Investors urged to rethink role of fixed income

Anyone following coverage of the bond markets in much of the financial media would think investors should be seriously considering major reductions to their fixed income allocations. Yet many have specific liabilities and need to allocate to the asset class and it remains a vital part of clients’ portfolios.

Traditional government bonds offering negative returns seem pretty unattractive, so yield-hungry investors have been moving further down the credit spectrum into areas such as corporate credit and emerging market debt. Others have extended duration to try and find positive yields, leaving themselves vulnerable to any moves in interest rates. 

In such an uncertain macro environment, central bank policies should continue to support the asset class, even with the Fed indicating a desire to raise rates by the end of the year. This should result in very low, but positive, returns for fixed income going forward, though bouts of volatility are to be expected.

The low yield environment has impacted all asset classes, including equities and real estate, says Steve Preikschat, client portfolio manager at Janus Capital Group, the Denver-based asset manager. “A properly constructed fixed income allocation can serve as portfolio ballast, counterbalancing more aggressive and volatile asset classes.” 

He notes that expected default rates remain low and believes there is reasonable value in many parts of the corporate credit market. But the way in which Janus is using fixed income has changed over the past five years. “We have moved from an opportunistic to a more defensive stance as yields have compressed relative to the potential risks,” explains Mr Preikschat, reducing exposure to long-end and higher beta corporate credit and increasing exposure to highly liquid government bonds. 

Investors should be wary of hunting for yield, which brings vastly higher downside risks, he warns. “Be patient and only stretch for yield consistent with your ability to tolerate risk. We believe defensive, liquid portfolios will benefit. Investors that are patient will likely have the ability to act from a position of strength as liquidity providers during the next inevitable round of market volatility.”

There are certainly plenty of risks to the global economy out there, agrees James Athey, investment manager with the global macro team at Aberdeen Asset Management. 

“Individually they might appear quite small – the risk of China blowing up for example. But add up all the small possibilities and you get an investment horizon that looks very uncertain and with a lot of potential for negative events. And we would still expect fixed income to perform very well during those events and probably outperform most, if not all, other asset classes.”

Core fixed income should therefore have a place in asset allocation decisions, he argues, because it does provide safety in times of economic or financial market stress. 

Chasing yield is a dangerous place to be, warns Mr Athey, and investors should not be forced into riskier asset classes, rather they should be taking on levels of risk which are appropriate and well-judged. “Investors are probably running more risk than ordinarily they would be happy with.”

New part to play 

Large capital gains from bonds are unlikely in the current environment, but that does not mean fixed income does not have a role to play, says Richard Ford, head of European fixed income at Morgan Stanley Investment Management. 

“Not all bonds are equal,” he explains. “Short dated bonds can offer capital preservation in times of market volatility, high yield bonds taking default risk can benefit from an improving credit profile, floating rate notes hold their value when rates rise and even low yields in long dated bonds can be attractive if central banks increase their buy programmes or we enter a period of deflation.”

Nevertheless, investors need to re-evaluate their portfolio positioning in the current market environment as historical portfolio construction is unlikely to be adequate to achieve desired outcomes, says Steven Oh, global head of credit and fixed income at PineBridge Investments. 

“Fixed income serves the dual purpose of income/yield and portfolio diversification and stabilisation, so that even if the income component is low, the diversification value of fixed income is an important aspect of portfolio risk management,” he explains. 

It is necessary for investors to look at asset classes and geographies that they may not have historically been exposed to, says Mr Oh, but they must recognise the incremental or differing risks they will be taking on. So, for example, emerging market debt should be a component of portfolios but it encompasses a wide range of categories ranging from local currency to hard currency sovereign and corporate credit. PineBridge currently favours investment grade corporate US dollar emerging market debt as an area with incremental yield but with a defensive positioning within the emerging market debt spectrum.

For those investors who are seeking income, both high yield and emerging markets do have their attractions, as, from a yield perspective, returns are simply not there from more traditional fixed income. 

“Emerging markets are generally expected to deliver positive returns next year,” says  Sergio Trigo Paz, head of emerging market fixed income at BlackRock. “The discussion with clients tends to be how to get into emerging markets, not when or if.”

