Fixed income is important because the future is uncertain. Fixed income is also important because it is a diverse asset class that can provide opportunities for investors across the full market cycle.
While obvious, this is important to remember in considering the importance of fixed income to investors in a world where yields are low. Consider May 2017. The Bloomberg Composite Bond index returned almost +1.2%, whereas Australian equities returned -2.75% for the same period (a difference in performance terms of almost 4%). This isn’t meant to say that we won’t see periods where bonds are a drag on returns, but avoiding exposure because this might happen is a big risk.
What happens if deflationary fears resurface? Notwithstanding yields are still relatively low (and we’d argue below levels consistent with the pace of economic fundamentals) sovereign bonds will rally their “socks off” (as they did at the start of 2016), and equities will fall. Bonds will outperform equities in a deflationary scenario by a significant margin. While this is not our central scenario, we build portfolios because we don’t have perfect foresight and this is not a scenario that can be discounted. Even if the opposite scenario unfolds and bond yields do eventually normalise, the impact on portfolio returns from holding bonds themselves is likely to be small (even if moderately negative in the short run).
Recap of the role fixed income plays in a portfolio
Fixed income can play a number of roles in an accumulation based portfolio:
– In a defensive capacity as a source of low risk return; for the diversification of equity risk; as a source of liquidity; the generation of income; and, to protect capital.
– In a more absolute return / return seeking role primarily utilising the entire diversity of the asset class
The ability of fixed income to play different roles in part reflects the diversity of the asset class (in contrast to equities). This diversity is reflected in a range of factors including issuer (governments v corporates), issuer quality (investment grade v sub-investment grade, developed v emerging), degree of subordination (senior secured debt v hybrid / subordinated debt), security type (fixed rate v floating rate), maturity, coupon, individual covenants etc.
The ability of fixed income to act as a defensive portfolio stabiliser, akin to portfolio insurance, paying off during periods when equities are stressed is primarily the result of duration (ie the sensitivity of bonds to interest rates which tend to correlate with the economic cycle).
Figure 1 - Bonds provide valuable portfolio insurance during times of market stress
Quarterly bond returns versus quarterly equity returns from January 1990 to June 2017
Source: Datastream, data since 1990. 1Bloomberg AusBond Composite 0+Yr Index. ^ASX200, prior to Q3 1992 the MSCI Australia TR Index is used as a proxy.
While in today’s market environment cash has some appeal as a low risk source of income, its role is different to that of bonds in that cash provides no ‘option pay off’ during periods of market stress (green quadrant in Figure 1 above). Any potential short term under-performance of bonds versus cash can be regarded as the insurance premium paid for the prospect of benefiting from an offset to equity volatility and ‘pay off’ during market stress.
With interest rates now at historic lows many advisers are questioning the role of fixed income in investor portfolios. However, there is no guarantee that interest rates are going to rise and if they do it’s unlikely they will move significantly. While interest rates are low by the standards of the last 30 years, within a longer context it is normal for 10 year yields to be sub 5% and with structural pressures on growth and inflation suggesting benign longer term outcomes low yields are likely to remain the norm (even if not quite as low as they have been).
Figure 2 –Historical Australian 10 year government bond yields
1980’s and 90’s were the exception, interest rates are now not that low by historical standards
Source: Global Financial Data
Putting rate rises into context – Addressing rate rise fears
The inverse relationship between bond prices and interest rates is an immutable fact and this simplistic see-saw view of the interest rate/bond price relationship has resulted in some excessive concern about the impact rising interest rates could have on investor portfolios.
Even if rates were to rise, this actually helps current bond holders over the long term. This is because coupons and maturing principal can be reinvested at higher yields. While there is no doubt that rising rates may result in short term mark to market losses, no-one has a perfect crystal ball able to predict the future with 100% accuracy and trying to over finesse timing can be damaging to longer run outcomes.
It is reassuring that the maths is reflected in history. If we look back at 10 year Australian government bond yields and returns over the past 70 years we see that in the late 1970’s when interest rates increased from around 9% to 16% there was an initial pause in the total return index before it continued to rise at an accelerated rate reflecting the higher yields at which bond coupons and principal could be reinvested.
Figure 3 – 10 year Australian government bond total returns increase faster after rate rises
 While cash is likely the better investment during periods when markets are adjusting to rising rates it is difficult to know with perfect foresight the direction of interest rates over a short time horizon.
