Investors keep powder dry as bonds enter the unknown

Economic cycles do not simply die of old age, but there is widespread consensus that the long-running recovery which followed the global financial crisis is nearing an end.

Central banks, which have flooded markets with liquidity via quantitative easing, have signalled their intention to turn off the taps, led by the US Federal Reserve which has raised rates three times so far in 2018, and is expected to continue along this path next year. Although other central banks are further behind in normalising monetary policy, the trend is clear.

Rising rates, along with stronger-than-expected economic data in the US, has led to a bond market sell-off in recent weeks and driven US Treasury yields to multi-year highs, which can cause market dislocations, as investors may become unwilling to take risk in the stockmarket if they can get similar returns from bonds. The cost of refinancing debt could also creep higher.

Although there have been ups and downs and bear markets, the last 35 to 40 years have in essence been a bull market in fixed income, says Lewis Aubrey-Johnson, head of fixed income products at Invesco. “As an asset class it has been perfect. It has given you attractive carry, protection – at least in government bonds – when you have needed it, and also capital uplift because of the decline in yields.” 

But times are changing, he warns, albeit gradually. “We are still at the very early stages of this adjustment, but know the potential upside for these markets is quite limited, and we don’t know what the downside is.”

Investors have not had to deal with a situation like this for some time, he warns, indeed many working in the industry will never have experienced it. So how to cope with that challenge? Invesco is keeping its powder dry. 

Positioning going into a bear market is just about the most important decision a fund manager makes in their careers, believes Mr Aubrey-Johnson, and can impact performance for years.

“Our sense is that with yields so low, the extra premia we can earn for clients is not that great, and can be easily wiped out and more in a poor market,” he explains. For some time, Invesco has been holding a lot of cash and core government bonds, and a lot of short-dated paper, investment grade paper in the higher yielding funds. 

“It doesn’t make for a great sales pitch, but sometimes the most important thing is to do nothing. So we are positioned relatively defensively with pools of liquidity and are waiting for the environment to change.”

JP Morgan agrees that we are at an inflection point, and recently rolled out what it calls its ‘Late Cycle Playbook’ for clients. 

“The curve is telling us that we are late cycle, not end cycle – I am not saying the economy is going to roll over this year – but that does mean we need to be a little more defensive,” says Thomas Kennedy, senior global fixed income strategist for global wealth management at JP Morgan. But he does not believe that means parking yourself in cash, which brings its own risks, rather adding quality and duration to portfolios. 

“You can’t just blindly allocate to an index when spreads are as tight as they are now,” warns Mr Kennedy, rather late cycle favours active investors. “We have all heard how it is a stock pickers market, well I think it is a credit pickers market too.”

Rising yields

Yields in fixed income have been suppressed for an extended period of time, but that is now changing, as bond prices and yields move inversely. 

“We have had a very big upward correction, particularly in the US treasury market,” says Scott Thiel, deputy chief investment officer of fixed income at BlackRock. “Five to 10 year notes are above 3 per cent, and five year notes very close to three per cent.”

This means getting yield from high quality assets has become an interesting option for investors, and BlackRock is putting together products targeting a 5 per cent yield, a figure much more comparable with historical returns. “Investors are becoming aware of the yield that is on offer. And for fixed income investors, boring is good, so if you lock in a high yield, and nothing happens, then that is fantastic,” he says.

But not everyone believes these higher yields are here to stay. “While in the short-term yields may continue to go up due to cyclical reasons – for example tax cuts and tariffs – the longer term secular case for low yields is still very much intact,” says Krishna Memani, CIO at OppenheimerFunds. 

Over the longer term, deflationary pressures due to global demographic trends, high levels of debt across the board and technology are driving low yields, and are not going to fade away anytime soon, he says. Despite all of the political and monetary issues facing the global economy, market volatility has actually been quite muted relative to where we are in the cycle, he believes. 

Nevertheless, bonds do have an important role to play in portfolios, believes Mr Memani, as they serve as ballast, particularly with equity valuations stretched. 

There is nothing magical about yields of 3 per cent, says Andrew Balls, CIO global fixed income at Pimco, who expects global yields to remain pretty anchored.

The probability of a US recession in the next 12 months is very low, he believes, but it makes sense to position for higher volatility.

“In a world where the trade war could gets worse and impact the global economy and US equities, then there is clearly a role for fixed income in your portfolios,” says Mr Balls. “It makes sense to be defensive at the moment, and you are not getting paid for taking risk. If we get a rise in volatility we may see opportunities emerge, so it makes sense to keep a little bit of powder dry now.” 

