The rates war


The aftermath of the global financial and sovereign debt crises have left economies worldwide struggling to find their footing. After years of government intervention, such as Quantitative Easing (QE) programs, some regions have shown signs of growth, while others remain concerned about potential deflation and decline.

Central banks are taking divergent paths, bond markets are challenged, and market uncertainty has grown. The path ahead is unclear. How does a fixed income investor restore order to their portfolio?

Different economies, different countries, different central bank policies. More and more of the global bond market is falling into negative territory and on top of that, there is a wide range of yields.

Some economies have an interest policy set above 0, such as Australia and the US; on the other hand, there are those below 0, such as Switzerland and Sweden.




The yield curves of these countries are going further and further into negative territory. Not only do investors have the challenging environment of low returns and a thin margin for error, there also exists a large number of places to invest with a wide range of potential outcomes. This is a significant problem for fixed income investors.




Figure 2 shows the average yield on the World Government Bond Market (WGBI) over the past 30 years, versus the duration – or the sensitivity that bond markets have to interest rate rises. Yields are low and durations have extended because of low rates and unprecedented government bonds issuance. This can create two major problems:

  1. Prospective returns – from here, returns are likely to be low for years to come. The average duration of the WGBI index is six years. The yield, on average, is 1%; this means 6-7 years of returns of 1% (maybe a little higher if hedged into AUD, but still low)
  2. The margin for error is thin – this can be calculated by using the yield of the WGBI and dividing it by duration; for the WGBI at the moment, that number is 12 basis points. This means that if rates rise 12 basis points this year, the investor could lose all the income for the year, effectively wiping out their return.

This is the dilemma that fixed income investors face – low returns and a thin margin for error if rates rise. With interest rates at all-time lows, rate increases are inevitable. However, with central banks on divergent paths, as illustrated by Figure 3, the quandary faced by fixed income investors is exacerbated.




An unconstrained approach to fixed income

Global yield curves are likely to remain volatile and on divergent paths. Due to historically low yields and a thin margin for error, traditional bonds will be challenged going forward, particularly index based investment.

Traditional bond funds are managed against an applicable bond index, which are generally most heavily weighted to the biggest debtors. The fund might be a passive fund that seeks to replicate an index, or an active fund that seeks to track an index – either way, the fund may have more exposure to countries or fixed income securities with significant amounts of outstanding debt.

If the index has a longer duration profile, the fund generally reflects that duration too.

Conversely, an unconstrained investment strategy is one that is not beholden to a benchmark. It is designed to be better able to navigate the complexities of the evolving fixed income landscape and changing economic environment.

Unconstrained strategies are typically managed to beat a cash or equivalent benchmark, rather than a bond index; this removes constraints around duration and sector positioning.

This results in a strategy that has the flexibility to dynamically alter its investment mix to find the best opportunities across securities, duration and geography.

In the current environment, professional investors are concerned about rising interest rates and the impact that they can have on long duration fixed income portfolios; this is particularly significant for traditional benchmark aware bond funds, which become more exposed to duration and credit risk as interest rates rise.

The structure of bond cash flows has an embedded absolute return. All other asset classes require a buyer to determine value (and for price discovery as well) … all except bonds.

Bonds have a natural buyer in the issuer, whether a company, a government or other party. The issuer is required to pay back the loan (bond) at full value when it reaches its stated maturity date. This gives bonds a greater predictability of returns and a natural “curing” mechanism during periods of volatility.

A powerful consequence of this natural buyer is that bonds that have sold off in the marketplace due to technical reasons (such as reacting to movements in interest rates, the stock market or credit spreads) will naturally pull back to their maturity price over time; i.e. the pull to par effect.

Any framework that targets a positive return from fixed income will focus on the front end of the yield curve, five years and in. As long as the entity that has issued the bond is solvent, other issues, such as interest rate moves, geography or sector allocation become less important.

Taking an unconstrained approach – thinking about generating positive returns rather than relative returns to a benchmark – is likely to win over the next 5-7 years, while portfolios anchored to a benchmark are likely to remain very challenged in this environment.


This article provides general information only and has been prepared without taking account the objectives, financial situation or needs of individuals. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management ABN 14 125 715 004 AFSL 317587 (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2016 Grant Samuel Fund Services Limited.

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