I am Article Layout

Select your investor profile:

This content is only for the selected type of investor.

Individual investors?

investing in absolute return fixed income

August 2019

Lower for longer again

With low rates here to stay it is crucial for fixed income investors to find the right balance between risk and return.

As little as five years ago, if anyone had offered you the opportunity to invest in an ultra-long maturity bond at a yield that barely covered inflation, you’d have made your excuses and left. But in today’s world of low interest rates, you’d probably find yourself giving the proposal some serious thought.

When Austria sold centenary bonds last month, demand outstripped supply by five-to-one, with the paper selling at a yield of just 1.2 per cent. Absurd, possibly, yet perhaps not so surprising when you consider that USD13 trillion of debt, globally, now yields less than zero.

It’s a situation that’s unlikely to change soon. The latest indications from both the European Central Bank and the US Federal Reserve are that rates will head lower in the coming months.

Which is why income-seeking investors appear to be in a tight spot. They either have to accept lower returns or take on more risk.

Yet the decision doesn’t have to be framed in such binary terms. With the right approach, investors needn’t compromise too much on either.

For the Pictet-Absolute Return Fixed Income strategy, the idea that interest rates would remain at rock-bottom levels for a long period has informed our thinking for several years. 

Historically high government debt levels have pegged back economic growth and kept inflation low. That, in turn, has resulted in low bond yields (see chart). And we believe these trends will remain in place even if short-term changes in economic conditions may allow for occasional doses of central bank hawkishness (such as seen earlier this year).

low inflation, low yields
US 10-year Treasury yields, %, and CPI inflation, % y/y
US inflation vs Treasury yields

Source: Bloomberg. Data covering period 31.01.1962-28.06.2019.

We look for opportunities from a broader range of securities than the majority of mainstream fixed income strategies, but – crucially – offset these with hedges to balance risk at portfolio level.

Unloved credit

At the riskier end of the spectrum, we see value in US BBB-rated credit, the bottom rung of the investment grade universe. Prices in this segment  have been under pressure and these bonds now trade at an attractive premium. Many of the biggest of these issuers – including several large, established corporations – are having to cut debt after engaging in merger and acquisition activity. And as they do so, their bonds are becoming interesting investment opportunities.

Corporate bonds should also gain from Fed rate cuts and the resulting economic boost.

negative correlation
5-year rolling correlation: BBB-rated US bonds versus Treasuries
US BBB credit vs Treasuries correlation

Source: Bloomberg, Pictet Asset Management. Data covering period 31.12.2001-30.06.2019.

However, these securities would be vulnerable in the event of a severe downturn or recession. That may not be our base case scenario, but our approach is based on weighing up probabilities and risks. Our aim is to analyse all the possible scenarios that could deliver gains for our investors not only when markets move up, but also when they move down. A long position in BBB-rated bonds is, in itself, too risky given this objective, so we need to find a cost-effective way to lower the risk while still generating attractive returns.

In this case, that means hedging that position by investing in longer duration Treasuries, with maturities of 10 to 30 years. Historically, returns from these government securities have consistently been negatively correlated with those of BBB-rated credit, making for a good hedge pairing (see chart). If the US economy suffers, US rates will go even lower than currently anticipated and stay there even longer, to the benefit of longer-dated sovereign bonds. We added to this position during the market sell-off earlier this year.

Similarly, in Europe we have hedged our allocation to investment grade credit - where we have focused on issuers operating in the real estate industry - by buying long maturity German Bunds.

Emerging balance

But the opportunities to gain a favourable trade off between yield and volatility is not confined to the developed world. They also exist in emerging markets. 

Emerging market (EM) bonds have tended to be particularly sensitive to changes in US interest rates. So US rate cuts should bring an additional boost to an asset class which is already on track to benefit from China’s transformation into a more balanced economy.

EM dollar-denominated bonds thus offer the opportunity to generate attractive volatility-adjusted returns over the coming years. However, long-term potential aside, emerging markets are well-known for bouts of short-term volatility. We believe we can mitigate this risk with short positions in a range of EM currencies versus the dollar.

Predicting the path of markets, economies and policymakers is notoriously difficult. And getting economic forecasts right is not something we want to stake our performance on. Instead, we focus on identifying long-term structural trends and investing in the opportunities they create, while carefully balancing and diversifying risks at every opportunity. At a time when rates are at rock bottom, but debt is at record highs, it’s an approach we believe makes a lot of sense.