The Fed is doing a good job of managing the end of QE, he believes, in contrast to the taper tantrum of 2013, although that did serve to let some steam out of the financial system. “But at the very least, central bank tightening means they are going from being suppressors of volatility to contributing to volatility,” says Mr Balls, warning that an inflation surprise in the US would make the Fed’s job more difficult.

Fiscal expansion

And inflation could become an issue, believes James Dowey, chief economist and CIO at Neptune Investment Management, not least because of President Trump’s fiscal agenda. The US administration authorised $1.5tn worth of cuts to corporate and personal taxes in January 2018, and later passed $300bn in federal spending increases. This may have pushed up short-term growth, useful for Mr Trump with the mid-term elections on the horizon, but could lead to inflation and increase the federal deficit, making it harder to carry out additional fiscal stimulus in the next recession.

“Doing this, at this stage of the cycle, when the Fed already has a difficult job in terms of stabilising the inflation picture, this is just setting the Fed up to fail,” says Mr Dowey. Tensions between the White House and the Fed have been increasing, with Mr Trump calling the Fed “crazy” for continuing to raise rates despite market turbulence in early October.

“Will the White House dominate the Fed? Will it suppress the interest rate increases, and allow the White House to follow a classic inflationary populist agenda?” asks Mr Dowey. 

He believes the Fed will stick to its guns and its mandate, but expects the White House and the Fed to be going “head to head” down the road. 

An inflationary environment would mean that bonds are no longer able to play the risk management role they have provided over the last 20 years, says Mr Dowey. “Bonds have been everyone’s friend because they have had a negative beta to the stockmarket. This is not going to be the case going forward. When you get an inflationary recession, stocks go down, and bonds go down at the same time. And that is the future.”

With equity markets at such elevated levels, along with the increased volatility seen in 2018, RBC Wealth Management has been advising clients towards incorporating an allocation of fixed income into portfolios. “Bonds provide both diversification to previously heavily equity-weighted strategies as well as incorporate a level of downside protection,” says Alastair Whitfield, head of fixed income, at RBC Wealth Management International.  

The firm sees opportunities to incorporate bonds across a broad spectrum of client portfolios, including those with income requirements or looking for a cash plus solution.  

“Our fixed income strategy is to provide capital protection while tactically looking at opportunities to enhance returns on a measured basis,” says Mr Whitfield. It is positioning more conservatively in US fixed income, while valuations in emerging markets look compelling.

Bonds will always have a role to play in client portfolios, believes John Ng, head of portfolio counselling and product strategy at DBS Bank, yet the Singapore-based institution continues to have an underweight to the asset class. 

“This does not mean holding no bonds,” he says. “It just means that there are areas of fixed income we prefer more than others, and relative to a benchmark, we would hold a lower amount.” 

In a rising rate environment where credit become more expensive for borrowers, DBS prefers bonds with higher credit quality, and is underweight developed government bonds. “Some emerging market corporate bond spreads have widened significantly, and may offer good opportunities to gain exposure as their higher spreads compensate against potential volatilities,” says Mr Ng.

Emerging opportunities

Indeed, most of those who spoke to PWM for this article see emerging markets as an area of opportunity in the fixed income universe, despite the turbulence they have suffered this year, most notably in Turkey and Argentina. The consensus is that while loose central bank monetary policies inflated prices in these countries, and the withdrawal of that stimulus, along with a strengthening dollar, threatens these markets, those who have carried out meaningful reforms should be in a relatively good position.

Invesco’s Mr Aubrey-Johnson says that while risks are elevated, there is also value to be found and big yields are on offer in Argentina, Brazil and South Africa. Simon Fasdal, head of fixed income at Saxo Bank, believes “sophisticated” investors should be able to find areas of Latin America which have sold off unjustifiably. Mr Memani at OppenheimerFunds says emerging market local currency and dollar denominated assets have underperformed relative to other sectors and probably represent the best opportunity in fixed income.

But Sergio Trigo Paz, head of emerging markets fixed income at BlackRock, puts it most colourfully, explaining how sell-offs create good buying opportunities because they highlight problems and many investors, who have bought the whole market, get out.

“Think about QE as a dating app. It meant that emerging markets put on their best profile. Brazil is growing, and its fiscal issues seem to be behind them. Argentina is going full steam ahead, and so on,” he says. 

