In focus - Markets

The surprising diversity of bond markets

The extent of the diversity of global fixed income markets, and the scope for achieving strong returns while managing risk, may be underappreciated by investors.

12/09/2019

Jonathan Harris

Jonathan Harris

Investment Director, Fixed Income

The traditional view is that bonds broadly tend to do better when interest rates are falling and, as such, provide a useful counterweight to equities. Equities, conversely, typically benefit from strong economic growth, which tends to result, ultimately, in interest rates rising so as to prevent economic overheating.

However, we believe this rather limited view risks overlooking all the potential benefits the right fixed income strategy can offer. The diversity across and within the numerous sub-sets of global fixed income is significant. The breadth and depth of global fixed income markets can provide a portfolio with both robust return potential and resilience to difficult economic conditions.

We think a useful way to think of the fixed income universe is as a continuum of risk and return potential, the various stages of which display different characteristics and are influenced by different factors. The chart below[i], showing returns of the sub-asset classes over time, attests to this. 

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Past performance is not a reliable indicator of future returns, prices of shares or bonds, and the income from them, may fall as well as rise and investors may not get the amount originally invested.

Returns vary markedly across different fixed income markets over time, which reflects this continuum of risk. We can broadly categorise the fixed income universe into five key groups:

Government bonds: the bonds issued by national governments. These would be regarded as the lowest risk, as governments should be least likely to default, that is to miss a scheduled interest or debt repayment, (in other words they are the most creditworthy). This is partly because they have the ability to raise taxes or the country’s central bank can print money to ensure repayments can be met. The credit rating and quality of the bonds will reflect factors such as the strength of the country’s economy and the ratio of public spending to tax intake. They tend to have relatively high sensitivity to interest rates (measured by duration), performing well when interest rates are falling and vice versa, and relatively low sensitivity to economic growth.

Investment grade corporate bonds: bonds issued by companies with an overall credit rating of BBB[i] or higher and as such, considered a relatively low risk investment. In some cases, IG credit (USD Corp, EUR Corp, GBP Corp in the chart) can be regarded as lower risk and higher quality than some government bonds. IG will generally pay lower interest or yield than high yield bonds. Like government bonds they have relatively high sensitivity to interest rates (as measured by duration), but are more sensitive to economic growth. The returns on IG bonds depend to some extent on companies’ performance.

High yield corporate bonds: bonds issued by companies with a credit rating lower than BBB, i.e. BB or below. The lower rating usually reflects factors such as the company owing a relatively high level of debt. HY is therefore regarded as relatively risky and has seen larger fluctuations than other fixed income asset classes in the past. However, it has relatively high return potential and tends to pay higher income (the rate of interest will tend to reflect the riskiness or credit quality), also tending to be more sensitive to economic growth than moves in interest rates.

Securitised credit: bonds secured against an underlying pool of loans (mortgages, credit cards, automotive loans, student debt, and others). One of the more protective features of securitised is that should the issuer of the bond default, the bondholders can still be repaid from the underlying loan assets. Securitised bonds will tend to offer relatively attractive yields, while they are also “floating rate”, unlike government and IG corporate bonds, which means the interest on the bonds will vary along wider interest rate levels. This reflects the fact that the rate of interest on the underlying mortgages or credit card loans will generally rise and fall depending on how central banks are setting interest rates. The ABS index tends to comprise higher-rated, often A or higher.

Emerging market bonds: bonds issued by EM countries or companies. This is a varied and diverse asset category in its own right. There are examples of EM countries and companies with high credit ratings, but overall it would sit at the riskier end of the continuum. Many EM economies are still relatively exposed to global economic growth and international trade. Some IG EM countries would be more sensitive to interest rate changes, while some HY is highly sensitive to economic factors. The EM bond universe is itself divided up between hard (bonds which are purchased in US dollars or euros) and local currency (purchased in EM country’s domestic currency). Hard currency bonds are more sensitive to changes in US interest rates as such, while local currency bonds can be more influenced by country specific factors.

Smoothing returns through diversification

The diversification possibilities from fixed income are significant. Most obviously, government, IG or securitised bonds can provide some downside protection against equities in the event of slowing or declining economic growth, when stocks would likely perform badly. Equally, there is also an array of options as to how much downside protection an investor can aim for in their portfolio versus how much return potential they want. 

Annualised-bond-market-returns-15-years.jpg

Past performance is not a reliable indicator of future returns, prices of shares or bonds, and the income from them, may fall as well as rise and investors may not get the amount originally invested. 

For the investor more concerned with keeping a high level of return potential, HY would certainly be an option. HY has produced strong returns over the past decade and a half, at times comparable to the returns seen from stock markets. Like stocks, however, HY is susceptible to volatility (the degree of fluctuation in returns during a certain period of time) and to larger declines than other fixed income sub-categories.

But, the drawdown (total decline from the high to low point) is smaller for HY than stocks, while the time it takes for HY to recoup losses is significantly less – over the past decade it has been less than half. This is evident in the 2009 rebound following the 2008 decline.

Additionally, combining different fixed income sub-asset classes can have diversification benefits. Take 2008, when HY markets saw negative returns, but global government bonds, US asset-backed securities (ABS) and US covered bonds[ii] made positive returns, while IG fell by much less. The decline in HY could have been mitigated, at least to some extent, by allocating to these areas. Broadly, this scope for diversification is not present within global equity markets, which usually move in the same direction.

Risk associated with bond investing

A rise in interest rates generally causes bond prices to fall.

A decline in the financial health of an issuer could cause the value of its bonds to fall or become worthless.

[i] A credit rating is assigned by independent ratings agencies Standard & Poor’s, Moody’s and Fitch. A company is officially rated once it receives a minimum of two ratings. The overall rating will range from AAA, the highest, down to C, calculated as an average. A rating will reflect the agencies’ assessment of a company’s financials and overall strengths and weaknesses, particularly factors such as how much debt it owes, its ability to meet interest and debt repayments, level of profitability and whether it can be sustained, and so on. 

[ii] Asset-backed securities (ABS) and covered bonds are debt securities issued by a financial institution underpinned by a pool or group of underlying loans made by that financial institution. The interest payments made to the holder of the ABS or covered bond come from the interest payments the financial institution receives on the underlying loans. These securities are seen as a relatively low-risk investment, typically receiving a high credit rating, as should the financial institution become insolvent the bondholder would have a claim on the underlying loans and therefore still be able to receive their interest payments.