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
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 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
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
Figure 4: Bloomberg Barclays Global Aggregate Index - Yield Decomposition
Flexibility, Innovation - Now Critical
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
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?
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
Figure 6: EM & DM inflation rates are converging
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?
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.