What does the future hold for fixed income?

Participants:

1. Roel Barnhoorn
Senior bond theme analyst, ABN Amro Private Banking

2. Pierre Bose
Head of fixed income, Europe, Coutts

3. Oliver Gregson
Head of discretionary portfolio management, Barclays

4. Kieron Launder
Chief investment officer, Schroders Private Banking

5. Adrien Pichoud
Economist, SYZ & Co

6. Emanuele Ravano
Head of global wealth management, Pimco

7. Ashok Shah
Investment director, London & Capital

8. Kristof Wauters
Fixed income and forex specialist, BNP Paribas Fortis Private Banking

Moderator: Elisa Trovato
Deputy Editor, PWM

Elisa Trovato: The aim of today’s discussion is to explore the outlook for fixed income, what assets currently offer good value relative to risk and the changing role of this asset class in private investors’ portfolios.

The market turbulence sparked by the US Federal Reserve’s signal that it would soon cut the pace of its $85bn (€65bn) monthly bond buying has underlined how dependent markets are on Quantitative Easing. Is perhaps the major challenge today that of a return to normality?

Kieron Launder: I do not think it is an immediate challenge. The Fed has deliberately set out to reintroduce volatility into the markets. A market can transition better if it is more able to sustain and accept levels of volatility. Transition and a renormalisation of yields are going to happen in time, but the pre-conditions are very different from 1994, where central banks were somehow detached from the markets. Now, they are very much engaged and significant participants in the markets. Their immediate job is to prepare the markets for renormalisation. 

The blanket of purchasing, which dampened volatility, is bound to diminish in future. The impact is an increase in volatility, because renormalisation is very unlikely to go straight back to whatever is determined to be fair value.

Emanuele Ravano: This is a once in a lifetime normalisation. On the fundamental side we have had $5tn (€3.8tn) of extra liquidity in the system, with the government going on a spending spree since 2008 to fill in the gap left by the private sector and, yet, the results are just about 2 per cent global growth. Normalisation cannot occur regardless of the levels of money velocity.

The technical picture is interesting; since 2008 fixed income ETFs (exchange traded funds) have grown by three and half times to $350bn. The inventory on banks’ balance sheets has contracted from $250bn to about $50bn. The technical picture is accident prone as the regulators are asking the banks to take less risk. At the same time, they are happy for us, as asset managers, to provide more liquid instruments. Somewhere in between, you have a central bank trying to find a normalisation.

We are in a realm of unintended consequences.

Elisa Trovato: Do you see any signs of inflation coming through as a consequence of this expansionary monetary policy?

Oliver Gregson: The extraordinary amounts of stimulus that had been pumped into this economy in any other circumstances would have led to some form of inflation. But the velocity of money remains incredibly low. The credit money multiplier is not working as it would in the normal environment. Around half of US stimulus is still in excess reserves held by banks of the Fed, for example. Because of this, the typical impact of that sort of effort is not bearing out in inflation.

Equally, I do not really see it being a concern for many of the central banks at the moment.

Ashok Shah: To expand further, with the changes from Basel II to Basel III, a bank’s tier-1 equity of 2 per cent in 2007 is going to tier-1 of about 11.5 per cent, including countercyclical buffers. Tier-1 needs are changing quite dramatically. Therefore, the bank’s loan book has to go down or new risk capital has to be injected into the system. It is a slow process. This is why banks have been given until 2019. Until the banks are able to expand their balance sheets, they cannot create additional demand, which then forces them to take out the spare capacity. I think inflation is a much longer-term problem. The shorter-term problem is deflation.

Elisa Trovato: What does that mean for interest rates and the fixed income market in particular?

Adrien Pichoud: I think there is no real chance we will see long-term rates go up much further. Either the economic dynamic in the US will soften under the impact of higher rates in the near future, thus prompting long-term rates to move back, or the Fed will send signals that it is not as much in a rush to reduce the liquidity injections which markets have started to anticipate.

The Fed has decided to stop a trend started at the beginning of April, which was one-way (up) for every single fixed-income security, becoming dangerous in some areas of the market. The recent correction therefore has largely been a re-pricing of risk. It is rather encouraging for medium to long-term prospects for fixed income markets, because we are back to a healthier situation, with differentiation between risks.

