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Investing in a rapidly-changing bond market

Investing in a rapidly-changing bond market

July 2017

Patricia Schuetz, Senior Client Portfolio Manager

Pictet's Absolute Return Fixed Income strategy offers a flexible, risk-controlled approach to bond investing.

01

Overview

The only way is up. Or so it seems for global bond yields. A three-decade long bull market is coming to an end, and an era of significantly weaker returns could be upon us. Indeed, wherever fixed income investors look, they're confronted with profound change. Disinflation has given way to rising prices in some places, once-ample monetary stimulus is being steadily withdrawn, globalisation is in retreat due to moves to cap trade and migration, while mainstream politics is threatened by disruptive, populist parties.

This present investors with a dilemma. While their search for yield remains undiminished, their reliance on the strategies that have delivered success in the past now threatens to introduce unintended risks into their portfolios. Traditional fixed income funds - which are tied to a reference benchmark - are no longer a viable option. 

Because most bond indices are capitalisation- or, perhaps more accurately, liability-weighted, they skew investments towards governments and corporations that issue the most debt. This leaves investors exposed to potentially unfavourable shifts in borrower creditworthiness, and often shuts them out from more attractive fixed income investment opportunities.

global bond duration has risen sharply

Duration of Barclays Global Aggregate Index

Duration risk
Source: Barclays, June 2017

Making matters worse, investors’ vulnerability to increases in interest rates (as measured by the duration of their portfolios) has never been greater. For example, companies are taking advantage of low interest rates, in anticipation that they’ll rise in the future, by issuing new bonds with ever longer maturities. So the duration of the Barclays Global Aggregate Index – one of the most widely used bond indices – has crept up to 7.0 years, from 5.4 years a decade ago.

This is particularly worrying at a time when interest rates across much of the world have stopped falling and, in some cases, are staring to rise. Currency and credit exposure are thus set to become more important sources of return.

The solution to this conundrum is greater flexibility. Investors might be better equipped to tackle the difficulties that lie ahead by pursuing a strategy that ignores the constraints of a benchmark, targets absolute rather than relative returns and focuses on mitigating the threat of capital loss at all times. The Pictet Absolute Return Fixed Income strategy adopts such an approach.

 

02

Pictet AM approach to absolute return fixed income 

In pursuing a flexible approach that targets absolute returns, investors may need to abandon some conventional ideas about bond investing. At the very least, they should be prepared to:

  • search further afield: they should seek income and capital return from a broad range of fixed income asset classes, from across the globe, whose returns are not highly correlated with one another
  • look beyond the economic cycle: they should focus on identifying and harnessing structural trends that will drive investment returns over the long run
  • diversify risk at every opportunity and methodically seek to maximise risk-adjusted return.

1. Look further afield

Bond investors have traditionally fallen into two camps: those that adopt a passive strategy because they believe markets are efficient, and those who believe that inefficiencies do exist and can be exploited to maximise returns.

Yet these approaches are not the polar opposites they appear to be. Both expose investors to the shortcomings of capitalisation-weighted benchmarks – the first group by tracking the indices and the second by seeking to outperform them.

As a result, there is often surprisingly little to distinguish between long-only, actively managed portfolios from their passive counterparts. Both are susceptible to the shifts in the broader market environment and changes in their benchmarks.

To give an oft-cited example, Greece stung benchmark-tied investors in two ways. First investors were exposed to losses until Greek bonds eventually dropped out of the main euro zone indices. They then suffered again by missing out on those assets' subsequent rally. We can also point to the continued inclusion of Venezuela in many benchmarks, despite that country’s rapid economic deterioration.

This highlights why it’s important to break free of the benchmark straitjacket. By doing so investors can also more effectively target specific sources of risk and return – interest rate, currency and credit premia. A portfolio which is well diversified across all three has the potential to gain in value across the various phases of an economic and financial cycle.

2. Look beyond the economic cycle 

Many bond investors spend a lot of time and effort attempting to forecast future economic conditions. Yet, economic forecasts can be inaccurate. (Famously, in 2008, economists did not forecast any recessions in 2009; a year later 49 of the 77 countries studied were in recession.1)

What’s more, official data often send conflicting messages, leading to disagreement between experts as to the true state of the economy. Finally, each business cycle is invariably different from the one before.  Radical shifts in the political landscape – such as Brexit or Donald Trump’s US Presidency – can up-end economic models. And then there’s the knotty problem of distinguishing cause from effect in any statistical analysis.

An alternative strategy is to look beyond the business cycle and instead try to identify the long-term structural changes occurring within the economic and financial systems.

A number of these secular investment themes underpin the positioning of the Pictet Absolute Return Fixed Income strategy. By selecting investments that harness these trends, investors can more effectively diversify the sources of risk and return in their portfolios.

a. Lower rates for longer. While interest rates are starting to rise from historic lows in some major markets, we believe it will be a slow process. Real economic growth remains subdued, and developed world governments face an uphill struggle to reduce public debt to levels that can support more fiscal spending. This should continue to put downward pressure on real interest rates.

b. Stuttering, protracted reform of the euro zone. The financial crisis has highlighted the need for far-reaching yet complicated reform of the euro zone, not least to establish a common banking union and create a fiscal transfer mechanism under which the public debts of euro zone members are pooled and supported. Yet given the politically-charged environment in which decisions are taken, it will take time for the region to overhaul its economic and fiscal structure. Europe’s increasingly vocal populist movements are likely to further delay progress, as could the fallout from the UK's decision to leave the European Union. We believe this presents as many opportunities for investors as it does risks.

c. A newly-assertive Japan. Thanks to the radical policies of Prime Minister Shinzo Abe and Bank of Japan governor Haruhiko Kuroda, Japan appears to be slowly moving away from the problems that have plagued it for the past two decades – recession, deflation, debt and ineffective government.

d. An economic transformation in China. China’s sweeping economic reforms are yielding early dividends, as its economic focus switches from exports to domestic consumption. Capital market liberalisation, the expansion of the local bond markets and a potentially more mature, slower-growing economy will have big implications for investment returns in China, as well as far beyond its borders.

