19 May 2015

A European Central Bank-led wall of monetary easing has pushed bond yields into negative territory in many parts of Europe. According to Bank of America data last month, the pool of European bonds that offered negative yields was $3 trillion in size. Although there has been something of a reversal in bond markets in recent weeks, in the UK 10 Year Gilts still yield just 1.95%1.  How can investors generate meaningful returns from bonds in such an environment?

Well, before making any decisions about their fixed income portfolio allocation, I believe it’s essential for investors to acknowledge and understand the macroeconomic and demographic factors that are having a profound impact on bond markets.

Supplies low

Central bank quantitative easing programmes have scooped up huge volumes of government bonds. The US Federal Reserve currently holds around $2.5tn of US Treasuries. The Bank of England has £375 billion in assets, mostly UK Gilts, on its balance sheet. The ECB is currently buying €60 billion worth of assets – mainly European government bonds on the secondary market – a month. That’s a huge supply of government bonds that has been taken, and is continuing to be taken in large amounts, out of the system.

Less net supply, the omnipresence of price-insensitive central bank buyers in the market and the fact that many institutional investors, such as pension funds, have to hold government bonds for regulatory purposes has sent government bond prices soaring and yields plummeting.

Demand high

At the same time, the world is facing an unprecedented demand for income. In many developed countries, populations are ageing, the ratio of people entering the workforce to retirees exiting it is changing and people are living longer.

Given the low yields currently available from developed economy government bonds (that were traditionally viewed as investments for income-generation in the past), investors have been forced to look elsewhere in fixed income markets for yield. This hunt for income has increased demand for higher-yielding investment grade of high yield corporate bonds. Though some yield pick-up over government bonds certainly remains in such assets, they may entail increased credit risk. For me, simply ‘risking-up’ in search of yield is not a sensible strategy.

What can investors do?

At some point monetary policy will begin to normalise around the world – soon in the US and UK, eventually in Europe – but even if (as I highlighted in my previous post) interest rates rise marginally and central bank asset purchase programmes come to end, it’s going to be a long-time before bond yields, particularly in Europe, return to the levels they were at before the 2008 financial crisis. So what can investors do?

Expand the opportunity set

I believe that in order to generate positive returns in fixed income portfolios with relatively low volatility, today’s environment demands a flexible approach to asset allocation. The ability to manage duration carefully and deliberately, and even go outright short duration, could help to protect returns in periods of rising rates.  Meanwhile, relative value strategies enable fixed income investors to generate alpha from their fundamental views while minimising the impact of market directionality. This means, however, that a flexible and agile investment strategy may be required to take advantage of such opportunities should they present themselves.

In a world where very few fixed income assets are ‘cheap’, the ability to access the broadest investment universe, by geography, sub-asset class and along the capital structure, could help fund managers to access diversified sources of return. Additionally, rather than broadly allocating to fixed income ‘buckets’, such as high yield and emerging market debt, we favour a more studied approach, combining top-down macro views with bottom-up asset selection to take advantage of the incredible divergence and variety of bonds and issuers within different sectors.

[1] Bloomberg, 19 May 2015

CARS ref: RSM-0925
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 07/05/15 and may change as subsequent conditions vary.

The ability to manage duration carefully and deliberately, and even go outright short duration, could help to protect returns in periods of rising rates.