The Fixed-Income Challenge: The Monetary Policy Pit
Fixed-income investors historically needed to worry about only two closed-state factors: the yield curve and issuer credit quality. Smart investors put tremendous energy into evaluating these two considerations at the outset. Once assured an investment was made, investors could apply appropriate asset allocation and clip their coupons.
Gone are those days. The global financial crisis saw to the demise of closed-state fixed-income analysis.
Now contexts requiring attention — even in such previously sleepy fixed-income markets as US government debt — are myriad.
Investors still worry about the yield curve and credit quality. In fact, as the income has disappeared from fixed income, there is no longer yield compensation for risks. So everything is about assessing the factors that affect credit. What considerations have been added to the mix? Global GDP growth, the fiscal policies of major economies, population demographics, geopolitical risks, decreasing liquidity, emerging market capital-flow volatility, and on and on.
Since so many factors affect credit quality, fixed-income investors are now just as fundamental in their analyses as their equity counterparts. They have to be, because the obstacle course is so much more challenging today.
But what is the biggest hurdle to success right now for fixed-income investors? Earlier this week, we asked CFA Institute Financial NewsBrief readers. Is it central bank actions? The vulnerability of emerging market debts to capital-flow volatility? An aging population in the leading economies and the associated pension pressures? A dearth of liquidity in most debt securities? Lagging economic growth? The deteriorating financial condition of credits?
The Monetary Policy Pit
An overwhelming majority of respondents (57%) said monetary policy is the major impediment to fixed-income investors. Why is this not surprising? Because the yield curve of old resulted largely from central bank actions. It is tempting, therefore, to conclude that nothing has changed from the old days of “Don’t fight the Fed.” I think, however, that most fixed-income investors believe the current environment is much different from previous eras.
For starters, there are now many globally important central banks other than the US Federal Reserve: for example, the European Central Bank (ECB), the Bank of England (BOE), the Reserve Bank of India (RBI), the People’s Bank of China, the Swiss National Bank (SNB), and the Bank of Japan (BOJ). Each of these banks can now affect the entire global fixed-income market with a misspoken word. This is a very different situation than ever before, when fixed-income investors only had to concern themselves with maybe two central banks.
What else is different about the current era? Of course, the extraordinary monetary policies adopted by the world’s leading central banks. These measures have scant historical data to support their use. Are they benevolent in propping up the economy for the long-term good? Or are they malevolent and undermining the foundations of the economy — like price discovery and inflation — for long-term ill? Is aggregate demand helped, hurt, or made irrelevant by these policies? Is inflation in check or bottled up and waiting to explode? No one knows, and this uncertainty means it is very easy to be on the wrong side of central bank policy as each nation acts in its own interests with little coordination.
What is the biggest obstacle facing fixed-income investors right now?
Tepid Economic Growth
Imagine you could hypnotize central bankers and ask them why they adopted extraordinary monetary policies. What would they say? “Tepid economic growth,” most likely, and 17% of poll respondents agree. Global fiscal policy in the post-crisis era provides almost no economic support in most developed nations. Instead, gridlock is the new normal for the United States and the European Union (EU), in particular. But it is not as if fiscal policy is innovative and supportive in other economies either. Can anyone point to a modern equivalent of the New Deal? Nope. What country serves as a global role model for fiscal policy innovation? No one.
Furthermore, can a debt crisis — which is how many characterize the global financial crisis — be solved by issuing more debt? If capital was poorly allocated previously, what makes investors believe it will be better allocated now? In fact, isn’t that the real reason for sputtering economic growth? Misallocation of capital. After all, central banks have injected market-warping amounts of “free money” into the global economy, and yet demand for capital for value-added capital investments remains anemic. Where is all the innovation? Where are the successors to the large-scale innovators of previous economic eras? Crickets. In short, there is an aggregate demand problem: No one wants a piece of the economic future.
If economic growth slows, issuers suffer and, consequently, so will the fixed-income investor. That’s an obstacle if ever there was one.
Graying Populations in Major Economies
But maybe the principal challenge in fixed income is not central bank policies or sluggish economic growth. Instead, perhaps it is the aging demographic profiles of North America, Europe, China, and Japan. After all, it is a near law of economics that as people grow old, they cut back on consumption, save more, and re-allocate what they do spend towards less productive enterprises, like health care, second homes, and vacations.
And, of course, the black lining inside of this cloud is the state of global pensions. Low interest rates make paying for promises made generations ago extremely expensive. Many pension trustees are taking on more risk in a quest for capital gains and higher yields. Increased risk in the safe portions of the portfolio is obviously not helpful to fixed-income investors.
According to 11% of survey respondents, these aging demographics — and the associated pension-related complications —constitute the chief stumbling block for today’s bond investors.
Distinct minorities of poll respondents consider a lack of liquidity in fixed-income markets (7%) or declining credit quality (6%) to be the biggest challenge. Liquidity has never been good. But in the face of monetary policies and recent financial regulations, bond market liquidity is evaporating. The combined total assets of the major central banks have ballooned from $6.4 trillion in 2008 to $17.6 trillion today, for a net increase in assets of $11.2 trillion in just the past eight years, according to Edward Yardeni. This drives other players out of the market and likely is hurting liquidity.
On the regulatory side, the capital requirements and leverage ratio implications of Dodd–Frank and Basel III have discouraged many banks from maintaining large inventories of bonds like they did in the past. These challenges notwithstanding, investors must still contend with credit quality concerns. So it is not surprising that some respondents are so concerned with credit deterioration: This is the part of fixed-income investing that is changing most rapidly. To paraphrase game theorists: All of the other obstacles are now known knowns.
Finally, the volatility of capital flows for emerging market fixed income was identified by only 2% of survey participants.
Apparently few expect another event like the Mexican debt or Asian financial crises of recent decades. Put another way, if there is a problem on the fixed-income horizon, it is likely to come from a larger, more macro context.
And isn’t that a big risk, too? Too much consensus — “It’s the central banks, stupid” — leading to a lack of appreciation for the outsider risk?
For more on fixed-income sectors, security selection, and portfolio construction, the CFA Institute Fixed-Income Management 2016 Conference will bring together researchers, analysts, portfolio managers, and top strategists on 20–21 October, in Huntington Beach, California.
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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.