Ten years on from the start of the financial crisis and fixed income investors are being selective with their allocations.
The reaction of the major developed market central banks to the crisis was initially to slash interest rates towards zero before moving into unconventional policy easing.
The consequence of these unprecedented actions has been for yields in developed markets to hit all-time lows.
By design, quantitative easing (QE) is aimed at forcing investors to take on more risk, whether that is by switching from the relative safety of government bonds to investment-grade and even high-yield corporate debt, or through revising overall portfolio asset allocation by moving from lower volatility fixed income products to higher volatility equities and alternative asset classes.
What next? While it has been a long road to recovery and growth has not rebounded as quickly as it has following previous recessions, the global economy no longer appears to need such emergency policy.
Indeed, in the US the Federal Reserve has already started a very gradual tightening of monetary policy and is now looking to start reducing the size of its balance sheet.
In the eurozone, with inflation picking up, it seems likely that the European Central Bank (ECB) will also look to ease back on the pace of QE, even if it is not yet ready to move into a tightening cycle.
One point that is worth noting, however, is that the great recession was mainly a developed market phenomenon, and while many emerging economies also moved to looser monetary policy to spur a recovery, they did not have to go to the extreme policy measure seen in the G7.
With this in mind, it is interesting to note that while low rates in developed markets may have held back some demand for fixed income, there are still areas that can aid investors to achieve their goals. In particular, as central banks in developed markets look to withdraw some policy accommodation, investors appear to be preferring low-duration benchmarks or are alternatively switching their focus to emerging market debt and the high-yield bond market.
Indeed, based on Morningstar data for the European ETF market, so far this year emerging markets have seen very strong demand, whether it is local or hard currency bonds.
Here, investors not only benefit from a significant yield pick-up relative to developed market sovereigns, but in addition, should the global economy take a turn for the worse, there is room for these central banks to cut rates.
There has also been strong demand for the US investment-grade corporate bond market, although a large part of this allocation has focused on defensive floating rate notes, which will not suffer the same degree of capital loss should yields rise.
The US high-yield market has also seen strong inflows so far this year as investors continue to seek income.
On the other hand, the largest outflows this year have been from European government bonds as investors seek yield elsewhere and prepare for the ECB to reduce the pace of QE.
The financial crisis has caused developed market central banks to take monetary policy to – and maybe past – its limits, which has distorted valuations, particularly in high-grade bond markets.
While this may have held back some demand for fixed income, there are still some areas that offer value and continue to see inflows.
We’re not talking about the sort of returns being seen in equity markets, but it’s worth remembering what role fixed income plays in portfolios.
Even with yields much lower than normal, bonds still provide good diversification benefits, and some segments – particularly via ETFs – can still provide real income.
Paul Syms is responsible for fixed income product management at Invesco PowerShares
