Harvesting bond returns as rates rise
The climate is changing for fixed income. Quantitative easing is winding down. Interest rates look ready to start reversing a generation of decline.
The climate is changing for fixed income. Quantitative easing is winding down. Interest rates look ready to start reversing a generation of decline.On the face of it, this seems a difficult background for bonds and, indeed, has already contributed to market volatility. Yet we believe it will be hard to replace the diversification, liquidity and security of bonds. In fact, we believe demand will continue to grow as populations age and increasingly need retirement income.
Managing bond portfolios in this environment will be harder than in the past. It will no longer be sufficient merely to be in the market: investors will also need to actively seek the best returns. Put another way, they can no longer rely on beta, but must now put much more emphasis on alpha. Intelligently managed, we still believe bond portfolios can prosper in this environment. This article briefly explains how.
The problem with being passive
While interest rates continued their long decline from the early 1980s, a buy-and-hold strategy made sense. Indeed, many fixed income investors simply adopted index-based, passive portfolios, but these investors now face particular problems. Substantial parts of the benchmarks used to construct their portfolios are comprised of government bonds, where not only are yields low, they are highly sensitive to rising rates. For instance, over 60% of the Barclays Global Aggregate Index – a popular benchmark to track – is made up of government and government related issuers (Figure 1, left-hand chart, red bars). We think this part of the market will be particularly vulnerable as yields rise and the quantitative easing instituted by the US Federal Reserve (Fed) goes into reverse.
Other index constituents can also force passive investors into unwanted exposures. For instance, an investor mimicking a global benchmark is often tying a substantial part of their fortunes to those of the Japanese market. In the case of the Barclays Global Aggregate, Japan accounts for around 17% of its value (Figure 1, right-hand chart, red bar). So just over a sixth of a passive investor’s portfolio would be dependent on a country where government debt is close to 230% of GDP and whose financial authorities have constantly to walk a tightrope between raising taxes to reduce debts and tipping the economy into recession. We think this is a precarious underpinning for a bond portfolio at a time like this.
Of course, there are ‘smarter’ ways to use beta to increase returns from a passive investment in government grade bonds. For instance, a buy-and-hold investor can leverage the minimal returns from high quality bonds to the desired level by using outright borrowing. Alternatively, they could buy longer dated or lower quality bonds. Unfortunately, while this increases the upside potential, it has similar – or worse – effects on the downside, particularly when yields might be expected to rise.
Figure 2 shows the leverage and the possible losses (or drawdown) we calculate a passive investor adopting these strategies might need to accept to achieve a 4% annual yield on certain asset classes. (The leveraged approaches are towards the left of the chart, while the longer duration and/or lower quality strategies are towards the right.)
This is not to say that these can’t be useful strategies if managed properly. Managers must be allowed the freedom to dynamically adjust and hedge a portfolio’s overall interest rate and credit risk to reduce the volatility of returns. So risk-averse investors may find the best way forward is to adopt a more flexible approach, with a strong focus on managing drawdown risk that doesn’t need to over-allocate to higher yielding assets.
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