3. Diversify risk at every opportunity

The radical shifts in the global investment backdrop in general, and in the bond market in particular, make the mitigation of risk even more important than usual. In our view, an effective way to dampen the volatility of returns and keep risks to a minimum is to embrace diversification at every stage of the portfolio investment process.

On one level, this involves taking great care to avoid over-exposing a portfolio to any one investment theme, idea or source of return. On another, it means ensuring investment strategies are expressed in a way that offers the most efficient trade-off between risk and return. Scenario-based portfolio construction is critical to meeting these goals.

a. Diversification by investment theme and risk scenario. If one investment theme does not play out as anticipated, it is important that the portfolio is sufficiently diversified to be able to deliver on its investment objectives. With this in mind, we make sure that all our themes and risk scenarios are evenly represented in the portfolio. This distinguishes us from typical strategic bond funds or active benchmark-oriented portfolios. The former tend to concentrate investments in high-conviction ideas, while the latter do not usually venture far beyond the boundaries of their reference index.

b. Diversification by source of return. Investing across a broad range of developed and emerging fixed income asset classes gives investors access to a number of potential sources of return. The Pictet Absolute Return Fixed Income strategy aims to secure returns from three main sources: interest rates (reflecting the yield curve and duration positioning in the major government bond markets); credit spread or premium (such as corporate debt and peripheral government bonds); and currencies. We also recognise that each of these is also a potential source of risk, and ensure the portfolio’s risk budget is equally distributed across all three sources.

diversified volatility profile reduces portfolio risk
Breakdown of Pictet's Absolute Return Fixed Income strategy volatility by currency, credit and interest rate
Diversified volatility profile reduces portfolio risk
Source: Pictet Asset Management, June 2017

c. Efficient implementation of investment themes. By embracing a broad investment universe, our investment managers are able to implement their ideas in the most efficient way.  We screen securities based on their valuations, and use only those offering the most attractive long-term value to implement our investment ideas.

For instance, we have a number of ways to express our conviction that interest rates will remain low for a protracted period. These range from long positions in corporate bonds which are likely to benefit from low interest rates, like high yield issuers, to offsetting hedges in US Treasuries.

A distinctive aspect of our investment approach is that we seek to identify a security, or combination of securities, to both capitalise on the investment idea and, at the same time, to protect the portfolio should the strategy not play out as anticipated. For example, our constructive medium-term view on China is reflected in an allocation to hard currency emerging market debt. However, our scenario analysis shows that this could be a volatile investment, and we have therefore combined it with short positions in emerging market (EM) currencies. Thanks to this risk-focused approach, we are prepared for any falls in EM hard currency debt, such as the one seen following Trump’s victory in US presidential elections in late 2016, and are able to continue to generate good returns from the combined position.

03

The role of Absolute Return Fixed Income in a diversified portfolio

Pictet's Absolute Return Fixed Income strategy offers investors the potential to secure attractive-risk adjusted returns over the course of the market cycle. Because our investment managers seek to capitalise on long-term trends, and because they also have the freedom to invest in a broad range of fixed income securities, they have greater scope to mitigate volatility and identify opportunities that offer value than strategies tethered to capitalisation-weighted indices.
diversification benefits

Correlation of returns: Pictet Absolute Return Fixed Income (ARFI) strategy vs major asset classes

ARFI returns vs other strategie
Source: Pictet Asset Management, Barclays. Returns for Pictet Absolute Return Fixed Income representative portfolio; bond market returns taken from Barclays Capital fixed income indices; equity returns taken from MSCI World Index and S and P 500 Index; commodities returns taken from SP GSCI Index; data covers period 04.09.2012-31.05.2017.

The strategy’s emphasis on risk management and diversification should not be underestimated. It is instrumental in ensuring the portfolio delivers an efficient trade-off between risk and return.

Thanks to its distinct characteristics, the returns generated by the Pictet Absolute Return Fixed Income strategy also exhibit a low correlation with those of most equity and fixed income classes. This means an allocation to the strategy could improve the risk-return profile of a balanced portfolio.

04

Concluding remarks

 

Bonds have historically provided investors with steady capital returns, particularly following the financial crisis. Yet the profound changes under way in the fixed income market indicate bond returns will be more volatile than they have been over the recent past. Investors looking for bonds to provide an anchor for their diversified portfolios should consequently modify their approach. We believe that flexible bond strategies such as the Pictet Absolute Return Fixed Income strategy that ignore the constraints of a benchmark, target absolute rather than relative returns and make risk mitigation an explicit part of their investment process  are more likely to prosper than traditional benchmarked strategies in this changing investment environment.