Pierre Bose: We also have to be careful that of late the larger shift upwards has been in real interest rates due to inflation breakevens falling. If this indicates a temporary fall in inflation expectations but increased longer term confidence in the real economy, that is not such a bad scenario as long as rate rises are slow. We also need to differentiate between looking at the economy from the perspective of investors, where there is an emphasis on nominal prices which drive short-term returns, versus companies who need to drive gains in productivity and profitability in real terms.

The latter lead to longer-term price gains and it is why as investors we should allow deleveraging to lead to lower nominal price multiples. Such a move is healthy as long as it does not impede companies, which for the last two or three years have proven they can manage their resources remarkably well on a real basis, from accessing capital markets and pursuing their objectives. Modest price declines driven by rising interest rates may lead to short-term losses but for longer-term gains, if rates rise slowly, we should focus on the real economy and not leveraged nominal price multiples.

Elisa Trovato: Would it make sense to start moving away from bonds into equities? Is the great rotation from fixed income into equities a myth?

Kieron Launder: The great rotation is a great tagline but year to date, it has been out of cash into both equities and fixed income. Very recently, we have seen the flows reverse out of the emerging markets, especially local debt, which is where a lot of money went earlier in the year. In the past few weeks, the introduction of tapering and the renormalisation has just increased the risk premium across the piece. There has virtually been nowhere to hide, except cash.

To get the great rotation investors need to believe that yields have renormalised to a sufficient degree and economies have stabilised and are growing. Central banks need to become outsiders or regulators, rather than insiders, because people are not going to have faith in any major asset classes while significant distortions continue.

Central banks will do this very slowly, unfortunately. You just cannot go and sell 40 per cent of the Treasury markets. I imagine the Chinese will be slightly more reluctant buyers than they have been in the past. The great rotation is perhaps something that will happen gradually.

Oliver Gregson: The issues raised by the events of 2008 and the European debt crisis still remain at the fore for investors. This has resulted in a great degree of inertia. A lot of clients are still not engaged in the market whatsoever.

Emanuele Ravano: You can use Japan as a not exact copy of what the future will hold. In Japan, in April 2003 the bond boom market ended, and yields have stayed the same for 10 years. In the meantime, there were a lot of false dawns in equities because growth never materialised. The demographics and some of the rigidities of the system in terms of reforms are very similar in Japan and in Europe. There have been historic situations where a boom market in bonds was followed by a 10 year sideways move in bonds, where those were, unfortunately, the best-performing assets, better than cash and equities. Equities have had volatile periods, and there have been ups and downs. However, on balance, you have not made much money out of the general trend in equities during that period.

Ashok Shah: The largest pools of the assets in the world – pension funds and insurance companies – are restricted in what they can do. They have to match assets and liabilities. It does not matter what the yield covers, they will just find value within it.

Also, the world’s population, and especially those that have the assets, is ageing very, very rapidly. A natural consequence of ageing is de-risking, not re-risking. You are in a world that wants to de-risk every year from now for the next 30 years, as the number of pensioners rises. I do not think that rotation will happen in earnest, or in any big measure.

Elisa Trovato: What are your views on market volatility?

Kristof Wauters: We saw an example of that recently just after the Fed comments, when emerging market and local currencies dropped dramatically. It is like being in a big room with a lot of people and a small door and everyone wants to get out.

Luckily, volatility also creates opportunities. A lot of emerging market currencies overreacted. For example, European investment bank bonds in Brazilian real over three years now yield 8.5 per cent, and less than 1 per cent in euro. There is a 7 per cent gap, so the currency needs to drop by 21 per cent in three years from this low point, to be worse off. That gives opportunities to dynamic investors.

Ashok Shah: The current correction is very welcome, because it was getting a little expensive on the other side. Relative strength indicators were already flashing red. Two or three months ago huge shorts were taken out. Around 40 or 50 per cent of the ETF fixed income population was shorted. There were tell-tell signs that everything had gone too much one way, and that it was time to be careful, to protect against the volatility, which was always going to spike up, because it had collapsed. Duration went right down from about seven to eight years to about two to three years. When volatility collapses, you buy protection.

Adrien Pichoud: There is a kind of mean reversion on both sides. If you exaggerate too much, as in April after the BoJ, at some point you need a correction. The trick is trying to avoid very crowded trades, and take advantage of opportunities when you have those corrections.

There can be distortions in the market leading to relative mispricing. For example, at the very moment of the Arab Spring, yields on Egyptian debt were actually lower than yields on Italian debt as the European crisis was at that time the main concern of investors.

Elisa Trovato: How has the role of fixed income in clients’ portfolios changed compared to a year ago? Given yields are so low, can they be still seen as income-producing assets?

