Stability Now! Why Fixed Income Is Still Relevant
In an environment where government bond yields are slim at best and negative at worst, one can be forgiven for writing off the asset class altogether as a worthwhile investment. Negative yields are not the stuff retirement commercials are made of. Why would any sane individual want to pay to lend money? The answer to that question is multilayered because the investment landscape has become more complicated to navigate.
When I first started working at PIMCO in 2005, we would lament how boring fixed-income investing had become. As a marketing investment professional, what excuse can you find to call your clients when both volatility and rates are at historical lows? A few short years later, we got our dose of excitement as the investment landscape became a lot more confusing and perilous.
Central Bankers Going Rogue
One of the metrics that is closely watched by fixed-income portfolio managers is forward guidance by central banks. Although they would never come out and say what they were going to do, there are key words that foretell the banks’ actions — just like in high school when my friends and I used code words to refer to the objects of our affections. For the casual passerby they meant nothing, but for the initiated they meant everything!
Back to bonds: Because sovereign bond rates are so closely tied to rate policy, it was a very nice set up. There was no wondering about what the central bankers would do. But we are currently entering a very different and scary world where central banks are, for a variety of reasons, choosing to keep their options open. Order be damned.
Bank of Canada’s January rate cut, in response to falling oil prices, came as a surprise to most, with jarring implications for bond portfolios, as the Canadian dollar dropped precipitously. To the south, the 27-28 January Federal Open Market Committee minutes also held surprises of their own. And in currency news, the Swiss National Bank’s sudden announcement to drop the Swiss franc’s peg to the euro created havoc in the markets. This indicates the start of a trend of much less forward guidance by central banks. As PIMCO’s Vineer Bhansali stated so eloquently in a recent blog post, “New Neutrals, Fat Tails and Distorted Markets”: “Hanging your hat on the ‘central bank put’ is becoming fraught with dangers like none of us have seen — ever.” Bond fund managers prepare with yoga and antacid.
Negative Yields — Say What?
Negative yields are a somewhat embarrassing phenomenon in the world of bond fund management. Case in point: Many models don’t even consider negative yields a possibility. The worst part of this is that we now have to admit we do not know everything.
There are several possible explanations to this upside-down business of negative yields. One is that they are caused by monetary policy. A second is the preferred habitat theory — the idea that investors prefer a certain part of the yield curve. I personally love this name because it makes bond fund management sound like an African safari. Another theory is that negative yields could be forecasting a sharp economic downturn, which would lead to defaults — both sovereign and credit. In this case, return of capital may be more important than return on capital.
Furthermore, global yields seem to be converging on Japanese ultra-low/negative yields, not the other way around, which may be an indication that this situation will continue for the foreseeable future. What is counterintuitive is that Japan’s bond market has been the best-performing bond market on a risk-adjusted basis over the past decade, despite persistently low yields. It is not always the level of yield that is important but the shape of the yield curve and the volatility of bond prices. A stable, steep yield curve is good. Low volatility will result in a better Sharpe ratio. Absolute level of yields is less important in this context.
All Terrain (Investment) Vehicle Needed
The aforementioned facts certainly bring to mind the latter part of the “fight or flight” mechanism nature has developed in us. But perhaps we need to be looking at this conundrum from a different angle. Even in the best of times, bonds are not expected to be the engines of growth in a portfolio. Their payout is asymmetrical. Active management aside, the best they can do is pay coupons and return principal. In the worst case, they default and you are left with nothing. What they do add is stability to a larger, more diversified portfolio. Investment-grade bonds, both sovereign and credit, remain an important offset to equity risk, as interest rate hikes are likely to be gradual.
From the beginning of time, people have thought that previous generations had it easier. This time, however, there is evidence that we have entered into an investing era with more uncertainty than before. There are more chances of things going wrong, and if they do, there is more of a chance it will be disastrous (fat tails). With a growing list of things that could go wrong, a structurally sound portfolio is needed.
Although the investors of yesteryear tried to time the market (which we were never very good at anyway), what is needed today is what I like to call “fuzzy investing,” the aim of which is not to try to time the market with any degree of precision. It involves a perpetual hedge against various scenarios to protect in most eventualities. Furthermore, unconstrained fixed-income strategies allow the manager to maneuver around pitfalls and take advantage of opportunities. Diversification being one of the best responses to uncertainty, a balanced, robust, managed portfolio of bonds with tail-risk hedging seems the order of the day.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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