One of my colleagues in sales told me recently that he had heard the same message from several clients in the recent past: “I don’t know what to do in fixed income, but as long as it’s not losing money I’m happy.”
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.
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.