Roel Barnhoorn: We do still see it as income, but also as a protection for clients’ portfolio because of its liquidity. In fixed income, we advise clients to hold one third cash, one third government and one third credits. On the credit market, we like high yield companies but the credit market is not so liquid. In government bonds, we like Spain and Italy, because of their higher nominal rates. They are the first and fourth biggest government bond markets respectively, and the European Central Bank is doing everything to ensure a smooth transition. We build portfolios based on default risk, and then we look for opportunities; it is not the other way round. Therefore we need to guide private clients based on the level of risk they want to take.

Elisa Trovato: What level of risk-adjusted total returns can investors expect from a fixed income portfolio in the medium term?

Roel Barnhoorn: In Europe, with Spain and Italy and high yield, I still think you can have a performance of 2 to 2.5 per cent, depending on how active you can play it. In discretionary portfolios, you can go quickly in and out, but on an individual basis, you can hardly do it, because the client needs certain cash flow and income.

In Europe, banks are not supporting the high yield market, so high yield companies are coming back to the market. I see European high yield as the most prosperous in the year, because it is better managed. This asset class is getting more mature, it is growing and I do not see it as speculation. Whereas in emerging markets there are a lot of mixed participants and there is a little bit more hot money and leveraged money. I do not see hot money in high yield, so it is one of our big themes in clients’ portfolios.

Elisa Trovato: In Europe, many companies have taken advantage of demand for yield to issue low coupons, and the market has been inundated by junk bonds. What is the risk there?

Kristof Wauters: The default rate is still fairly low in European high yield, and we find value there. The carry is way lower than a few years ago, but still very decent, certainly from a relative point of view. The proportion of high yield bonds has increased in the European market because there are pretty big companies, such as ArcelorMittal and Lafarge, which have become high yield. They basically are the market right now.

We also play Italy and Spain, but primarily through the corporate bonds, because for example, Telefonica, Gas Natural or Repsol are pretty well diversified companies, both on a geographical basis and income basis. They source the majority of their revenues from growing markets. That is the type of investment we like in the investment grade space. The rest of the bonds, like the single A bonds, are very, very expensive at the moment.

Roel Barnhoorn: Ten years ago, you wanted to follow the index because you thought it was well-diversified and represented the market. But triple, double or single As today are not issuing bonds. They have a lot of cash component. So, from a risk perspective the index has actually weakened and is more concentrated in triple Bs. Those ‘fallen angels’ will fall lately in the high yield market as well.

Oliver Gregson: The predominance of market-cap weighted fixed income indices has been a real challenge for us in performance related terms, as portfolios are structured according to these benchmarks. These indices contain the largest weightings to many of the securities our clients want to avoid, yet it is these instruments that have rallied the most.

Roel Barnhoorn: In some portfolios we do not even have one bond of the benchmark, because we do not like it, because the market has changed. There you have a compliance issue. You cannot change the contract of a client every two years because the market has changed. So, we need to educate the clients that what you buy today is not safe for the next two years, we need to have a very thorough process.

Pierre Bose: The reality is also that a single benchmark index will not tell you everything you need to know about how to build a portfolio or manage risk. They mainly reflect market structure. Common sense portfolio construction rules remain a critical overlay. There is also greater divergence between indices and portfolios because compressed yield curves lead investors to consider alternative allocations, for example high yield bonds.

For the last couple of years, the risk return balance on investment grade was phenomenal. The risk element has gone up and returns have gone down. So the marginal allocation has become high yield, and an index will not guide you on how to weight the allocation and which market (Europe, US or Asia) or part of the capital structure is going to capture the risk return best. You have to do the bottom up analysis in a rapidly moving market.

Elisa Trovato: Is there space for inflation-linked bonds in portfolios?

Oliver Gregson: Yes. We prefer inflation-linked to conventional. The distorted level of the treasury market is substantial: central banks own more than 50 per cent of all treasuries, the Fed controls over 50 per cent of all flow, the BOE owns 40 per cent of the Gilt market etc. The result is that these securities are fiercely expensive. For inflation-linked bonds, we feel the opposite is true. When we look at longer-term view – five-year forward rates, for example, or 10-year break even rates – I think there is an interesting opportunity now, from a portfolio positioning perspective, to look at linkers in contrast to conventionals especially when combined with the fact that people tend not to take insurance out when they need at least.

