Fixed income, in today's world
Understanding the complexities of fixed income — and the macroeconomic drivers, and impacts —is what will help advisers unlock this asset class’s potential in the current environment, and allow it to be used for more than a defensive component of a portfolio. Here we examine the key areas to be considered.
In today’s world, and despite it being a feature in almost all investment strategies in some way, fixed income is not a well understood asset class. This is for a number of reasons: because it’s “misnamed”, because of its relative complexity, and because of the diversity of approaches taken. Ultimately, it is the things that make fixed income hard to understand that give it its enduring value. Even in an environment of rising interest rates, many of the concerns about fixed income that are discussed later are misguided and dramatically overstated.
We are in a world awash with fixed income investments. Outstanding global bond debt at around USD$130 trillion is almost double that of the market capitalisation of the global equity market. Fixed income assets make up a significant part of the global investment universe.
Fixed income is used in a portfolio for two primary objectives:
- In a defensive capacity, as a source of low risk return; for the diversification of risk (predominately equity risk); as a source of liquidity; the generation of income; and/or, to protect capital.
- In a return seeking role, primarily utilising the higher risk parts of the universe — global high yield, hybrids and subordinated securities — and comingled “absolute return” fixed income strategies that may involve the use of both leverage and currency positions to generate absolute return outcomes.
The current fixed income debate is primarily related to one particular aspect of the fixed income universe – namely the level of interest rates and, in particular, the impact (positive and negative) of duration.
The ability of fixed income to play different roles in part reflects its diversity. This is reflected in a range of factors including the type and quality of issuers, issuer quality, the degree of subordination, security type, maturity, coupon, individual covenants, and so on.
The defensive properties of fixed income come primarily from two sources:
- The countercyclical nature of interest rates — they decline when economies slow or inflation slows
- The underlying quality of the securities, reflecting issuer quality, the relative seniority of debt in the corporate capital structure, the predictability of the income stream, and the fact that, unlike equities, which are effectively perpetual securities, fixed income securities generally have fixed contractual maturities.
The primary driver of the idea that bonds can diversify equity risk in a cyclical sense is related to the first of these factors. When economic conditions moderate, central banks often cut rates, dragging down bond yields and boosting bond returns. Typically this is occurring at the same time that profits are slowing and equities are falling, meaning returns to bonds are at least partially offsetting weakness in equities. Of course, this is the theory and in practice it is never quite so pure.
The relevance of fixed income in portfolios and its effectiveness to play a defensive role has come under much scrutiny given the impact of the structural bull market and global QE on both bond and equity prices. There are a number of key considerations for investors as central banks begin to unwind their balance sheets and we navigate the path to normalisation.
Bonds still provide diversification benefits
A big concern is that as bond yields rise, riskier assets that have benefitted from stimulatory monetary policy will also underperform. The evidence is mixed. Correlations between government bonds and riskier asset returns have mostly been negative over the last several years in spite of QE. For us, the more important point to remember is the diversification benefit of owning fixed income (duration) typically comes when needed the most during periods of risk aversion and stress environments — those typically characterised by falling equity markets.
In most circumstances, when risk assets or shares falter, bonds will outperform, as figure 1 illustrates comparing the Bloomberg AusBond Composite index versus the S&P/ASX 200 index. Although the performance history is shorter compared to other global markets, we see a consistent pattern of bonds outperforming when equities experience negative returns and the contributions of bonds to a portfolio increases as the returns on shares get worse.
Rising rates make fixed income more valuable
We have already seen a significant sell-off in US bonds. US 10 year bond yields touched 1.36% in early July 2016, and more than doubled to be just over 3% by mid-May. The sell-off has been pronounced across the yield curve with US 2-Year bond yields rising by almost five-fold (+0.55% to +2.57%) and US 5-Year bond yields rising three-fold (+0.95% to +2.92%) largely due to a period of sustained global growth and lifting inflation — and we have already seen central banks shift their policies to these changing economic conditions.
The US Fed has led the way, steadily lifting the cash rate. We’ve seen yields on bonds rise as a result, but how high yields go depends on several factors, including whether more countries begin to lift rates too, or if we see inflation start to accelerate. Our view is that most other countries compared to the US are lagging in terms of growth, and economic differences will likely play out via currency moves, while the market isn’t priced well enough for inflation to pick up more than expected. We also expect more structural issues — such as high debt load, ageing demographics, and the disinflationary effects of globalisation and technology — to further limit longer-term yield rises.
While a rise in Australian rates is still some way off, the rise in US rates provides opportunities for fixed income managers to exploit a broader universe of opportunities across markets that are at different points in the economic cycle. These opportunities can include yield curve, and cross market or active currency positioning.
With the threat of rising rates already upon us, a lot of people spend time worrying about changes in yield levels and the impact on short-term bond returns. However, the maths of bonds is that over the long term, the level of income is much more important for returns than are changes in yields. In other words, a rise in yields in the short term, while sometimes a little painful, sets up better long-term performance driven by higher yield (income) levels, as illustrated in figure 2, which shows the increase of bond returns over the longer term.
During periods of rising rates, this largely comes down to the reinvestment of coupon payments at higher rates, which help cushion the impact of declining prices for existing bonds, and can boost total return over time.
Fixed income’s value in a broader portfolio context is also improving. Because bonds have to a degree already repriced but expensive riskier assets have not, fixed income is starting to look appealing. For example, our medium-term return forecasts expect a higher return now from US government bonds than from US equities.
Additionally, although the focus is on the upside in the cycle, we’ve got to be cognisant of risks to the downside. Our modelling suggests that US recession could come as early as the end of 2019. Higher yields now build in better recession protection for later.
If we’re right about structural forces limiting the upside in yields, and the end of the (at least US) cycle is looming, then there’s also a reasonable chance we’ve seen the worst of the yield move already.
Now is not the time to go passive
Passive fixed income strategies track the benchmark, and don’t have the flexibility to adjust positioning to account for changing conditions, such as rate rises. While these strategies have produced relatively good returns over the past few years, investors may not realise that the benchmark they’re invested in is not as low risk as they think. A benchmark such as the Bloomberg AusBond Composite Index has limited diversity, being dominated by government issuers taking advantage of lower borrowing rates to pay back over longer periods. This means that benchmark duration, or its sensitivity to interest rates, has increased, and with it the amount of risk as illustrated in figure 3 below.
This is where active management of fixed income is crucial. As markets normalise, we’re likely to see volatility, and active management becomes critical to ensure this volatility is minimised, as well as to manage portfolio duration exposures as we navigate through rising rates. Active managers can also take full advantage of the breadth of the fixed income universe, to seek opportunities as well as to control downside risk to provide capital protection and stability in your portfolios.
– Our base case is that bond yields rise from current levels reflecting rising inflation and steps towards more “normal” global policy settings. As a consequence actively managing duration exposure is — as always — important.
– We challenge the assumption that fixed income’s ability to diversify the risk of shares has broken down. Should growth falter and recession risk rise, fixed income will be the place to be.
– We also expect modest returns from fixed income, including the potential for negative returns in the short run.
– That said, the downside risks to fixed income returns are overhyped and overstated. The diverse nature of the asset class itself ensures it will always play a defensive role in your portfolio.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.