Fixed Income

From Fixed to Flex

Andy Sowerby, Managing Director, Legg Mason Australia
February 2019
For much of the past 30 years, global fixed income investors have enjoyed an unbroken run of positive absolute returns. Global fixed income has not only done its job of providing protection and diversification, but it has also formed the basis of strong overall portfolio performance, particularly on a risk-adjusted basis. It has been a truly golden period in which a relatively static strategy has proven to be highly rewarding. But this strong trend towards lower yields is definitely aging.

Figure 1: 10-Year Government Bond Yields

Source:  Bloomberg Barclays Global Aggregate Index as of 31 January 2019
In the past few years we have experienced some temporary periods of rising bond yields – think Taper Tantrum in 2013, the Bund Tantrum in 2015 and the spike in bond yields in the weeks following President Trump’s November 2016 election victory. But in 2018 investors had to contend with a more significant rise in yields in response to strong US growth and monetary policy tightening from the US Federal Reserve. 

Whether we are at the beginning of a sustained rising-rate environment is still debatable. However, the “scenery” does seem to be changing now that central banks have started to remove the very easy monetary conditions that have supported the global economy since the GFC. We may not be in a bear market yet, but it’s worth considering the implications.

With the down-trend in yields slowing and benchmarks’ duration expanding, creating greater sensitivity to interest rates moves, future returns from traditional fixed income funds appear more mixed. And if a trend towards higher rates eventually emerges, index-constrained investors may end up nursing capital losses as low coupons may not be sufficient to cushion potential price drops.

The Fallacy of Benchmarks

The Bloomberg Barclays Global Aggregate Index is one of the most followed benchmarks for global fixed income investors. Its current construction highlights the risks that investors may be exposing themselves to and this has led many to question the potential for “rewardless risk” over the near to medium term.

The rise in the duration of this index - as evidenced in Figure 2 - is particularly important to note. This longer duration increases both the sensitivity of the index to future rises in interest rates and the likelihood of capital erosion.
Figure 2: Bloomberg Barclays Global Aggregate Index Rate and Duration History
Source: Bloomberg Barclays Global Aggregate Index, data as of 31 Jan 2019
But this is not the only component to focus on. The Barclays Bloomberg Global Aggregate Index currently has approximately 21,000 issues that span 84 countries and 24 currencies. It is a monster, making it difficult to efficiently replicate, incurring higher transaction costs and greater tracking error in the process, should you want to track it.

It also doesn’t necessarily provide as much diversification as investors may expect. For example, it is heavily biased towards countries that have been issuing the most debt (think the US, Eurozone and Japan) and these sovereign issues make up more than half of the Index.
Figure 3: Big Universe, Limited Selection
And, what of return expectations? As of 31 January 2019, this index offered a yield of just 1.90% - hardly attractive. And even worse, such a low yield may offer little protection to the shocks that could lie ahead. If one looks past the headline rate and analyses the decomposition of this yield, around 36% of the underlying securities in the index are paying a yield below 1%, with a fair share rewarding a negative yield, eating capital in the process. While some investors are tightly mandated to hold allocations close to the index, those with the ability to choose to avoid the less attractive parts of the market will already be on the move.
Figure 4: Bloomberg Barclays Global Aggregate Index - Yield Decomposition
Source: Bloomberg Barclays Global Aggregate Index, as at 31 Jan 2019

Flexibility, Innovation - Now Critical

With this backdrop it is perhaps not overly dramatic to say that fixed income investing is going through a sea change. Indeed, from discussions with investors, there is a far broader agenda on the table with increased scrutiny and deeper thinking around how best to structure portfolios for the next market phase (ie the end of the rally and eventually rising rates).

The asset management industry has responded to these evolving needs with a far-reaching range of strategies and products created. This innovation has been witnessed in the development of niche strategies designed to exploit structural alpha sources through to broadly based unconstrained approaches that shun benchmarks in favour of seeking out the best risk/return opportunities.

Fixed income investing isn’t what it used to be.

Return Seekers - This Way

The background and problems outlined above mean that new approaches and new strategies are becoming the order of the day. However, it is not that straightforward as investors fret over how to construct portfolios if core fixed income offers less protection and, potentially, becomes more correlated to traditional growth assets.

Indeed, the lines blur further still due to the growth of alternative fixed income strategies that are aggressive in their approach, utilising shorting techniques alongside complex trading and derivative strategies.

However, if the index is the “rewardless risk” trade many believe it to be, the question is how to invert this to optimise outcomes.

The question then becomes: Where is the value in markets?

Finding Value

Regardless of the direction of rates, the interconnectedness of global markets and the dominant presence of central banks will continue to fuel market dislocations, and therefore investment opportunities.

Common sources of market dislocations include:

  • Fear and greed
  • Supply and demand, including non-economic players such as central banks
  • Lack of long-term investment horizons
  • Unexpected changes in the economic environment
  • Demographic shifts
  • Technological change

Any combination of these factors can cause market prices to deviate significantly from fundamental fair value for a period of time, creating investment opportunities. But, eventually fundamentals tend to reassert themselves and prices adjust to reflect inflation trends, credit conditions and the amount of liquidity available in markets.

Let’s look at one of these dislocations: assuming that the history of interest rates is the history of inflation, as seen in Figure 5

Figure 5: The History of Rates is the History of Inflation
Source: Bloomberg Barclays Global Aggregate Index, as at 31 Jan 2019
One could be forgiven for thinking that the fast-growing Emerging Markets (EM) have a faster inflation pace than the traditionally slower developed markets (DM). But, as Figure 6 demonstrates, this is not the case, and EM and DM inflation rates are actually converging.
Figure 6: EM & DM inflation rates are converging
Source: Brandywine Global, 2018
As Figure 7 shows, the real yields offered in emerging markets such as Brazil, India and Russia are attractive at current levels, given the fall in inflation in those countries. So there seems to be value here. Whilst these countries still carry other investment risks, the relatively high returns on offer provide some level of compensation.

This contrasts dramatically with the lack of value in European developed bond markets where many countries, including the UK and Germany, have negative real yields as policy rates remain at record lows. Same goes for Japan.

The largest and most important market - US sovereigns - appears to be close to fairly valued on this analysis. 
Figure 7: Where is the Value?
Source: Data has been obtained by and used with permission of Macrobond, which Brandywine Global believes to be accurate and reliable. Chart created by Brandywine Global with data as at 30/11/18.

In Conclusion

Much is written about normalisation of markets, but - what is normal? Is the post Second World War period any guide at all, or is normal more similar to the nineteenth century when bonds offered low,  stable yields for multiple decades? How will the great quantitative easing experiment end and what tantrums and turmoil might we seeing going forward? And, how does the geo-political flux impact returns and expectations?

As ever in the investing world, asking questions is so much easier than finding the answers. The good news is that our industry has evolved and developed a range of strategies, instruments and approaches that can be applied to navigate an ever more complex world. It is this complexity that should drive more investors away from poorly constructed fixed income benchmarks, freeing them to embrace the flexibility and improved return and diversification potential of a more unconstrained or even absolute return approach. 

Past performance is no indication of future performance.

Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group. Any reference to ‘Legg Mason Australia’ is a reference to Legg Mason Asset Management Australia Limited. The information in this article is of a general nature only and is not intended to be, and is not, a complete or definitive statement of the matters described in it. The information in this article does not constitute specific investment advice and does not include recommendations on any particular securities. These opinions are subject to change without notice and do not constitute investment advice or recommendations.