Kristof Wauters: In principle, there is always space for inflation-linked bonds in the portfolio for diversification purposes, but at the moment, it is not the most liquid nor preferred market. If you buy inflation-linked bonds right now, you are eventually stuck with mostly core European or US long-dated bonds, where you do not really want to be right now. It could be good on a relative side, but you could still be in the minus in the end, because you have long-dated, low remunerated paper.

Pierre Bose: We would agree that on a standalone basis inflation-linked bonds may not be attractive in the short term but with inflation expectations so low we believe there is a place for long term inflation protection particularly when other hedges, for example gold, are performing so poorly.

Elisa Trovato: Which segments of the fixed income market do you favour?

Adrien Pichoud: Once the ongoing correction is over, emerging debt in local currency will probably become the most attractive opportunity. Before the correction, there was a large mispricing of risk. I think emerging currencies have now been overreacting and I would not expect them to depreciate much further.

In emerging economies, I would favour government debt over corporate bonds. The sovereign risk component of the corporate bond yield is much larger in emerging economies than in developed markets. Already bearing sovereign risk and currency risk, I would not add credit risk on top of those. You have sufficient reward in government, or government-like bonds.

Kieron Launder: We have seen this year how susceptible emerging market corporate bonds are to flows, and maybe investors will think that a risk premium needs to be put back into less liquid areas. I would not necessarily argue that in emerging markets there is potentially more interference in the corporate sector by governments, and therefore the corporate risk and sovereign risk are not independent.

I would prefer developed to emerging market high yield. Here you have to be more selective, and it is definitely an area where credit research and indeed active management is probably the default choice.

In high yield, you want shorter duration for two reasons: it keeps you away from sovereign duration risk, but also it increases the visibility on the underlying corporate earnings and cash flows. In longer dated high yields the spread may help offset some of the risk of a yield backup.

Emanuele Ravano: We are more cautious on high yield – I am talking about developed markets – and to us it is a question of optics. When you invest in a high yield bond, from the coupon you need to subtract the average default rate; maybe you assume a little worse if growth is going to be weaker, as we do, and today you end up with a pretty low yield.

In a government bond, you have your coupon; there is no default rate; you also benefit from the positive yield curve because in a steeper environment the bond will be yielding a lower level in the future.

In addition, there is a liquidity charge to exit high yield, whereas in government bonds there is a much lower premium to get out. Once you price everything in, what looks good becomes less attractive.

Pierre Bose: We like high yield and emerging market bonds, sovereign and investment grade, but emerging high yield is not in focus. Developed markets may grow slowly but you know the rules of the game when a company is in distress. In emerging markets you may get a very low recovery on distressed high yield names and as a foreign investor you may have limited rights. Lower yields have also offered an insufficient liquidity premium so you have to be careful in taking that extra step in risk. Closer to home, if for example you look at the Italian versus German bank loans, there is a significant difference between a corporate restructuring situation across geographies.

Roel Barnhoorn: We like high yielding bonds very much too and as a consequence we have rolled out a European opportunistic bond research with the focus on BBB, BB and single B opportunities. Within government bonds, we like Italian and Spanish debt.

Emerging markets have different pockets of value and different drivers. The South African rand has a huge correction, because normally it is quite correlated to the euro, but if you see the South African government bond – triple B – you can switch them into EIB, which is triple A, at the same level. There is, then, some dis-allocation in those markets, which investors can play.

Kristof Wauters: In high yield, we prefer Europe and US. That is partly our sweet spot. The peripheral corporate bonds are a side-line, and for the more defensive investors we see some interest in floating rate notes, especially from non-financial issuers. The market was not really big until recently, but we see more and more non-financial issuers coming to the market with fairly interesting bonds.

Oliver Gregson: Fixed to floating is definitely a theme we are starting to play, because of the limited duration you have with those instruments. Our best selling solution is our higher yielding strategy, which is kind of a crossover strategy. There are clients who are looking at what they are getting in cash and saying, ‘I want the 4-5 per cent income yields of yesteryear’. In the interest rate environment we are in, a lot of people tend to be too concentrated, they are dropping out from investments in lower yield commodities or alternatives. That is potentially storing up a problem for tomorrow.

Elisa Trovato: Adrien, how do you manage duration today?

Adrien Pichoud: We share the view that rates have much more chance to go higher than lower in the long term. But when you look at the time to recovery, what matters is how fast they rise. If they rise gradually, then it is not that painful to hold long-dated bonds and they can contribute to a portfolio. It is quite difficult to try to time the market and exit when you have spikes in long-term rates.

