CPD: Bonds are back!

Fixed income investments have returned to favour and once again are playing an important role in client portfolios. This article from GSFM explains why bonds are back and that the role of fixed income a diversified portfolio is reasserting itself in the current environment.

For many years advisers and investors have relied on the stability of, and reliable returns from, fixed income investments. However, recent years have seen this traditional haven rocked by a series of external events. The ongoing ramifications of the Covid-19 pandemic and its attendant supply chain disruptions, geopolitical tensions in Europe, the Middle East and Asia, and persistent inflationary pressures have all left their mark.

At the same time, there are key structural trends at play.

• The globalisation of skilled labour supply that arose following the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India is abating.
• Globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of industrial policy
• Domestic regulation of goods and labour markets is increasing in scope, leading to upward price pressures
• Baby boomer workforce participation is in decline, limiting labour supply and lifting wages.

Combined, these elements created an artificially low interest rate environment, followed by inflation and central bank actions to increase rates (figure one).

One of the benefits of investing in fixed income is that it has a natural buyer in the issuer, which is required to pay back the loan (bond) at par value – i.e. the maturity value of a bond – when it reaches its stated maturity date. This gives bonds a greater predictability of returns than other assets, such as equities or property.

A powerful consequence of this natural buyer is that bonds that have sold off in response to market forces, such as central bank interest rate decisions or sharemarket movements, will naturally ‘pull back’ to their par value as the time to maturity draws nearer. Those securities where there is a greater risk of default (i.e. not receiving the principal at maturity) need to pay investors a higher yield to compensate them for the increased risk.

Bonds in recent history

For that period of time when interest rates hovered at all-time lows, bonds fell out of favour with many investors. Being anchored by zero or negative short-term interest rates means bonds that provided negligible yield. At times, 10-year government bond yields in most developed markets were offering a yield less than 2%. Such a rate is not an attractive proposition, either in nominal terms or real terms against inflation rates that were also about 2%. In other words, a zero return prospect. Accordingly, money flowed away from bonds into equity markets.

Initially brushed off as temporary, inflation has proven more enduring than expected, leading to a notable uptick in bond yields across the board. Global interest rates have been rising for nearly four years, most notably in developed markets where both nominal and real interest rates have increased at a pace unseen since the 1970s^[1].

In the current environment, with positive real yields, there is increasing recognition that bonds can once again play an important role in a diversified portfolio.

Are all bonds created equal?

There are several key differences when comparing bonds and there’s significant diversity in the types of bonds investors can buy.

Diversification can be achieved via geography, currency and credit quality. There’s the diversity across issuers, such as developed or emerging market governments, as well as bonds issued by international agencies, semi-government organisations and corporations right across the rating spectrum.

There’s also diversity in securitised bond asset classes, such as residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities and collateralised loan obligations.

Importantly, there’s diversity in duration; bonds can be bought at issue and held for the term – or duration of the security – or bought (and sold) during that security’s term.

Given the current environment, one where years of persistent long-term low interest rates have been replaced by consistently rising rates, investors should be aware of the potential risk posed by longer duration assets.

When assessing fixed income investments during a period of rising rates, advisers should look for portfolios with low sensitivity to interest rate movement. Such portfolios will have the bulk of interest rate exposure in the front-end of the maturity spectrum as illustrated in figure two.

At the same time, short-dated bonds are more likely to benefit from the potential for an interest rate cutting cycle around the world; a decline in short-dated government bond yields can provide a solid capital gain for investors.

The yield curve (see figure three and explanation below) of the 10 year US treasury is currently inverted, which means that short term yields are higher than longer term yields^[2]. Australia’s 10 year government bond yield curve is currently normal (longer term rates higher than shorter term), shorter term fixed interest securities have seen an increase in rates – and longer dated bonds a decrease – that may result in a change in the curve’s shape^[3].

Fixed income strategies

To be a direct investor into fixed income securities has generally been the realm of institutional or other large investors, as minimum transactions are substantial. Although technology has enabled direct investment in some types of fixed income securities, most investors get their exposure to this asset class through a listed or unlisted fund.

The most common unlisted products can be classed as either ‘traditional’ (benchmark aware) or absolute return (unconstrained and benchmark unaware) fixed income funds. Passive funds have experienced an increase in popularity, largely resulting from the increased availability via exchange traded funds (ETFs).

Passive fixed income

Passive fixed income is generally comprised of fixed income index funds and ETFs, both which generally mirror a particular bond index.

In Australia, this is commonly ‘high credit quality’ indices like the Bloomberg AusBond Treasury, Government or Composite indices. The Treasury Index comprises Federal Government Bonds only – all rated AAA. The Government includes Federal Government and State (Semi) Government Bonds while the Composite also includes investment grade (rated BBB- or higher) credit bonds.

For global bonds the choice is generally between Bloomberg Global Government or Bloomberg Global Aggregate – typically with currency hedged back to $A. Introducing currency risk to the defensive component of a portfolio is generally not regarded as a prudent approach.

There are several potential drawbacks with passive fixed income investments. The first is that investors have to passively accept the characteristics of the index with respect to duration and credit quality. The second, generally more apposite to corporate bond indices, is that they are issuer weighted. This means that the biggest issuer (or the most indebted corporate) has the biggest weight in the index. Now that is not necessarily bad if that big issuer is matched by its size or ‘market-cap’ but it can also be a little counter-intuitive that the investor has the biggest exposure to biggest debtor where one might expect ‘ability-to-pay’ concerns to emerge.

