For the past 30 years, global fixed income investors have enjoyed an unbroken run of positive absolute returns but it may be coming to an end.
Global fixed income has not only done its job of providing protection and diversification but has formed the basis of strong overall portfolio performance, particularly on a risk-adjusted basis. It has been a truly golden period wherein a relatively static strategy has proven to be highly rewarding.
FIGURE 1: 10 YEAR GOVERNMENT BOND YIELDS
Source: Bloomberg Barclays Global Aggregate Index as of 30 Nov 2017
However, in recent times more and more commentators have started to call an end to this secular bull market. Indeed, in the past few years we have certainly experienced some 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. Whether we are at the beginning of a sustained rising-rate environment is still debatable – however, there seems to be a more established inflection point becoming evident since July 2016, when China unveiled a package of stimulus measures, sustaining the then incipient global reflationary trend.
FIGURE 2: INFLECTION POINT FOR GLOBAL BOND YIELDS
Source: Bloomberg Barclays Global Aggregate Index as of 27 Nov 2017
Such reflationary environment could bring an end to this virtuous bond environment. Whether this transition is - ideally - slow and gradual, or swift and violent, is still to be seen, but our view is that we are likely going to see a change of scenery as we are at or near cyclical lows in yields.
This is relevant because, with benchmarks’ duration expanding, creating greater sensitivity to interest rates moves, future traditional fixed income returns appear mediocre at best. At worst, index- constrained investors may end up nursing capital losses as low coupons may not be able 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.
It is the rise in duration of this index - as evidenced Figure 3 - that is particularly important to note. This longer duration increases both the sensitivity of the index to future rises in rates and the likelihood of capital erosion.
Figure 3: BLOOMBERG BARCLAYS GLOBAL AGGREGATE INDEX RATE AND DURATION HISTORY
Source: Bloomberg Barclays Global Aggregate Index, data as of Nov 17
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 the diversification that investors may think that it should. For example, it is heavily biased to countries that have been issuing the most debt; the US, Eurozone and Japan via sovereign bonds, which make up more than half of the Index.
And, what of return expectations? As of 6 December 2017, this index offered a yield of just 1.60% - 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, some 39% 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. Negative yielding government debt outstanding climbed over the US$10 trillion mark in December 2017, up from year-end measurements in 2016 (US$9 trillion) and 2015 (US$6 trillion)*. While some investors are tightly mandated to hold allocations close to the index, those with the ability to make the choice to avoid the less attractive parts of the market will already be on the move.
* J.P. Morgan estimates
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 exposure in the next market phase. And 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 askew the benchmark in the search for the optimum balance between risk and return.
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 reverts to where is the value in markets?
FIGURE 4: BIG UNIVERSE, LIMITED SELECTION
Source: Bloomberg Barclays Global Aggregate Index, as of 30 Nov 2017
Regardless of the direction of rates, the interconnectedness of global markets and the overpowering presence of central banks will continue to fuel dislocations, and therefore opportunity. In general, these dislocations are created because:
1) Fear and greed
2) Supply and demand, including non-economic players such as central banks
3) Lack of long-term investment horizons.
Due to any combination of these factors, prices can deviate significantly from fundamental fair value, but over time prices typically adjust to reflect inflation, credit fundamentals and liquidity conditions.
Alongside these dislocations sit the economic opportunities that arise as the outlook for growth, inflation and liquidity conditions changes. These are impacted by longer term drivers such as indebtedness, demographics and technological change.
FIGURE 5: BLOOMBERG BARCLAYS GLOBAL AGGREGATE INDEX - YIELD DECOMPOSITION
Source: Bloomberg Barclays Global Aggregate Index, as of 5th December 2017
Let’s look at one of these dislocations: assuming that the history of interest rates is the history of inflation, as seen in the Figure 6…
FIGURE 6: THE HISTORY OF RATES IS THE HISTORY OF INFLATION
Source: Bloomberg Barclays Global Aggregate Index, 30th November 2017. PCE stands for Personal Consumption Expenditure, an inflation index excluding food and energy.
One could be forgiven for thinking that the fast-growing Emerging Markets (EM) has a faster inflation pace than the traditionally slower developed markets (DM). But, as Figure 7 demonstrates, this is not the case, and EM and DM inflation rates are actually converging.
FIGURE 7: EMERGING MARKET DEBT INFLATION CONVERGING WITH DEVELOPED – EXTEND POTENTIAL
Source: Brandywine Global as of November 2017.
This is where value can be found. As Figure 8 shows, the real yields offered in emerging markets such as Brazil, Russia, South Africa and India are attractive at current levels, given the drop in inflation in those countries. This contrasts dramatically with the European developed market stalwarts of the UK and Germany, whose real yields are negative as rates remain at record lows.
The largest and most important market - US sovereigns - appears to be fairly valued on this analysis and here the debate is most pronounced around the value of the US dollar. A strong argument would be that the greenback is over-valued, measured on a purchasing price parity (PPP) basis, and President Trump would certainly like to see it lower. This trend - a weakening US dollar - has been evident since his election in late 2016.
FIGURE 8: WHERE IS THE VALUE?
Real 10 year bond yield ranking - based on 12-month % change of headline CPI
As of 31st October 2017
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 QE 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 benchmarks, freeing them to embrace the flexibility and improved return and diversification potential of a more unconstrained or even absolute return approach.