As we entered 2014, conventional wisdom held that, in anticipation of higher official interest rates, core government bond yields would rise from their historic lows. It all made sense: national deficits were still too large, borrowing remained too high, and – most worryingly – the central banks were keeping yields artificially low by buying more than their governments issued. But even as UK and US central bank bond-buying programmes slowed, the rise in yields did not happen. They have actually fallen in most instances, rendering the “wise” majority wrong.
To help understand why this might have been the case, it is worth remembering an all-too-often overlooked fact: bonds have inherent demand. There will always be a significant amount of buyers because people will continue to need income, and liabilities (of which there are still many) still need to be matched.
A seismic shift in Western investors’ investing patterns has been occurring. Sweeping regulation in the insurance and pensions market has resulted in one-time changes in asset allocation patterns; insurance companies now hold the highest proportion of their assets (circa 60 per cent) in bonds and the lowest proportion in equities. Pension plans at many companies have been de-risking and general liability-matching strategies that inevitably require buying many bonds.
What is more, ageing developed-world populations will ensure a steady stream of fixed-income buyers as they seek to secure reliable retirement incomes. Diversification is another reason, with standard risk-modelling tools also continuing to recommend fixed income as part of a balanced client portfolio. The fact that bond returns are typically negatively correlated to equities means their inclusion within a portfolio offers a useful – and in the long term – necessary, balance.
Last but not least, central banks worldwide continue to have an insatiable appetite for their own government’s bonds. While the US Federal Reserve has backed away from further buying – at least for the time being – other banks such as the ECB and the Bank of Japan have doubled down given weak growth outlooks and even weaker inflation expectations.
Of course, this does not mean that yields will not start to rise, and that fixed-income markets will not come under pressure. That view would be naïve. It just means that the path upwards is not predetermined, and is unlikely to be smooth and straight.
Many a career (and fortune) has been wrecked based on the logical conclusion of undeniably overvalued government bonds, positioning portfolios accordingly only to find that they stay overvalued, or worse, become even more expensive. After all, while the origin of the quote “the market can stay irrational longer than you can stay solvent” is contentious, the sentiment certainly is not. Perhaps it was the economist John Maynard Keynes who first said it. In which case, his reminder that “in the long run we are all dead” might provide some light relief here.
It might be heresy to say so in front of fellow investors, but there is an argument that bonds are not that overvalued any more. We realise this is not conventional wisdom, but when the consensus is so wrong for so long, it might be time for conventional wisdom to change. First, global economic growth has slowed, even stagnated in much of Europe, Japan and even once high-flying China. This means one traditional driver of inflation – ever increasing demand – is not there any longer. Second, those countries’ populations have begun to expect prices to rise less rapidly or, as the worry now developing in Frankfurt goes, even to fall (the proverbial deflation or Japanification of Europe economically). We suspect that once inflation expectations fall, it could take some lifting – and a lot of time – to bring them back. Again, see Japan.
But what are investors to do in the meantime? Even if we might be wrong on bond valuations – I have some ideas.
The first is, where possible, to instil some flexibility to bond allocations. In such an uncertain environment, it makes sense to adopt a dynamic approach. Being able to quickly shift duration positioning (a portfolio’s sensitivity to interest-rate moves) can aid overall returns. Simply shortening duration, or even moving negative if the investment mandate so permits, is one option, but it can be painful if yields do not rise.
Further, going global – the ability to alter geography and credit quality can, if implemented effectively, offset the effects of rising rates domestically. Not all economic cycles move together. For example, we expect the US to grow more steadily and indeed even experience moderately rising inflation. The UK is likely to do the same, albeit to a lesser extent given its reliance on European partners. The point is that diversification should go beyond companies, industries and domestic asset classes to the world as a whole.
We would also suggest looking at investments in high-yield and emerging markets. History tells us that, as long as the credit environment (by which we mean the quality of companies, their industries and the countries in which they operate) remains stable, bonds with greater yield spread levels over government bonds offer more of a cushion in an environment of rising rates. Interestingly, some assets, such as high-yield, have demonstrated a negative correlation to interest rates and instead a positive one to equity markets. Ironically, we see many companies in Europe – despite the stagnant economy – doing quite well. Asian and US corporate bond issuers are benefiting from their economies’ higher underlying growth and are doing even better. I think this positive tone will continue, creating as good a reason as any to think globally about bond allocations.
Irrespective of the challenging backdrop, all segments of the bond market continue to have a role within client portfolios. However, the emphasis of each particular area should come under greater scrutiny and requires a rethink.
So with the ‘wisdom of the crowd’ proving something of a paradox or ‘folly’at present, investors and their custodians must be brave enough to break away from more traditional approaches to fixed-income investing, recognising that what worked in the past will not necessarily work in the future. I think the tools are already in place in non-traditional areas such as credit, emerging markets and through global approaches.
Brad Crombie is global head of fixed income at Aberdeen Asset Management
Key Points
Bond yields have fallen over the past year.
There is an argument that bonds are not that overvalued any more.
As long as the credit environment remains stable, bonds with greater yield spread levels over government bonds offer more of a cushion.
