A framework for action in fixed income
The aftermath of the global credit crisis left interest rates and bond yields close to the lowest levels in recorded history in many countries across the developed world (Figure 1). Indeed, the yield on cash and government bonds in some markets even dipped below the rate of inflation. Traditionally ‘riskier’ corporate bond yields have also fallen considerably, having been dragged down by government bond yields, while spreads have been compressed further in investors’ scramble for yield.
This environment presents investors with serious problems. Bonds have provided income, capital preservation, absolute returns, diversification, liability matching, liquidity and even inflation hedging in varying proportions and at varying times for decades. During that time, they have been a great buy-and-hold investment. But with yields at current levels, none of those things can be taken for granted any longer.
Unfortunately, there does not appear to be a single ‘magic bullet’ replacement for the multi-faceted solution bonds have delivered in recent years. As a result, we believe investors need to build portfolios to meet their specific needs and accept that these probably will not come with the free added extras many bondholders have become used to over the past 30 years. This article will try to outline the main reasons why institutions hold bonds as a key part of their portfolio, and provide a framework for how they can both assess their requirements and meet them in the changed circumstances in which they now find themselves.
New conditions demand new approaches
We are faced with very different economic and market conditions to those before the crisis. Investors broadly accept that future returns in developed bond markets are likely to be below historical averages, yet their fundamental requirements have not necessarily changed much: real returns are still needed, liability payments have still to be met, incomes must still be supported. Unfortunately, given today’s starting point, a traditional bond portfolio anchored to a typical market index is unlikely to meet these requirements, even over the long run. To misquote Einstein, to persist with the same old strategies in a dramatically changed environment and expect the same results is, if not insane, certainly irrational.
So, in addition to the well-rehearsed drawbacks of using traditional fixed income benchmarks, the whole asset class is in a particularly vulnerable position. While active management can mitigate some of these problems by diversifying away from the benchmark, the index-anchoring restrictions in most mandates still serve to limit the benefits. The basic strategies bond managers have historically used in the context of a benchmark-related portfolio are duration, credit, interest rate curve and currency management. Many of these strategies have been highly correlated with the markets themselves, with rewards being available simply for being there. But this is changing.
Trends may not exactly reverse, but will likely become less clear, thus providing good opportunities for active managers – at least those with courage and conviction – to differentiate themselves. We believe institutional investors will need to be commensurately bold.
The opportunity costs of being early are very low from this starting point (yields cannot fall much further). The risk of being late (in other words, staying in index-anchored treasuries when yields start to rise) could be significant. We think that this is no time for complacency.
Understanding the rationale for bond investing
The first step in our framework for action is for investors to consider why they hold bonds in the first place. We outline the most likely reasons below (Figure 2) in broad terms, along with our suggestions for the most important objectives for different types of investor.