“But quantitative tightening is like the actual date. Suddenly your investment is real, you see it in the flesh. And you think, ‘Oh my god, I want to get out’. Most investors who go into emerging markets for the wrong reasons want to exit. But if you get to know the real story, you stay. Emerging markets pay you for the risk you are taking, once they reprice. And some are very attractive, despite their faults, because they are doing something about them.” 

Bond ETFs enjoy rapid growth

Fixed income ETFs have surged in popularity in recent years, according to Antoine Lesne, head of strategy and research at SPDR ETF. He reports that total assets in these vehicles, which stood at approximately $50bn a decade ago, have now reached $850bn, while the number of products now stands at around 950, and allow investors to gain exposure to most segments of the fixed income universe.

“At SPDR ETF we have seen growing appetite for corporate bonds, both investment grade and high yield, over the past few years, while appetite for emerging market debt local currency bond ETFs has also risen of late as investors search for yield enhancement in the current environment,” says Mr Lesne.

Fixed income ETFs have seen healthy inflows in 2018, says Brett Pybus, head of Emea fixed income strategy at iShares, although not quite as high as the “exceptional” ones witnessed in 2017. “But ETFs are still very small in the context of the overall bond markets,” he says, though adds that MiFID II should give ETFs an added boost.

There are considerable opportunities for active ETFs in the fixed income space, argues Jason Xavier head of Emea ETF Capital Markets at Franklin Templeton Investments, as participants are able to leverage their expertise with unrestricted allocations  and offer a better risk-adjusted outcome for clients.

“For investors looking for transparent access to fixed income assets coupled with the flexibility and agility of active management, an active fixed income ETF may be an option to consider,” he says.

VIEW FROM MORNINGSTAR: US proves resilient while other markets falter

Despite anxiety over an ever-lengthening credit cycle and tightening monetary policy, US bond markets remained resilient over the summer. 

However, non-US developed bond markets struggled in the shadow of political tensions. As the details of the UK’s separation from the European Union remain under negotiation, with neither party expressing willingness to compromise on critical factors, sterling experienced a precipitous fall relative to the dollar in mid-August, though it recovered somewhat to end the quarter. 

The euro followed a similar pattern, but its August dip was attributable to concerns around Italy’s budget and widening yields on its debt. 

The continued strength of the dollar coupled with idiosyncratic risks across emerging markets countries contributed to a tough environment for that sector. Turkey, which has pursued aggressive economic growth policies in recent years, was under pressure as its central bank’s credibility eroded. Argentina’s bonds and currency also struggled, as the IMF agreed to accelerate and increase the size of its bailout. 

While steep losses for Turkey’s and Argentina’s local currency debt dominated headlines, the pain was not widespread. The hard currency JPMorgan EMBI Global Index resisted contagion and generated a 1.9 per cent return for the quarter, for instance.

Sonal Desai, co-manager of the Templeton Global Bond and Templeton Global Total Return funds since 2011, will step down at the end of 2018 to take over as CIO of Franklin’s fixed income group. Ms Desai’s expertise will be missed, but Michael Hasenstab, who has managed the fund since 2001, will continue making the final calls here. 

The funds ply a benchmark-agnostic approach and stand out for their general avoidance of low-yielding developed markets debt. Instead, the team focuses on emerging markets and is willing to buy what the rest of the market shuns (for example, Ireland during the 2011 eurozone crisis, Ukraine in 2015, and Argentina through its recent political turmoil).

M&G Global Macro Bond has been managed by Jim Leaviss since its inception in 1999. He has been backed by emerging markets debt specialist Claudia Calich since July 2015, which is helpful given the fund’s increasing focus on emerging markets. This “go-anywhere” strategy can take long-short positions across the global fixed income and currency markets. Mr Leaviss has used this flexibility well over the long term, resulting in a strong and consistent performance record. 

Legg Mason Brandywine Global Fixed Income Fund is managed by Steve Smith and David Hoffman, who have long disregarded issuance-weighted indexes, instead searching for high real yields and undervalued currencies in countries with strong or improving fundamentals. That has led to significant emerging markets exposure and little exposure to low- to negative-yielding developed markets staples such as Japan and the eurozone. 

While this contrarian approach has spurred a good deal of volatility, it should continue to reward patient investors in the long run.

Mara Dobrescu, CFA – associate director, Manager Research, Morningstar