If a client is invested in a credit ETF and a big issuer defaults (for example, think Enron in the early 2000s), there is the potential for big drawdowns compared to an active investor who is better placed to avoid credit ‘accidents’. So far in 2024, there have been 29 defaults, the highest number since 2009^[4].

The third drawback is that an investor locks in underperformance of the specific index by the amount of the fees charged.

This is not to say a passive fixed income investment, whether listed or unlisted, cannot play a role in a diversified portfolio; however, there are potential shortcomings that advisers and investors should be aware of.

Traditional bond funds

Traditional fixed income funds tend to employ a relative return investment strategy, one which aims to beat a benchmark index, such as the Bloomberg AusBond Composite Bond Index. When a fund is managed with reference to a benchmark, it is typically more constrained, owning similar securities in similar proportions to that benchmark.

For example, if the Bloomberg AusBond Composite Bond Index returned -10.5% over a calendar year and an investment manager achieved a -8.0% return, that manager beat the benchmark by 2.5%. Through ‘traditional’ investment, the manager delivered a negative return … but has met its objective.

A market cap weighted index is an interesting snapshot of the bond market, but from an investor’s perspective, does it make sense to use a strategy that largely replicates the index? As with passive funds, relative return funds are generally exposed to fixed income securities that have the highest benchmark weighting. In other words, those that are the most indebted, which is not always a good rationale for investment selection. And, as with passive funds, exposure to long duration assets is not always the best positioning for investors.

Any strategy that mimics an index will share the characteristics of that index. In an environment with rising bond yields, higher inflation, market volatility and a high degree of geopolitical uncertainty, traditional benchmark-based approaches to fixed income investment may be less effective.

Absolute return funds

The increased number of absolute return (or unconstrained) fixed income funds illustrates that investment managers are thinking about how to best position a fixed income portfolio to generate positive returns for investors. Unlike traditional bond funds where the majority of return is driven by the performance of the benchmark, returns from absolute return strategies are driven by the investment approach adopted by the manager.

An absolute return investment strategy is not beholden to a benchmark; instead it’s a strategy generally designed to better navigate the complexities of the evolving fixed income landscape than traditional bond funds that are constrained to managing a fund to a specific benchmark.

Absolute return strategies are typically managed to beat a cash or equivalent benchmark rather than a bond index, thus removing constraints around duration and sector positioning. Consequently, absolute return funds typically have lower duration (i.e. are less sensitive to changes in interest rates), a good thing when the interest rate environment is changeable. At such times, it can be more challenging for managers of traditional funds to make quick changes to allow for a changing economic environment or market circumstances. Absolute return fixed income managers can do that much more quickly.

Absolute return funds and the current environment

Fixed income specialists Payden & Rygel believe there’s likely to be a reversion to positively sloped yield curves around the world. In that environment, the starting yield should be outperforming cash. For a manager that can actively rotate between sectors and select quality issues within that, fixed income will offer quite attractive above cash returns in an environment where forward-looking returns from global equity markets may be more mixed than in previous years.

When bond yields are lower, fixed income managers have to ‘reach’ for yield, moving further out on the curve to attain a satisfactory yield and sometimes taking on more risk. In the current environment, absolute return portfolio managers are able to benefit from the high quality investments paying a high yield at the short end of the curve. There is good running yield potential in higher quality bonds relative to the last few years, plus potential price upside. Absolute return managers are well placed to take advantage of these dynamics.

A key benefit of an absolute return portfolio is being able to identify risk and swiftly take appropriate action to protect the portfolio. Being able to do this early is paramount; when things go poorly and investors are trying to exit positions at the same time, it can have negative consequences for the portfolio.

Because an absolute return fixed income portfolio isn’t managed with respect to a benchmark, there are fewer risks that need to be managed to (such as duration or liquidity risk). It provides the manager with greater flexibility and greater latitude with respect to asset class participation; all parts of securitised assets, corporate bonds, emerging market debt, developed government debt. In short, a lot of opportunity for diversification.

An absolute return approach to fixed income is better placed in the current environment because it:

• removes the benchmark from the equation
• can focus on companies/countries with the least amount of debt
• can focus on lower duration securities
• actively selects issuers that will add value to the portfolio
• can embed additional yield for investors
• actively manages risk exposure irrespective of benchmark positions
• focuses on positive returns.

Looking ahead, the active management and flexibility inherent in an absolute return fixed income strategy are key ingredients as global macroeconomic trajectories diverge, volatility increases and opportunities arise. The defensive qualities of fixed income – the potential to help to preserve value, provide diversification and provide income – have underpinned this asset class’s position as a stalwart of most investors’ portfolios. Advisers should be thinking about how to position the defensive part of their clients’ portfolios at a time when bond yields may start to fall, but in an environment where inflation remains problematic.

 

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Notes:
[1] Payden & Rygel, 2024: The Year of the Dragon, Unconstrained Bond Strategy, February 2024
[2] https://www.gurufocus.com/yield_curve.php, as at 7 April 2024
[3] https://tradingeconomics.com/australia/government-bond-yield as at 7 April 2024
[4] https://www.ft.com/content/f811649b-f66d-43aa-8a66-2412a4f0be50

The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives, financial situation or needs. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. 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 Payden & Rygel, GSFM Pty Ltd, their 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.