Select your investor profile:
This content is only for the selected type of investor.
Individual investors?
The trouble with bonds
Quantitative easing and its effects on fixed income markets are here to stay. Investors ignore that at their peril.
Written by
Andres Sanchez Balcazar
Head of Global Bonds
Quantitative easing has turned the fixed income world upside down. But even though central banks are starting to reverse their emergency policies, QE isn’t going away completely. For investors, this means adopting new rules.
In many ways, bond investors have been guinea pigs over the last 10 years of QE. They were part of a massive experiment, one in which central banks expanded balance sheets to provide liquidity to the market and have ended up owning more than 20 per cent of outstanding global bonds. Throw in tighter regulation, and the effect has been to change the structure of the financial system, leaving banks a significantly less important source of credit.
In 2007, 61 per cent of debt instruments in non-financial firms were bank loans. Last year that figure was 45 per cent.
Bond managers and investors have felt like guinea pigs over the last 10 years of QE.
And investors are stuck with QE. Not only is it now an essential part of central bankers’ toolkits for supporting economies when interest rate cuts aren’t likely to be effective, but high government debt levels – they're touching 120 per cent of GDP among G-7 countries – make QE an important backstop for when the markets struggle to absorb fresh bond issuance.
That’s the first and most important of the eight lessons that I believe will help us navigate this new world of QE: QE is here to stay.
Next is that even with QE, the law of diminishing returns holds. Early rounds of stimulus are more effective than later ones. Which is a worry if the next crisis rolls around before central banks have been able to restock sufficient monetary ammunition.
What is more, given QE’s permanent, if variable, role, it’s important for investors to forget about GDP forecasting when talking about the credit cycle. Instead, they should pay attention to what’s happening to central banks’ balance sheets and to their guidance. That's necessary because QE has disconnected the credit cycle from the economic cycle.
It’s also important to retain plenty of flexibility. Investors shouldn’t just rely on market liquidity to satisfy their investment needs. By trying to shore up banks’ balance sheets, central banks reduced liquidity in markets. It means investors have to be prepared to absorb more shocks in future.
Keeping pace with debt
G6 central bank balance sheets and national debt as % of GDP
G6 comprises US, Switzerland, euro zone, UK, China and Japan. Source: National central banks, Thomson Reuters Datastream, Pictet Asset Management. Data as at 30.06.2018.
Fifthly, it pays to think a bit differently by taking a contrarian stance or buying out-of-favour assets. Ugly can be beautiful. Before QE, investors would have done well by investing in the previous year’s best performing sectors. After QE, the strategy that worked best was to buy the 'losers’, assets that are out of favour but still have value.
The sixth lesson is that the yield curve matters. As an investor, the most important decision you’re going to make is duration, or whether to raise or lower your portfolio's sensitivity to changes in interest rates. Before the crisis, curve positioning and duration decisions went pretty much hand in hand. Back then, investors had two basic curve strategy options, depending on how they saw central bank policy unfolding.
If they expected rate cuts, they’d use bull steepeners, under which shorter dated bonds are expected to outperform long-dated ones. Or, if investors envisaged rate rises, they’d set up bear flattener trades, which are designed to benefit from a sell-off in shorter-maturity debt. But since the crisis, other types of yield curve strategies are just as common as a result of central bank bond buying.
Then there’s the matter of changes in the relationship between different fixed income assets. There have been several instances in which assets that usually move in lockstep with one another failed to do so for long periods, and vice versa. In other words, bond investors cannot rely on historic market correlations.
Before the crisis, investors could rest assured that they would achieve a decent amount of diversification by combining safe government bonds and credit in their portfolios. And that the correlation of returns between the two was relatively stable. But after the crisis, this correlation has fluctuated. This is a new risk and it’s not going to go away.
And finally, zombies can be opportunities. Once upon a time, companies that struggled to pay the interest on their debt would fail. But with low interest rates and investors willing to refinance these companies, there has been a fairly gradual increase of the number of such zombie firms globally. Before the crisis, credit managers would do their credit work and make their selections only from among companies that could actually pay their interest costs. But after QE, that probably was not the right answer. You had to pick some of the zombies to outperform.
By the same token, investors need to be aware that as central banks remove liquidity from the system, as they try to reverse QE, credit markets are likely to be most vulnerable. That’s where the rubber hits the road.
