Fixed Income

Fixed Income and the road to fair value


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

The descent of core market bond yields towards and through zero continued apace over the March quarter, driven by an aggressive ECB prepared to buy bonds at yields down to -0.20%, consolidation of commodity prices at low levels following the December plunge, reduced near term expectations for inflation, a raft of global policy easings in response, a strong US dollar which unsettles both US domestic and emerging markets, and an ongoing search for yield.

That is the view in the rear view mirror. It may also be the windscreen view for momentum-driven investors or those without conviction of process, but it is not ours. Our process is anchored by the strong belief that valuations are the primary driver of future returns and risk.

Even without a valuation approach, prospects for bonds aren’t great. The close proximity to zero of bond yields in much of the world means that returns to maturity will be low (negative in the case of all the bonds in Europe trading with negative starting yields) and the probability of loss over shorter periods will be high (with little yield to offset the impact of capital price changes if yields rise).

However, poor valuations amplify these risks: fair value yields are significantly higher than current and repricing to fair value would bring forward losses. Additionally, there is some asymmetry around the possible path of yields given conventional wisdom that zero represents the notional lower bound.

Where should bond yields trade? In the long run, the government bond yield should be a proxy for the countrywide minimum acceptable return on capital, which in turn should be broadly aligned with potential nominal GDP. In the US, potential nominal growth is around 4%, some way from the current 10 year Treasury yield of 1.95%. In Australia, fair value of approximately 5% compares with 2.40% in the current yield of 10 year maturity government bonds. The drivers of fair value for government bond yields are the long run drivers for growth and inflation in an economy - while these do change with long run demographic, technological and institutional trends, they vary little over the short term.

Notoriously overshooting markets will create challenges for valuation-driven investors with long-term horizons. Recognising this, we augment our valuation-based approach with cycle and liquidity overlays. On balance, these influences are broadly offsetting at the moment.

The US economy continues to strengthen despite headwinds from the stronger dollar, which are roughly counterbalanced by the beneficial effect of the oil price slump. Closure of the output gap should revive endogenous inflationary pressure after a long layoff, and bring a forward-looking Fed to lift official rates off the floor. In Europe and Japan too, central bank policy, weakening currencies and the fall in commodity prices are improving cyclical prospects, and probably helping to balance global risks more evenly (away from dependence on US-led growth). Recession in the major economies – though some probability in Australia – is a distant risk.

Liquidity conditions are broadly very favourable for core market government bonds, supported by the ECB, BoJ and other price inelastic buyers, but we’d be wary about the music stopping, or even the record playing backwards (after all, policy tightening could involve central bank balance sheet shrinkage, including via bond sales). In credit markets, liquidity is challenged by changes to the regulatory regime that restrict the historic intermediary role played by banks in transferring risk between market participants.

Our negative view on valuations, in conjunction with our mixed expectations for cyclical and liquidity considerations, could leave you with an impression that we’d do away with fixed income altogether. This is certainly not the case, for we continue to see a very strong role for fixed income in broader portfolios, given the role bonds play in providing capital stability, income, liquidity, and diversification. While the diversification benefits of fixed income may be challenged by yields approaching zero and possible changes in correlation with risky assets, in scenarios involving either deflation or significant stress in risk assets there is likely to be no substitute for bonds as a portfolio insulator.

Our focus on delivering absolute returns, protecting downside risk, managing uncertainty and balancing the role of bonds in a broader portfolio leaves us with considerably less duration than the benchmark, driven predominantly by rich valuations and an inconsistency – from an investor’s viewpoint - between lengthening benchmark duration and falling yields. Most of the short duration position is concentrated in the US front end reflecting the relative strength of the US cycle and probable policy consequences. We expect the duration position to continue to be the main driver of relative-to-benchmark returns, and importantly, to help protect the Portfolio should markets reverse.

While valuations are also expensive, investment grade credit remains the most favourable return-risk proposition in the fixed income universe hence we hold a moderate overweight. We are wary about high yield credit at current valuations and EMD still needs to cheapen further before we would consider an allocation. Our allocation to RMBS has remained steady as this is one of the few fixed income sectors where liquidity premia is still being rewarded. Our weighting to cash remains elevated, providing a source of stability to the Portfolio and the flexibility to respond to repricing opportunities as they arise..

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