Is there still opportunity in traditional fixed income? Yes, there are certainly opportunities, provided investors work with an adept manager who offers a suite of strategies with flexible guidelines to help navigate through changing market conditions.
The Follies of Benchmarking
Our Global Fixed Income team has managed global bond portfolios since the early 1990s. In some ways we consider ourselves pioneers in unconstrained fixed income investing since we have been managing our portfolios in a benchmark-agnostic manner for 25 years. We consider global bond benchmarks to be flawed because of their construction methodology, whereby weightings are based upon the amount of eligible issuance. For example, the largest issuers of debt are assigned the largest weights in the benchmark.
Our Flagship Approach to Unconstrained Investing
We have always maintained that this approach to index construction creates a misalignment of interests between issuers and investors; instead we have employed a top-down, macro-driven, valueoriented approach to portfolio construction that has served us well over time. One of the significant benefits of this value-driven approach has been our tendency to outperform the market during periods of negative performance for the indices, resulting in our strong down-market capture.
Enhancing Our Unconstrained Strategy
While we always enjoy beating the market, as the old saying goes, you can’t eat relative returns. Therefore, we have developed an arsenal of unconstrained products over the last decade to meet investor demand for more flexibility, whether it’s through the management of duration, country yield curves, sectors, currencies, credit quality or a combination of these factors. Since June 2008, we have advanced our investment approach to incorporate the ability to establish short positions in bond, interest rate, and currency markets. Importantly, in doing this, we did not need to change how we manage portfolios or how we thought about the world philosophically. Instead, we simply broadened our portfolio toolkit. Given our value-oriented approach, we believe this progression of our capabilities was a natural evolution, creating the opportunity to earn positive returns from assets declining in price while employing short positions as direct or implied hedges against other portfolio positions.
In the current environment, we cannot overstate the importance of this enhancement to our approach. It feels as though we have been discussing a potential rising rate environment forever, and we have certainly experienced some periods of rising rates—think Taper Tantrum in 2013, the Bund Tantrum in 2015, and more recently 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. What is not debatable is that we have been in a 30-year secular bull market for fixed income. We at Brandywine Global do believe that we are near the end of this virtuous environment for bonds. Whether it ends slowly and gradually, or quickly and violently, we take the view that we are at or near the cycle lows in yields. This implies a return stream for traditional fixed income that is at best mediocre, and at worst creates negative returns for long-only investors given historically low yields with greater price sensitivity (see Figure 1 and Figure 2).
Figure 1 10-Year Government Bond Yields %, As of 12/31/2016
Figure 2 10-Year Treasury Bond Yield %, As of 12/31/2016
Source: Thomson Datastream
Either way, this is clearly an environment that becomes more challenging for the investor who uses a long-only strategy to navigate through an increasingly complex bond market. In their search for greater yield potential, investors have responded by increasing their allocation to credit sectors, thereby typically reducing overall portfolio credit quality, or moving into “bond-like” equities such as real estate investment trusts (REITs) and utilities. These shifts may have reduced their exposure to interest rate risk but only serve to increase the systematic risk of the portfolio, particularly in regard to a higher degree of correlation to the broader equity market (see Figure 3).
Figure 3 Equity Alternatives 10-Year Correlation vs. S&P 500, As of 12/31/2016
We believe that our long-only strategies have their place in a diversified portfolio and will continue to outperform traditional global bond indices, although the return opportunity through a conventional, restricted approach has likely diminished. While there is no riskless reward, there could be “rewardless” risk. We believe that now is the time to consider accessing our skillset via a more flexible and adaptable toolset.
So, is there still opportunity in traditional fixed income? Yes, there are certainly opportunities, provided investors work with an adept manager who offers a suite of strategies with flexible guidelines to help navigate through changing market conditions. At present, investors are facing a world of structurally low interest rates, and therefore “rewardless” risk may be on the rise. We have a variety of flexible solutions to help investors manage this current environment, at a time when traditional long-only bond strategies are falling out of favor.