Ultimately, investors need to bear in mind that the fixed income markets’ transformation since the financial crisis is here to stay.
We need to face reality and think that maybe the lessons we’ve learned over the last 10 years will also apply over the next 10.
related articles
Demystifying absolute return fixed income
Patricia Schuetz
January 2018
Important legal information
This marketing document is issued by Pictet Asset Management. It is neither directed to, nor intended for distribution or use by any person or entity who is a citizen or resident of, or domiciled or located in, any locality, state, country or jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. Only the latest version of the fund’s prospectus, the KIID (Key Investor Information Document), regulations, annual and semi-annual reports may be relied upon as the basis for investment decisions. These documents are available on assetmanagement.pictet.
This document is used for informational purposes only and does not constitute, on Pictet Asset Management part, an offer to buy or sell solicitation or investment advice. It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date. The effective evolution of the economic variables and values of the financial markets could be significantly different from the indications communicated in this document.
Information, opinions and estimates contained in this document reflect a judgment at the original date of publication and are subject to change without notice. Pictet Asset Management has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and this document is not to be relied upon in substitution for the exercise of independent judgment. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Before making any investment decision, investors are recommended to ascertain if this investment is suitable for them in light of their financial knowledge and experience, investment goals and financial situation, or to obtain specific advice from an industry professional.
The value and income of any of the securities or financial instruments mentioned in this document may fall as well as rise and, as a consequence, investors may receive back less than originally invested. Risk factors are listed in the fund’s prospectus and are not intended to be reproduced in full in this document.
Past performance is not a guarantee or a reliable indicator of future performance. Performance data does not include the commissions and fees charged at the time of subscribing for or redeeming shares. This marketing material is not intended to be a substitute for the fund’s full documentation or for any information which investors should obtain from their financial intermediaries acting in relation to their investment in the fund or funds mentioned in this document.
EU countries: the relevant entity is Pictet Asset Management (Europe) S.A., 15, avenue J. F. Kennedy, L-1855 Luxembourg
Switzerland: the relevant entity is Pictet Asset Management SA , 60 Route des Acacias – 1211 Geneva 73
Hong Kong: this material has not been reviewed by the Securities and Futures Commission or any other regulatory authority. The issuer of this material is Pictet Asset Management (Hong Kong) Limited.
Singapore: this material is issued by Pictet Asset Management (Singapore) Pte Ltd. This material is intended only for institutional and accredited investors and it has not been reviewed by the Monetary Authority of Singapore.
For Australian investors, Pictet Asset Management Limited (ARBN 121 228 957) is exempt from the requirement to hold an Australian financial services license, under the Corporations Act 2001.
For US investors, Shares sold in the United States or to US Persons will only be sold in private placements to accredited investors pursuant to exemptions from SEC registration under the Section 4(2) and Regulation D private placement exemptions under the 1933 Act and qualified clients as defined under the 1940 Act. The Shares of the Pictet funds have not been registered under the 1933 Act and may not, except in transactions which do not violate United States securities laws, be directly or indirectly offered or sold in the United States or to any US Person. The Management Fund Companies of the Pictet Group will not be registered under the 1940 Act.
For US investors, Shares sold in the United States or to US Persons will only be sold in private placements to accredited investors pursuant to exemptions from SEC registration under the Section 4(2) and Regulation D private placement exemptions under the 1933 Act and qualified clients as defined under the 1940 Act. The Shares of the Pictet funds have not been registered under the 1933 Act and may not, except in transactions which do not violate United States securities laws, be directly or indirectly offered or sold in the United States or to any US Person. The Management Fund Companies of the Pictet Group will not be registered under the 1940 Act.
Pictet Asset Management Inc. (Pictet AM Inc) is responsible for effecting solicitation in North America to promote the portfolio management services of Pictet Asset Management Limited (Pictet AM Ltd) and Pictet Asset Management SA (Pictet AM SA).
In Canada Pictet AM Inc. is registered as Portfolio Manager authorised to conduct marketing activities on behalf of Pictet AM Ltd and Pictet AM SA. In the USA, Pictet AM Inc. is registered as an SEC Investment Adviser and its activities are conducted in full compliance with the SEC rules applicable to the marketing of affiliate entities as prescribed in the Adviser Act of 1940 ref. 17CFR275.206(4)-3.