The past 12 months have seen a proliferation of articles questioning the rationale of purchasing ultra-low (if not zero) yielding bonds, especially by pension funds whose liability driven investment structures rely on stable return streams. Most market participants – including those at investment consultancy firms and on pension investment teams – would agree with the arguments, yet many continue to be steered by passive, highly constrained fixed-income investing frameworks. With the world now focussing on expectations that the Federal Reserve will start hiking interest rates, we may be at a critical inflection point in global fixed-income investing.
Market activity so far in 2015 may well provide a wake-up call to traditional asset allocation and fixed-income investing but will it lead to serious questions regarding the risk versus return argument? Only time will tell. The recent volatility of global asset classes could be a sign of times to come.
Looking back at the second quarter this year, the German 10-year bund lost 7%, declining in price from 160.32 to 148.98 from 20 April to 10 June (Bloomberg ticker RXA Comdty). This is a price move resembling more of a risk asset such as equities rather than the reliable 'defensive asset' in millions of European pension funds.
Furthermore, the 10-year yield on the German bund reached single digits in basis points mid-May, meaning that this short period of loss instantly wiped out decades of expected return for recent buyers. While these statements may seem dramatic, they represent what could just be the start of a multi-year era where short-term volatility causes havoc for defensive allocations while offering very little in terms of expected return.
Looking beyond the recent price action, the April to May rise in yields takes us back to levels seen only late last year. At the time of writing, the German 10-year bund was offering a yield to maturity of just 78 basis points: this is hardly exciting for pension funds, and private investors saving for the future.
One must also not forget that any hint of a tick up in inflation expectations over this 10-year period and the real yield could move into significant negative territory, with negative real yields already seen in parts of Europe and Scandinavia. The point of putting these recent moves in a longer-term context is that it is not too late to address the issue by looking at alternative income streams.
Before tackling alternatives to passive investing in low-yielding, volatile assets, it is important to look at how we got here, why this behaviour has persisted for so long and why we are at arguably irrational levels of yield with some countries, such as Switzerland, having seen their yields go negative in recent months.
History professors often lecture that, to analyse the future, we must understand the past. This lesson is apt when considering the state of the world's bond and financing markets. Since the financial crisis of 2007/08, central banks have had an unprecedented impact on global markets. Starting with the Fed's interest rate cuts, followed by its multi-year policy of zero interest rates, all the way forward to the European Central Bank's programme of buying up the debt of its embattled member states.
Despite the lack of any technical merit, 'The Hunt for Yield' is a moniker that has been adopted to describe global investors' behaviour to satisfy the need for investment returns during this phenomenon of falling interest rates. Since 2007, investors in fixed income have achieved strong capital gains, associated with the process of buying demand and falling yields in the primary sovereign bond markets such as the US, Japan and Europe; however, as the capital gains sought to be booked, investors were left with a smaller forward-looking return.
Investors see high past returns for bonds in investment reports but have perhaps forgotten that these returns have been essentially taken from the future. Unlike equities, fixed income cannot go up forever as the holder is going to be paid a fixed value upon maturity. Basic bond maths means that a fixed-income instrument has a fixed return over its life and if the asset is bid up in value before maturity, the holder can sell it for a profit. But how many remember that those returns come from the total return of the instrument's life?
So, as yields marched lower, investors started to look away from the highest rated sovereign markets, such as the US and Germany, to corporate bonds, compressing IG spreads, to high-yield bonds such as speculative tech and energy firms, all the way to lower-rated sovereign bonds of countries from Ecuador to Ghana. As all of these instruments and markets began to experience massive inflows, the yields have been declining.
Only a few years ago, Spain and Italy were trading at double digit yields, only to fall to low single digits after the famous Mario Draghi "whatever it takes" speech during the height of the European crisis. Again, we saw central bank policy (or speculation of policy) driving asset prices without much change at the underlying fundamental level of those institutions that had issued the debt.
The somewhat perverse aspect of investing in debt especially via exchange traded funds (ETF) is that a debt index is defined by those entities who issue the most debt, as opposed to an equity index, where constituents grow mainly due to underlying earnings growth. Due to the low interest rate policies in the US, Europe and Japan, borrowers (corporate or sovereign) were encouraged to borrow even more, as their credit spread premium has traditionally been the price of these major markets.
As such, the most indebted nations and firms were able to borrow even more, due to low policy reference rates such as LIBOR, as well as higher buyer demand and ETF inflows, leading to a self-reinforcing spiral of lower and lower yields. The top four constituents of the iShares Emerging Markets High Yield Bond ETF are currently Turkey, Russia, Indonesia, and Petrobas – the first three having serious geopolitical concerns, while the latter is now engulfed in corruption scandals.
Most recently, we have seen risky borrowers, such as Morocco that had a well-received €1 billion issue completed in early June, issue debt in euros due to the ultra low rates in the region, leading the buyer to also take on currency risk in a troubled EU. Further along the risk spectrum we have seen large inflows into yielding type assets, such as infrastructure, REITS, and yielding structured notes - more evidence of a continuing creep into lower quality assets to generate a return.
Sovereign fixed-income markets – perhaps more so than any other – are known to have price-insensitive buyers. In other words, some institutions simply do not care where a bond is trading – they have to buy it, and will continue to do so regardless. The two main groups here are highly regulated pension funds and insurance firms. More recently central banks in the US, Japan, and now Europe have also joined the party via their bond buying programmes to kick start their economies.
With these huge players in the market, it makes little sense for a fund with the option of not buying these instruments to actually participate in this market, unless such low yields do satisfy their return expectations. Where this could make sense is for a fund to essentially 'front run' these entities, on the expectation that they will buy at certain levels and at specific times of the month. This, however, is more like a risky trading technique than a long-term investment strategy, where the opportunities may not even last that long.
Investors who are flexible should be looking at alternative income streams away from traditional fixed income. Much of portfolio theory that still dictates a fixed income-biased asset allocation was developed decades ago when interest rates were high and the concept of near zero yielding bonds was farcical. These are not only now a reality but, in Europe for example, make up a significant portion of the investable universe for bond investors. It is possible that for many pension funds their approach to managing allocations and risk has not kept up with the development of fixed-income markets, both in the option of instruments as well as strategies that are now available.
With the case for sticking to benchmark-hugging fixed-income allocations being highly questioned, investors should continue to explore all the options at their disposal to achieve a defensive‐like return stream for their portfolios. Given the developments of fixed-income markets and sophisticated absolute return strategies, looking beyond traditional fixed income for long-term, lower volatility returns has never been more suitable to allocators and pension fund CIOs as they look to adapt to the vagaries of both low and rising rate worlds.