Investec's head of fixed income believes bond managers are going to have to work ever harder to sque...
Investec's head of fixed income believes bond managers are going to have to work ever harder to squeeze gains out of the market in its current low return environment. John Stopford said the current behaviour of global fixed interest markets, which Alan Greenspan described in February as a "conundrum" demonstrates just how much investors are willing to risk for minimal returns.
Usually when the Federal Reserve starts to raise rates the bond market falls and keeps doing so until it anticipates rates are going to come down, at which point it rallies. However, this time around bonds had an initial sell-off but have since rallied even though the Federal Reserve has been increasing rates. The global savings glut, Asian central banks recycling their assets and demand for longer-dated assets from pension funds may go some way to explain demand, according to Investec.
But for Stopford the fundamental reason is that in a low-return world, investors are prepared to take higher levels of risk for less return. He added: "If you look at the US treasury market, there is now no risk premium for investing longer down the yield curve, which is something very unusual. Historically people wanted a higher return for lending money for longer. If you look at the UK, real yields are about as low as they have ever been. The UK Government has recently launched a 50-year inflation-linked bond, which will give a real yield of just over 1%. Historically, real yields have never been so low.
Part of the reason for this is that very few assets have high returns. And if you concentrate on just the higher-returning assets like equities, you invite a very high level of volatility. "If you have a 100% equity portfolio, there's a huge dispersion of potential returns. If you are lucky, you'll get very good returns. If you are unlucky, you can have negative returns for a long period of time."
While equities have a far better long-term reward profile, Stopford said investors should still be looking to use bonds, because of their characteristics as a portfolio diversifier. He added: "The advantage of using other asset classes, and bonds are the traditional option, is that adding them doesn't reduce your returns nearly as much as it reduces your risk. So you can get a much better trade-off between risk and return by adding bonds to an equity portfolio, even in a low-return world."
The big issue for fixed interest managers is how they can generate higher levels of gain to ensure the combined equity and bond portfolio has a decent overall return level, while still offering diversification characteristics. Stopford said the first area fixed interest managers should look at is how they diversify the risks within their portfolios. He argued different sources of return - for example, credit risk, duration, yield curve, currency and country, can all be blended to increase overall return and diversify risk.
His second suggestion was that fund managers need to broaden the universe of areas where they look for exposure to beta, or at least the upside in the market. He argued that property, emerging market bonds, currencies and high yield were going to be important in the future.
Stopford's final source of higher return was alpha, although he acknowledged this could be expensive and inconsistent. He said the advent of Ucits III and the greater scope of using derivatives within portfolios meant it would be easier to separate out and manage alpha separately from beta.
He added: "In particular, they create the ability to short markets on an unleveraged basis. This allows managers to exploit relative value opportunities without having to take directional market exposure. This creates the potential to add performance in both up and down markets."
Bond markets are currntly rising at same time as interest rates. Usually when rates rise, bond markets fall.
Real bond yields are close to their lowest levels since 1700.
Bonds are a good diversifier when put with equities, but fixed interest future returns likely to be low.
There is a need to maximise returns from bond portfolios to compensate for lower returns generally.
Ucits III means greater use of derivatives can be used to squeeze extra return out of bond markets.
Investors need to make greater use of techniques such as currency overlay.
Three years at Wells Fargo
Effective from 9 December 2019
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