Fixed income faces hard times

It is easy to understand this view: we are at a point in time when yields have fallen since the 1985 Plaza Accord heralded a new era of central bank inflation targeting, followed swiftly by the fall of the Berlin wall in 1989, leading to an opening up of the east and China swiftly moving onto the world stage just at the point (or causing) when global trade was increasing rapidly as a share of global growth.

All of these dynamics and more have seen yields fall in a very nearly straight line from 10.34 per cent to the sub 2.70 per cent level we are now.

One thing the end of QE has introduced has been a pick-up in volatility.

Bringing us right up to date, 2018 saw investors fretting about the end of the cycle and the impact of higher policy rates as the Fed told us hikes were on the way.

Recession fears leave fixed income exposed

Towards the end of the year, we found ourselves jumping to the other side of the ship as rate hikes were taken off the table and the fear of recession spooked holders of risk assets.

During the last few years of the bond bull-run, yields and risk premiums (spreads) fell, driven in part by quantitative easing.

Massive bond buying programmes have forced investors down the quality curve and meant that most asset classes have delivered some excellent returns.

In the UK for instance, since March 2009, the gilt market is up almost 55 per cent in total return terms, investment grade is up 120 per cent, and European high yield 235 per cent.

If lower yields and tighter spreads were driven by these unprecedented monetary policies, market commentators were keen to point out that the reversal would be catastrophic.

In essence, it is unlikely to be as simple as one extreme to the other. Although one of the impacts of QE has been to support the banking sector and allow it to de-lever, indebtedness is still a challenge as both the corporate and private sectors are still big borrowers.

That means policymakers are not likely to make a dramatic U-turn at this stage of the cycle and fiscal measures may also be required.

So, how do we manage our bond exposure in an environment which is changing so rapidly?

Beware credit complacency

One thing the end of QE has introduced has been a pick-up in volatility.

Credit spreads have moved rapidly to price in the risk of a slowdown and also to reflect the absence of a massive buyer – the world’s central banks.

Credit sensitive areas such as investment grade and high-yield bonds, along with emerging markets, all suffered towards the end of 2018.

All these assets will struggle if we do see a recession, but for now they are probably overcompensating us for the current macro scenario. However, it remains important not to be complacent about credit levels – buying at the right valuation remains the key.

Indeed instead of letting volatility dictate everything, we are using the change in the environment to move our funds towards better fundamental credits – not just improving the average rating of assets entering funds, but looking at how a company sits in the community in which it operates and the management’s attitude to risk and leverage that will likely dictate how well that group does during a tougher economic environment or greater political scrutiny. 

With credit being a mean reverting asset class, volatility also leads to changes in liquidity for credit. Increasingly, it is important to use periods of shifting liquidity with intelligence and calm. Being contrarian with the liquidity trend should pay off over the next few years now the central banks have moved on.

This means buying good quality businesses when the market is selling off and reducing areas of concern when the market is rallying.

Key points

• Bond investors have been fearing a rise in bond yields.
• Massive bond buying programmes have forced investors down the quality curve.
• The threat of higher yields on government bonds still exists given tight labour markets.

Government bond yields have also repriced rapidly. The threat of higher yields still exists given tight labour markets and extremely low yields, rather than higher levels of economic activity.

Typically, when worried about rising yields, bond investors reduce duration – the impact of rising yields is greater on long-dated bonds than it is on short-dated bonds.

While the starting yield on shorter-dated bonds may be lower, so too is the downside risk to capital and potential volatility.

That said, I do not think the risk of higher yields is too significant in the near term. For the time being, central banks appear to have taken hikes off the table and along with weaker economic data, this means the risk of a dramatic spike in yields may have been and gone for now, as the graph (on the previous page) shows.

It feels like a tough time in bonds again – not helped by a higher level of volatility.

In summary, I would look to keep interest rate exposure relatively low and stay both active and diversified.

Without the stabilisers of QE, bond markets will be volatile, giving us at the very least opportunities to rotate and rewards for patient fundamental credit analysis.

Shifting valuations bring more opportunities to add value and to protect capital. At a fund level, mandates with the greatest flexibility are likely to see the best outcomes in this environment.

Roger Webb is head of pan-European credit at Aberdeen Standard Investments