However, investors need to be selective, and he recommends flexible strategies where duration can be hedged. BlackRock currently has around 10 per cent in high yield and 10 per cent in emerging market debt in its flexible funds, though this could go higher.

“You need to be in assets where if liquidity was to dry up you would be happy where you are because you can’t sell it,” adds Mr Trigo Paz.

Emerging markets have certainly benefited from a more hesitant Fed policy and therefore a more stable US dollar, with total returns year to date all well in positive territory, says Jeremy Spain, fund manager and senior bond analyst at Charles Stanley. Although the asset class has enjoyed inflows due to the hunt for yield, and there is no sign of this ending, he wonders if the best returns have already been found. “The market tends to expect prolonged central bank accommodation but it might well be too late to capture any further outperformance in this arena,” warns Mr Spain.

High yield

US high yield has also been an area of the market that has attracted considerable interest, with the asset class enjoying a significant rally that began in February and has continued throughout 2016. 

The gradual recovery in the oil price was the initial catalyst for this turnaround, explains Niklas Nordenfelt, senior portfolio manager of the Wells Fargo US High Yield Bond fund, as there had been so much fear about high yield’s exposure to the commodity.

Since then there have been three things underpinning the continued recovery, he says. Central banks have been extremely accommodating, oil prices have continued moving up and there has been a presumed Clinton victory in the upcoming election.

“High yield offers a US dollar-denominated asset with yield, and in a world where finding yield is extremely challenging, this makes it very attractive,” adds Mr Nordenfelt.

Could a Trump victory derail the high yield market? It could certainly usher in heightened volatility, but he believes that would impact the stockmarket first. Risk assets would be impacted broadly by the uncertainty, and high yield could be impacted. “But would it have an impact on company fundamentals? That is what drives high yield over the long term.”

And the much talked-about rate increases should not carry any meaningful impact on company fundamentals. “A rate hike of 25 basis points would have virtually no impact on a company’s ability to refinance,” he says. “Rate hikes beyond that could impact equity valuations in which case you would see low quality bonds sell before high quality bonds.”

Indeed investors should not be stretching themselves to find yield even in this asset class, warns Mr Nordenfelt. “That might seem strange when you are talking about high yield – most people believe they are stretching by simply investing in the market. But within high yield, we have actually been reducing our risk exposure, and are sticking with companies that we think would be able to weather a potential downturn.”

But those looking for superior returns and turning their attention to high yield bonds should not overlook the fact that liquidity risk has increased dramatically since the end of 2015, warns Sean Ryan, senior analyst at Markov Processes International, a global provider of investment research, analytics and technology. 

“For mutual funds that invest in illiquid assets, such as high yield bond funds, liquidity is a major concern,” he explains. “If too many investors try to cash out at the same time, to provide liquidity, a fund may be forced to sell its holdings at fire sale prices – if it can find a buyer at all.”

High yield bond investors could face a rocky ride ahead, with increased market volatility and uncertainty over US interest rates meaning investors should be on the lookout for liquidity red flags and understand the investments that their managers are making into illiquid securities. Mr Ryan points to Fitch forecasts that show $90bn of high yield debt could default by year end, while S&P Global predicts the US speculative grade default rate will climb to 5.3 per cent by the end of 2017’s first quarter, up from 3.8 per cent 12 months earlier.

But liquidity is not just an issue for the high yield market. “Investors should be under no illusion that liquidity is fractured in fixed income markets,” says Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers. This stems from two main causes. Firstly, the unconventional monetary policies of central banks mean they have bought and hold up to 30 per cent of all outstanding government debt and have therefore reduced the free float of major sovereign bond markets. Meanwhile tightening regulations such as Basel III are strongly reducing banks’ ability to hold and trade fixed income. “Banks are acting more like brokers than principals,” he explains.

Liquidity has been reduced substantially in fixed income markets, agrees PineBridge’s Mr Oh, noting how although there are significant trading volumes, trade sizes have become much smaller and the ability to trade large lot sizes has become constrained.  

“This change means that smaller, more nimble firms are still able to navigate their portfolios but the large mega-managers lose their ability to actively manage portfolios.”

