Logic dictates that borrowers should pay lenders and not the other way round. However, the world of negative interest rates is defying that logic and investors are increasingly challenged to find value across global fixed income markets when yields are so low.
Going forward, the risk is that investors are likely to capture more of the downside in market sell-offs than upside in market rallies, and therefore we anticipate higher levels of bond market volatility.
Managing fixed income in the current environment is more challenging and demands investors stay focused on preserving capital as well as seeking return. Over the last few years, investors could make attractive returns from investing in longer-duration assets as yield curves flattened.
However, we believe there is less value to be found by simply taking duration exposure alone, as well as more downside risk.
Of course, it would be impossible to determine with any certainty the point at which interest rates will start to rise; for now we remain under the scenario of ‘lower for longer’. However, there are rational reasons to believe that yields at current levels are unsustainable:
1. While headline inflation will stay low, deflation threats in developed economies have diminished. The rise in oil prices will feed through into headline inflation in coming months.
2. Labour markets are reaching full employment, particularly in the US, and this should put modest upward pressure on wages.
3. From a UK perspective, sterling’s devaluation will ultimately be inflationary, though somewhat offset by lower growth. Further out, a weak currency, large current account deficit, wider fiscal deficit and credit ratings downgrades will be less supportive to UK gilts.
Performance of sterling vs dollar over 1yr
Source: FE Analytics
4. We have been saying for some time that central banks cannot be solely responsible for stimulating growth and reflating economies. Governments will at some point have to share the load. A large fiscal stimulus package in the form of significantly higher infrastructure spending could spook bond markets and lead to even higher debt levels in developed economies.
5. The US treasury market tends to exert a gravitational pull towards other developed sovereign bond markets. When the Fed restarts its tightening programme, currently priced for early 2018, this is likely to push yields higher globally.
It is therefore important that investors are be able to strike the right balance between participating when bond prices are rising and avoiding getting caught out should yields move meaningfully higher, such as during the taper-tantrum episode in mid-2013.
It is a difficult conundrum, but we believe the optimal risk/return approach is twofold.
First, we believe it is important to stay fully invested in government bonds on a market weight basis, but in short-duration assets that we would be happy to hold to maturity should interest rates rise. While this position will not always fully participate if bond markets rally, it should help to preserve capital if yields rise sharply.
Second, we are holding a bias towards some higher yielding areas of the credit market. We believe that the current environment is ripe for active investors who are able to cast their net wider and search out value in more esoteric areas of an $87trn global fixed income universe.
In the post-financial crisis years, banks have retrenched from lending, fuelling growth in public debt markets - euro high yield, emerging corporate debt, as well as specialist areas, including infrastructure and peer-to-peer lending.
These sectors are less duration sensitive and offer investors a higher yield premium for the credit risk taken (i.e. risk of default).
Within our own portfolios, we have been increasing exposure to emerging market sovereign debt and US high yield energy bonds, where valuations look more attractive relative to sovereign bond yields. In addition, we are continuing to seek out yield opportunities in property and infrastructure.
Matthew Toms is an investment analyst at Heartwood Investment Management. The views expressed above are his own and should not be taken as investment advice.