With 2014 set to become another challenging year in fixed income, Ian Winship, manager of the BlackRock Global Absolute Return Bond fund, on where he is anticipating opportunities...
Volatility in bond markets and the lack of returns from cash deposits are making many investors reconsider how they view these asset classes.
The value of cash savings has been falling as the rate of inflation has exceeded the interest paid by banks. For example, the European Central Bank’s (ECB) key interest rate is currently 0.25%, while the inflation rate in Germany is 1.4%, in France 0.7%, Italy 0.7% and the Netherlands 1.67%. In the UK, the key interest rate is 0.5%, while inflation is around 2%.
For many conservative investors, fixed income has been an asset class of choice due to its risk/return characteristics. It is hardly surprising, given that, for the past 30 years, government bonds have helped preserve investors’ capital by offering average annual returns on par with stocks and with lower volatility.
Take control in changing bond markets
However, the unprecedented monetary stimulus measures taken by central banks since the global financial crisis have led to changes in how we invest in global fixed income markets.
As the trajectory of government bond yields become less predictable, the old approach of maintaining a static allocation to this one area of fixed income looks unlikely to remain as effective as it was in the past.
Time to be flexible
In order to continue meeting clients’ expectations in this challenging environment, a bond strategy must be flexible enough to look across the whole of the global fixed income universe and nimble enough to re-adjust its positioning quickly in advance of less predictable market moves.
This is why we believe the time is right for absolute return funds, which aim to produce positive returns in all market conditions.
Many of these funds seek to achieve that goal by extracting relative value from a broad range of fixed income-related investment strategies, some of them traditional actively managed and some of them based on quantitative models.
Such an approach will become more useful as changes and a growing gap in central banks’ monetary policy is expected to lead to higher volatility in bond markets.
We are living through some interesting times for bond investors. In my view, 2014 is likely to become another challenging year in fixed income.
We expect the world’s leading central banks to try to maintain their commitment to keeping interest rates low for a considerable period.
They are keen to avoid the volatility that beset financial markets in May and June 2013.
We believe this should create at least some sense of ‘calm’ about the risks bond investors are expected to take to achieve a sensible return in the core markets of the US, UK and eurozone.
I also think this will provide a favourable environment for the so-called risk assets, such as corporate bonds, emerging market debt and high yield bonds.
However, for the first time in many years, financial markets are approaching a period of monetary policy divergence.
The world’s four major central banks – the effective determiners of pricing across the global bond market – are set to find themselves taking slightly different stances with regard to monetary policy.
We believe this will offer investors a number of opportunities. Higher volatility in government bond markets will mean that we will need to be particularly flexible and tactical in our investment approach to duration exposure.
Going for ‘risk assets’
The European credit cycle is yet to turn, as banks continue to deleverage – something that is changing the European capital markets. We believe corporate bonds issued by European financial companies should generally be supported by negative net supply and company-specific opportunities, such as mergers and acquisitions and asset disposals.
We also expect corporate bonds to remain attractive, supported by surplus liquidity and low default rates. High yield bond spreads still price in excess default premiums given low default rates while their fundamentals remain solid.
However, the relative risk-reward now looks less attractive than in previous years.
After the underperformance we saw in the second half of last year, hard currency emerging market debt (both government and corporate bonds issued predominantly in US dollars) are beginning to look attractive relative to corporate bonds issued in developed markets.
We expect this area of fixed income to remain volatile, with investment opportunities driven by differences in fundamentals of individual country markets.
We expect a very interesting period in the next three to six months.
I always thought bond fund managers have tended to have a fairly grim view of the world as we look out for things to turn out badly. However, looking at today’s markets, I am feeling quite optimistic.
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