European opportunities

Although yields are compressed and beta returns are extremely hard to come by, alpha generation potential in European fixed income remains significant, believes Jozef Prokes, portfolio manager in the Fundamental Euro Bond team within BlackRock’s fixed income group.

“There are even larger dislocations than before. Investors are abandoning parts of the market because they do not think there is any value left. You might need to move into different volatility regimes, but you don’t have to chase beta, you can focus on alpha.” 

BlackRock particularly likes European banks, where it sees “pragmatism” starting to enter the regulatory environment. 

“European banks in general are well capitalised,” says Mr Prokes. “We know there are some specific idiosyncratic stories, but we know where the problems are, and they tend to be legacy issues.” 

Generali Investments is positive on European credit, as it expects the ECB to continue to purchase around €8bn ($8.8bn) a month of investment grade and crossover non-financial and insurance debt. Meanwhile, the default rates remain very low. “In addition, firms are reducing their leverage by buying back their expensive existing debt and refinancing it at better yields,” says Eric Domergue, head of fixed income for third-party business at Generali Investments. 

“This is the opposite of what is happening in the US, where companies finance their stock buybacks and dividends by issuing debt.”

VIEW FROM MORNINGSTAR: Yields continue downward spiral

The continued accommodative monetary policy from developed market central banks, and stubbornly low global economic growth, have been supportive of global fixed income markets so far in 2016 (to September 30). This can be seen by the 9.8 per cent return of the Barclays Global Aggregate index and the 7.2 per cent of the Morningstar Global Bond category. 

Markets with a larger proportion of long-term issuance, such as the UK gilt market, have rallied strongly year-to-date. However, ‘Brexit’ added tailwinds to the 14.7 per cent return generated by UK gilts so far (as per the Bank of America/Merrill Lynch UK Gilts index). The yield on the 10-year UK gilt dropped 65 basis points on the week following the ‘out’ vote’s victory. 

The strong rally in government bonds however has also meant that yields have continued their downward trend, reaching record lows over the course of the year (yields on the 10-year Japanese government bond and the 10-year German bund dropped to -0.28 per cent and -0.18 per cent, respectively, in July). As yields continue to grind lower, the asymmetric risk of the fixed income asset class, especially for developed-market sovereign bonds, has become more prominent. 

In this environment, investors with a global opportunity set are encouraged to explore other areas of the market for more attractive yields, such as emerging markets debt. An increasing part of the opportunity set for global bond managers, emerging markets local-currency debt had a dreadful 2015 as evidenced by the -14.9 per cent return of the JPM GBI-EM Global Diversified index. 

Although in positive territory, 2015 was no standout year for emerging market hard currency debt either, returning only 1.2 per cent as per the JPM EMBI Global Diversified index. However, a variety of factors such as stabilisation of China’s fundamentals, narrowing current account deficits, accommodative central bank policy and ever-present hunt for yield, are behind the spectacular returns across the emerging markets debt complex (17 per cent for local debt and 14.7 per cent for hard currency debt) year-to-date to the end of September. 

In that context, the early move into emerging market local currency debt for Legg Mason Brandywine Global Fixed Income, which has a Morningstar Analyst Rating of Bronze, has been the key driver of the strong performance year-to-date (to September 2016). The fund is managed by experienced investors Steve Smith and David Hoffman, who have worked together for more than two decades at Brandywine and have built a compact yet experienced team of analysts to contribute to this fund, which invests in global sovereign and quasi-sovereign bonds. 

Despite the tough year thus far for Templeton Global Bond, rated Silver by Morningstar, its strong, long-term track record remains unscathed. The fund is among the boldest entrants in the category and its emerging-markets-heavy profile (as at August 2016, the top three countries in the fund were Mexico, South Korea and Brazil) has caused it to move in sync with riskier assets. More recently, the fund’s negative 0.28 years duration and short positions in the euro and Japanese yen against the US dollar have been key detractors. Over time, investors have had to endure many shocks caused by currency swings and emerging-markets sell-offs, but manager Michael Hasenstab’s macro calls and patience have made the extra volatility worthwhile.

Carlos Gonzalez-Lucar, manager research analyst, Morningstar