01 December 2015

Central bank policy divergence looks set to widen this month, with the Federal Reserve (Fed) poised to finally start raising rates and the European Central Bank (ECB) potentially announcing further easing measures at their respective monetary policy meetings.

You need only look at how spreads have widened between US Treasuries and German bunds to see how the prospect of central banks moving in different directions has already created dispersion in fixed income markets. According to Bloomberg, on 18 September 2015 (the day after the September Federal Open Market Committee meeting) 10-year US government bonds yielded 2.13% while 10-year German government bonds yielded 0.67%. At the time of writing (a little over two months later), the former yields 2.29% while the latter yields 0.49% – a widening of 34 basis points. The effect is understandably more profound in bonds with shorter maturities: Bloomberg data show that today two-year US government bonds yield 0.94% while the equivalent in Germany is in negative territory at -0.40%.

What can investors do?

At BlackRock, we believe that such dispersion builds the case for an unconstrained approach to fixed income. By unconstrained, we mean investment strategies that are not necessarily managed relative to a benchmark.

Why? Well, because if you want your portfolio to have the potential to capture the opportunities and avoid the idiosyncratic risks that arise as policy divergence widens, then your investment universe may need to widen out too.

Unconstrained approaches at BlackRock tend to comprise three key elements that could make them effective in times such as these:

  1. Flexibility
  2. As we think about it, flexibility gives us the scope to take on as much interest rate exposure as we believe is appropriate in any of the countries in the global marketplace. We’re not beholden to a particular sector allocation or country mix. We’ve almost lost count of the number of rate changes around the world this year; flexible duration management is likely to be key as we move in to 2016.

  3. Diversification

    Having the potential to allocate to multiple sources of return means we aren’t forced to take big bets within our unconstrained portfolios to generate alpha. Instead, we look for relative value opportunities, but don’t scale any one opportunity to too large a size. Combined with the flexibility that unconstrained investing brings, it means we take this relative value approach over and over again: find opportunity wherever it arises, scale appropriately, then look at how it correlates and relates to other areas of the portfolio so we can create stable and durable alpha over time. This approach means that while portfolio managers like myself set the top-down asset allocation and overall direction of the fund, we are reliant on BlackRock’s network of sector specialists, analysts, traders, researchers to put the best bottom-up ideas together – whether that’s individual security selection or even sub-sector selection.

  4. Downside risk management

    With more flexibility and diversification comes a myriad of risk factors – dispersion, liquidity, beta risk and more – that need to be managed carefully. We use BlackRock technology to run scenario analysis and stress tests to determine what we think might happen in different environments. Every time markets move, every time there’s an event coming up, we run different types of stress test. As you can imagine, ahead of the potential policy moves in December, we have been running such tests on a very frequent basis.

Dates for your diary

There’s a couple of dates in December that should be in every fixed income investor’s diary:

  • 3 December – Governing Council of the ECB: monetary policy meeting in Frankfurt
  • 15–16 December – Federal Open Market Committee (FOMC) Meeting

And the questions investors need to be thinking about are: Is my fixed income portfolio ready for what could be a volatile end to 2015? Is it flexible and diversified enough to capture new opportunities and avoid new risks? Do I have the right risk management tools in place?

If the answer to any of these questions is no, an unconstrained approach to fixed income may be a strategy worth considering.

CARS ref: RSM-2617
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 23 November 2015 and may change as subsequent conditions vary.

Having the potential to allocate to multiple sources of return means we aren’t forced to take big bets within our unconstrained portfolios to generate alpha.