Therefore, it is interesting to have a balanced approach, with credit risk and yield generation on short maturities and some long-term exposure to good names to benefit from the roll down, liquidity and safety. In the current environment, it is difficult and potentially dangerous to give a strong tilt to the portfolio in terms of duration or credit risk.

Elisa Trovato: In the current environment, how does active management compare to passive?

Oliver Gregson: Potentially we are at a watershed moment for fixed income products, and that is being driven by two big things: one, the regulatory environment with RDR and MiFID II breaking up the value chain into its component elements and secondly, the market dynamic: a 30 year bull market where there has been a prevalence of pretty poor product being created for distributors to benefit from that trend, but which was over-reliant on a limited number of asset classes, too concentrated and in tough times suffered from volatility.

That is certainly a challenge for asset managers: the fixed income product of yesterday is not going to meet the needs for fixed income of tomorrow. You are going to see increasing use of passive management within this space. In an environment of lower total return, where costs become increasingly important, fixed income ETFs are solving a number of problems for us. We are starting to use them a lot more within our portfolios.

The changing nature in the product requirements I am going to look for from manufacturers is going to be substantial: more flexibility, greater ease of constraints. If I am paying active management fees, I want to see active share; there is a prevalence of cheap beta out there, and so a benchmark hugging product, which has ridden a bull market for 30 years, is not going to be acceptable. Also, as yields rise, risk management is going to be key.

Emanuele Ravano: In a period of high debt and potentially very volatile growth outlook, you need active management to avoid capital losses. We have moved to less benchmarked-focused, more flexible strategies and we like an income orientation.

Also, high quality is going to be at a premium because the pool of high quality assets is diminishing very quickly. People are worried to be in high quality assets because they have been marked down in price, but the pool of high quality assets, whether it is inflation protected securities or some government bonds or mortgage securities, is diminishing, because central banks are buying particularly those assets. The most current aspect, then, is to buy high quality assets while they are cheap.

Pierre Bose: That speaks to the concept of including relative value (“long-short”) strategies, which help reduce the proportion of a portfolio positioned to profit or lose solely based on whether the market is going up or down.

With such strategies the focus is instead on trying to benefit from differentiating between outperforming and underperforming companies regardless of whether the world is moving faster or slower.

Market directional allocations in your portfolio remain important, but incrementally, if you think that rates are moving higher, it is important to have a ‘market neutral’ element which also allow for more subtle views about the market.

Elisa Trovato: What is the future of fixed income in clients’ portfolios?

Roel Barnhoorn: Unlike in the past, where we presented the client with one fixed income portfolio, we recommend the client should split his fixed income assets in a very basic portfolio, and an additional, more risky portfolio.

In the first one they have liquidity and quality – and you still have a debate about what ‘quality’ is – they can play elements such as governments or inflation. In the second one, they can play the more risky assets, including currencies. They can play duration, not only credit risk. Clients they need to have a risk budget.

Kieron Launder: The discussion of the future of fixed income as a private client investment seems to make the assumption that there is a generic use for fixed income. If we do have a very steep yield curve then if you are looking for income, there are different ways of playing income where you can perhaps have credit and shorter duration. Is it income and safety, is it total return, is it a risk diversifier? Looking for the sweet spot depends on what the role of fixed income in your portfolio is, so there may not be one, generic sweet spot.

Kristof Wauters: A sweet spot of the current market is diversification – it is really being invested with a good spread between high yield, forex, flexible funds, with top quality investment grade and triple-Bs more on the peripheral side.

Through that mix, clients are protected from the volatility which is probably there to come and stay for quite a while, and will still have some decent deals. European based investors who are very conservative and have to be aware of the reality of low yields. You cannot expect a lot from fixed income markets; if you want a bit of yield, you have to take a bit of risk.

Ashok Shah: The vast bulk of our clients want to use the capital, make it grow with inflation a little bit more, so they are always in a capital preservation mode: they just do not have the risk budget to deviate too far away for a significant part of the portfolio out of the fixed income universe. In a way our task really is, within the fixed income universe, to find places to hide or to be without trying to be clever in terms of trading short-term trend. Sometimes we will just back off like we have been doing recently, waiting for the sell-offs, which we celebrate, because it allows us to re-engage in the right parts of the markets.

There are components in equity that we like, but obviously we are not going into that right now. I think that everything is pointing to the fact that financial repression is here to stay. You need income generating assets. Fixed income is the ideal place to give you income and it will remain incredibly important for us.