlackRock certainly believes so. “ETFs can help enhance price discovery, provide investors with low execution costs to establish a diversified portfolio, and increase bond market liquidity and transparency,” according to in a recent Pimco report. It adds that “Even during periods of market stress, ETF shares are at least as liquid as the underlying portfolio securities.”
The conspicuous rise in demand for fixed income ETFs over the last year certainly suggests that a broadening community of investors share this view. According to BlackRock’s most recent data, inflows in the first quarter of 2016 reached a record $43.8 billion globally. Demand for credit ETFs was especially strong, with $11.9 billion of net inflows in March alone.
Vasiliki Pachatouridi, Fixed Income Product Strategist for iShares at BlackRock, says that much of the increase in trading in European fixed income ETFs came in the immediate aftermath of the ECB’s announcement of its intention to add corporate issues to its bond-buying program.
Pachatouridi says that the increased trading volumes in fixed income ETFs in the first quarter of 2016 were also a reflection of growing investor confidence in the transparency that ETFs bring to the underlying OTC market, which has historically been regarded as opaque. “ETFs are clearly playing a key role in strengthening the fixed income market from a price discovery standpoint by bringing equity-style transparency to the market,” she says.
Rising demand from institutions such as pension funds and insurance companies, as well as from asset managers, supports BlackRock’s confidence in the long term prospects for fixed income ETFs, which remain underdeveloped relative to their equity counterparties. “To put the numbers into perspective, the global fixed income ETF market is currently valued at about $550 billion,” says Pachatouridi. “This is still only about 15 percent or 16 percent of the global market for exchange-traded products (ETPs), which is worth about $3 trillion. So fixed income ETFs are still a small part of the total market, but it is definitely the fastest-growing segment.”
Market participants are hopeful that electronic trading platforms will have a key role to play in the increased transparency and visibility that ETFs bring to the fixed income universe. Tradeweb, for example, has recently announced the launch of an electronic over-the-counter (OTC) marketplace for US-listed ETFs, which builds on the success of its European platform, where average daily trading volumes now exceed €500 million. “We’re at the early stages of the electronic development of the ETF market,” says Billy Hult, President and Head of US Operations at Tradeweb.“Although fixed income ETFs may not be a panacea for the bond markets, the Tradeweb ETF platform will support improved liquidity by enhancing transparency and providing an innovative way to execute larger-size, or traditionally less-liquid trades.”