James Klempster

Fixed Income: horses for all courses

James Klempster

Equities tend to dominate ‘financial’ headlines for the most part while bonds carry on quietly in the background. Yet moves in sovereign bond markets since the global financial crisis have been incredible and these continued in a pandemic-ravaged 2020.

While the trend in yields was largely down last year, there have been significant moves upward in long bonds so far in 2021, largely on the back of growing inflation fears, bringing fixed income markets back into focus for many investors.

Traditionally, fixed income, especially sovereigns, has played two roles in a multi-asset portfolio – offering a reasonable running yield and the prospect of capital gains as yields fell. The former characteristic, combined with the ability of countries with a fiat currency to print more money, means the risk-free rate from government debt should generally offer a real yield greater than inflation.

For us, a further key benefit is diversification, with higher-quality paper in particular tending to be lowly or even negatively correlated to riskier assets such as equities. Expecting a single bond – or even a single class of bond – to provide both returns and diversification is asking a lot but fixed income sub-classes are so varied in their nature that there are many different horses for the courses we have to navigate. There is a downside to all this flexibility, however: not all bonds are created equal, which investors have to navigate.

More recently, even before the Coronavirus-driven move down in yields, it was difficult to make a case for government bonds being cheap. From present levels, neither UK gilts nor US Treasuries appear likely to be a source of meaningful capital appreciation in the long run; on the positive side, these assets do at least offer a positive running yield for the most part, with the exception of some one to two-year gilts.

Many European and Japanese government bonds currently have negative prevailing yields, however, five years out in the case of Japan and 20 for Germany. Negative-yielding bonds cost more upfront than investors get back in interest and capital over the asset’s lifetime and holding these instruments to maturity guarantees a negative return in nominal terms. Given such a profile, these can only be a good long-term investment if inflation is negative for a significant part of the bond’s tenor, meaning that, in real terms at least, the holder ends up better off. While not inconceivable in Japan as growth and inflation have underwhelmed for a long time, Germany and much of Northern Europe mimicking this experience is not in many analysts’ assumptions.

Despite a fundamentally unattractive long-term outlook, however, there are times when it makes sense to hold government paper, even at such expensive levels, and this is where diversification comes in. Periods of market stress are when government bonds come into their own as the ultimate event risk hedge: they typically go up when risk aversion rises, in their traditional safe haven role, which is a boon from a portfolio construction perspective because this negative correlation with equities reduces overall risk. It can be seen as a form of portfolio insurance; you have to pay for it but when things get tough, you are glad to have some.

For example, we held gilts in the Multi-Asset Active fund range as a downside protection trade last year, reducing the position as the recovery gathered pace. We preferred UK gilts to US Treasuries as there was more stimulus in the US and a faster recovery, meaning greater potential for inflation and rate rises versus the UK.

Within government bonds, we currently prefer index-linked debt, where interest payments are based on consumer prices and yields are adjusted to ensure a positive real return after inflation. While overall newsflow remains weak at present, there is a growing consensus that vaccine rollouts should drive an economic turnaround, which should in turn put upward pressure on bond yields. In today’s low-yield environment, and with extraordinary levels of government stimulus being pumped into economies, we believe there is a risk of inflation surprising on the upside and so linkers continue to offer a more attractive return opportunity than nominal sovereign bonds.

As is clear from the financial press in recent weeks, inflation is predicted to increase significantly in the coming years, with Statista, for example, forecasting 3% by 2023. Even longer-dated bonds – 25-year gilts yield 1.4% at present – appear seriously vulnerable to increases in yields should this forecast inflation materialise: capital losses caused by a 1% change in yield would be substantial in this longer-dated debt. Inflation priced into the gilt market is currently around 3.2% based on five-year breakevens, the level where investors would be indifferent between holding nominal UK gilts and equivalent inflation-protected debt. Should inflation prove higher over the life of the bond, owners of the index-linked paper would be better off.

Elsewhere in sovereign bonds, emerging market debt (EMD) is denominated either in the national currency of the issuing country (local currency) or a global benchmark currency, most often US dollars (hard currency). The yield on local currency debt is a function of the interest rate environment in that particular country, meaning these bonds are subject to additional exchange rate risk. If the country has a fiat currency, the risk of default reduces because the central bank can print more money, although this can weigh on the currency and be a headwind to returns for international investors.

In contrast, hard currency EMD removes the currency risk but introduces a greater chance of default as the borrowing country has to buy US dollars to repay the debt. Like all bonds, when the risk of failed repayment is deemed low, the spreads demanded over Treasuries (as a ‘risk-free’ asset) is low, but as perception of risk increases, so does the required yield pick-up.

While spreads look reasonable, we currently believe the idiosyncrasies of the emerging market environment are potentially better rewarded in EM equities. Furthermore, US dollar-denominated debt will be subject to moves in the US yield curve.

While all the debt issued by companies is lumped together as credit, there are also huge variations within these markets in terms of risk/reward, with the common factor being that they tend to pay a higher yield over equivalent government bonds. This spread usually increases during periods of risk aversion, meaning credit may underperform government bonds when volatility spikes (again, highlighting the case for diversification) but it is this additional yield that makes these investments attractive in the first place.

Our job, and that of the underlying managers we select, is to decide whether the yield pick-up is sufficiently attractive for the additional risk. Investment grade credit is the highest quality, and the yield pick-up over government debt is therefore lower. At present, we feel the paucity of spread means investment grade is tainted by overall low benchmark yields; the modest yield pick-up means this debt looks reasonable from a relative value perspective versus sovereigns but it is not an attractive proposition in its own right.

These investments are a useful way to pick up duration (interest rate sensitivity) without having to pay the punitively low rates of interest in sovereign markets; the downside to doing this is the risk of spreads widening in periods of market stress. As a result, investment grade bonds provide some prospect of a running yield ahead of inflation over the long run and are a reasonable diversifier against equities in all but the worst times in markets.

Moving down the quality scale, high yield has a lower credit rating and commensurately higher spreads over government bonds, and can be more correlated with equities. High yield therefore offers fewer diversification benefits but should provide a better total return to long-term investors. While spreads are still relatively tight by historical standards, the returns available from high yield are reasonably attractive and an overall risk-on environment should be supportive of prices.

An often-overlooked corner of the bond universe is convertible debt, paper that can be switched to equity at a certain strike price. A well-managed portfolio of convertibles can provide useful sensitivity to positive moves in equities with stability provided by the bond floor. While this floor helps make convertibles a low-risk, equity-like asset, these bonds have limited capacity to provide impactful diversification benefits. As a result, and given the fact convertibles offer little yield, we see this asset as akin to low-risk equity returns rather than a pure diversifier.

Across our multi-asset funds and portfolios, we hold an array of fixed income assets and, given the wide variety available, avoid taking a one size fits all approach to choosing managers in these markets. For some sovereign bond allocations, for example, we tend to follow a passive approach on the basis that active managers struggle to generate alpha in what are very large, liquid and efficient markets.

Lower down the credit spectrum, however, there tend to be greater opportunities for active managers to add value. This is also the part of the market where security selection plays an important risk management role and, as a result, we tend to make use of active managers in the credit space.

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Tuesday, April 6, 2021, 9:06 AM