Source: Schroders, eVestment
A structural bear market in bonds is near impossible over the long run
We believe talk of a ‘structural bear market’ in bonds is overblown. What the maths and history show us is how difficult it is to resist the inexorable rise in bond total return indices over time driven by the coupon return (‘carry’). Rate rises are mere blips in the face of the rising tide of total returns even during the rapid inflation and rising rates of the late 1970’s or the sharp rise in rates in 1994. We would require interest rate rises at an ever increasing rate in order to force the total return index shown in Figure 3 (blue line) to flat-line. Yields would have to rise at an exponential rate continuously for extended periods of time to force the total return index into a downward trend – a most unlikely event.
Markets are a discounting mechanism
It is also worth remembering that if markets anticipate an environment of rising rates then these expectations will already be discounted in forward rates. If future rates rise as expected then investor returns will be no worse than cash.
Is active still relevant?
Fixed income still has an important role to play in investor portfolios in an uncertain world and even in the event of rising rates investors should have little to fear. However, the performance of active fixed income managers over recent years has been disappointing.
The passive portfolio is akin to a momentum strategy and it has been difficult to outperform a passive buy & hold index while the market has continued to trend higher supported by the tailwind of declining rates.
Active managers (including Schroders) have become wary of the increased risk associated with longer duration fixed income benchmarks and as valuations have become expensive. Portfolio positioning across many portfolios has become increasingly defensive however this has been detrimental in an environment when fixed income just keeps getting more expensive.
Figure 4 - Rolling 3 year returns of the Schroder Fixed Income Fund versus the peer group and the Bloomberg Ausbond Composite index
Source: Morningstar Direct
Not surprisingly, index funds are capturing an increasing share of flows into this sector.
What are the dangers of the passive index?
Deep pocketed central banks have not only driven interest rates to low (even negative) yields but have also distorted the composition of bond indices. Issuers have taken advantage of this environment by issuing longer dated debt which has seen the duration of benchmarks across the developed world lengthening over recent years. Belgium, Ireland and Argentina are just some examples of countries issuing 100 year debt.
It is important to avoid the temptation to chase past performers when looking at fixed income returns. As central banks look to unwind their balance sheets and normalise rates, fixed income benchmarks with their longer duration look increasingly vulnerable. We would argue that the time for passive fixed income investing is coming to an end.
How is the Schroder Fixed Income Fund positioned?
Our view remains that duration is expensive. Our short duration position (currently totalling 0.6 years) is concentrated in Europe, where valuations – reflecting ECB intervention - are most extreme. While all developed bond markets remain expensive on our measures, in general our preference is to be short the low yielding / most expensive markets in favour of owning the higher yielding / less expensive markets. The underperformance of US rates over the last several years has put the US back into the ‘higher yielding’ camp alongside Australia, and we view opportunities between these two markets from here as being mostly tactical (currently favouring Australia over the US). We’re still biased for some yield curve steepening with term premia remaining depressed, and added to this positioning recently. We also retain a small long position in Inflation Linked Bonds mainly in Australia, as pricing for future inflation protection remains cheap.
In credit we’ve made few changes to our broad positioning over recent months, having steadily pared exposures over the prior year as spreads compressed. We hold a very modest absolute exposure, about the benchmark weight. Our preference remains for short duration high quality Australian debt over longer and lower quality global exposures, and
over subordinated domestic issues. We’ve also recently pared our government-related spread exposure to semi-government and supranational issuers to below benchmark weight. Cash remains elevated as a result of our negative valuation view on both government and corporate opportunities.
Fixed income performs an important function for investors. It provides regular income, rising total returns over time and diversification to equities. The diversity of the asset class also provides investors with opportunities across the full market cycle. These attributes are not diminished by the prospect of rising rates. While short term paper losses may result from rapidly rising rates this is essentially portfolio insurance where fixed income typically performs strongly when equities are performing badly (as has generally occurred over recent decades). Low yields do not void this benefit. Over the longer term the shorter term ‘paper losses’ disappear and rising rates are actually good for bond investors in the long run.
Passive fixed income indices have outperformed active managers over recent years as the asset class has become ever more expensive. Returns to passive index funds have also been boosted by the lengthening of duration that has occurred in this asset class. However, the active versus passive debate always goes in cycles and more so within fixed income where it should be increasingly clear that a long duration low yield portfolio is unlikely to continue to outperform more actively managed portfolios as rates normalise.
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