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Delivering income
EquityOct 4 2017

Is the bond bull market over?

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Is the bond bull market over?

Over the past decade, extremely accommodative global monetary policy has helped fuel a search for yield that has driven up bond market valuations. However, the multi-decade bond bull market that has been underway since the 1980s might have passed its apex, with yields having risen since mid-2016 amid accelerating global growth. 

Despite this, the returns available to fixed income investors are still low by historical standards. Furthermore, the US Federal Reserve (Fed) is set to begin reducing the size of its balance sheet in the coming months, which could put further upward pressure on yields. These dynamics have ensured that the risk-return profiles of many fixed income markets are unfavourable relative to historical standards. 

Nevertheless, changes in population demographics and supportive policy from central banks elsewhere in the world should ensure that demand for income-producing assets remains strong. As such, my colleagues and I at Brooks Macdonald are searching for ways to generate income by investing in assets outside fixed income. One way to do this is through alternative investments such as convertible bonds, structured notes, property and infrastructure.

Convertibles

A convertible is a type of bond that can be converted into a predetermined number of the issuing company's shares, usually at the discretion of the holder. Convertibles offer the capital protection and income characteristics of bonds, while also providing upside exposure to potential increases in equity prices. Although they generally provide slightly lower yields than non-convertible bonds offered by the same issuer, the optionality inherent in their structures provides the opportunity for enhanced returns if equity markets perform strongly, allowing them to provide highly asymmetric pay-off profiles.

Despite forthcoming changes in monetary policy having the potential to adversely affect bond markets, there is a good chance equity markets will remain resilient. The Fed will reduce the size of its balance sheet only gradually, with the goal of maintaining financial market stability, which should avoid any undue pressure on equity markets. Meanwhile, the corporate operating backdrop is accommodative.

Key points

  • Global monetary policy has helped fuel a search for yield.
  • Alternative assets offer another option for receiving income.
  • Structured notes are another option that depend on the underlying asset.

Although Fed policy changes will have a direct effect on the treasury and mortgage-backed securities markets, corporate bond markets could benefit as the Fed reduces its balance sheet. Fixed income investors might reallocate funds to areas of the market that are less affected.

Commercial property

In certain instances, property yields remain higher than those that can be attained from high-quality bond or equity investments. However, it is uncertain how correlated property returns will be with those of other asset classes, given the declines suffered by the sector during the global financial crisis. There is uncertainty over the medium-term effects of Brexit on UK commercial property and this could weigh on the sector. 

Potential changes to the regulation of open-ended property funds are also a cause for concern. Several open-ended property fund managers applied large dilution levies on investors following last year’s referendum in response to high volumes of redemption requests and insufficient liquidity in their underlying investments. As such, I hold a cautious view on commercial property as an asset class, albeit acknowledging that there are still opportunities to gain attractive exposure to higher yielding assets within the sector on a selective basis.

Infrastructure

Infrastructure assets often benefit from inelastic demand and enjoy contracts that specifically grant them an ability to earn a defined return on investment. Sometimes these also include mechanisms to adjust their revenues for factors such as inflation. As such, they can be considered income-producing assets and can be used to diversify balanced investment portfolios.

It is possible to gain exposure to infrastructure assets via individual equities, collective investments or buying individual infrastructure assets outright. Each has their own benefits, but I generally access the asset class via investment funds that use asset-selection processes to identify and invest in individual assets with superior profiles, while building diversified portfolios that exhibit lower overall risk than their individual parts.

Structured notes

Structured notes are investments where returns depend on the performance of an underlying asset, often a market index, over a set period. They are generally considered long-term investments and have the potential to provide fixed returns if their underlying index declines, while some structures also offer equity-like returns if markets rise. Structured notes incorporate an element of capital protection, with the holder potentially receiving all the initial invested capital at maturity even if markets have fallen heavily. 

Generally issued by a counterparty, usually an investment bank, structured notes can be customised to provide the exposure the purchaser desires. They can facilitate highly tailored risk-return objectives. There are various types, including ‘synthetic zeros’ and ‘autocalls’. The main difference between these two is that synthetic zeros always redeem at the end of their term, while autocalls have the possibility of redeeming early  – usually depending on the level of an underlying index on a set annual date.

Structured notes offer a unique way to diversify balanced investment portfolios given the challenges facing fixed income markets. 

The following is an example of a structured note's return profile describing, just for illustrative purposes, the workings of a notional defensive autocall with the following features:

  • An autocall coupon of 8%.
  • Barrier drops of 7.5%.
  • Capital protection set at a barrier of 50%.
  • A maximum term of five years.
  • Each level taken on an exact date each year after inception.

This example uses an underlying index starting point of 7,000. If the index is greater than or equal to its starting point of 7,000 at the end of year one, the autocall will terminate and the holder will receive their initial investment plus the autocall coupon of 8 per cent. If the index has fallen, the holder will continue to hold the autocall for another year. 

If, at the end of the second year, the Index is greater than or equal to 6,475 (7,000 minus the barrier drop of 7.5 per cent), the holder will receive their initial investment plus the autocall coupon of 8 per cent interest for two years. 

If the autocall has not expired before the maturity date (the maximum term of five years after its issue date), then one of two things will happen:

  • If the index closes at more than the capital protection barrier of 50 per cent of its starting level of 7,000 (3,500), the autocall returns the holder's original investment.
  • If the index closes below the capital protection barrier, the holder's loss mirrors the fall in the index, meaning they will lose 1 per cent of the investment for every 1 per cent the index has fallen. 

Do be aware that, under this arrangement, the holder theoretically has the potential to lose all their investment, but only if the index were to fall to zero or if the counterparty failed to fulfil their obligations.

Richard Larner is head of research at Brooks Macdonald