G20 debt surge spurs rise in investor bond holdings

The most poignant of these is that since the end of 2007, the market cap of traditional bond indices has nearly doubled, reflecting an increase in both debt issuance and prices.

G20 countries now have $40trn (£25.7trn) more debt than they had at the beginning of the crisis, according to the Bank of International Settlements. This observation raises alarm bells for fixed income investors.

The mirror image of this relentless surge in debt has been the rise in fixed income holdings by investors. For example, annual asset allocation survey results compiled by consultancy firm Mercer show that pension funds’ allocation to fixed income currently stands at 48 per cent of total assets, compared with 36 per cent in 2007.

Of course, risk premium-focused investors are not the only players in global fixed income markets. The deployment of large-scale quantitative easing by key central banks in the aftermath of the 2008-09 crisis means they have now become prominent players, with different incentives compared with traditional investors.

The effect on investors’ views is clearly visible in the increased commonality in positions – or herding – held by various categories of investors, which have mainly been using market-cap allocation schemes to access fixed income assets.

This trend is disturbing in a world with very high debt, as it can lead to sharp moves when everyone starts to head for the exits.

In addition, both the regulatory situation and quantitative easing programmes have played a big role in fracturing what we call micro liquidity – the ability of market participants to go in/out of the market with limited impact and the expectation that they will be able to do so in the future.

In view of this backdrop, it appears fixed income investors have the following choices:

Continue with passive market-cap investing, which will lead to further herding; or

Use active management around market-cap allocations, which runs the risk of choosing managers who either follow the benchmark or take extreme off-benchmark bets;

A third choice investors have is to build a fixed income portfolio based on fundamentals, with the aim of delivering quality-based diversification by directly mitigating credit risk.

Given the broader environment, advisers and their investors don’t have any influence on the direction of regulation – which is likely to tighten further – or the consistency of central bank policy going forward. But they do have a degree of freedom in the form of portfolio construction and the investment vehicle in which they access this with.

In addition to the focus on portfolio construction, the choice of the right access point is also important. One such vehicle advisers and investors could consider is the use of exchange-traded funds (ETFs) to access fixed income risk premia in order to benefit from the liquidity support of the secondary market.

For example, even if underlying bond liquidity is being tested, market makers may be able to continue to support the liquidity of an ETF due to the inventory that they hold. This was tested in equities recently when trading was suspended on a large chunk of underlying Chinese A-shares, but the ETFs tracking these shares continued to be bought and sold on the exchange.

This additional layer of support applies to bonds and clearly shows that the secondary market may help them out of their fixed income position if liquidity in the underlying bonds gets fractured.

Howie Li is co-head of Canvas at ETF Securities and Salman Ahmed is global strategist and portfolio manager at Lombard Odier Investment Managers