The fixed-income future
Nick Gartside, international chief investment officer for global fixed income, JP Morgan Asset Management.
Increasingly, it looks like developed Western nations are following the path set by Japan – overburdened by debt, growth remains low, deflation rather than inflation becomes the major preoccupation for central bankers and interest rates remain low.
What’s the message for fixed income?
Short Japanese government bonds remains the graveyard of global bond managers over the last decade and the message is that fixed income performs well in this environment. The precise question is – what sort of fixed income?
Government bonds should perform well. The major competitor to governments are cash rates – going nowhere any time soon – and inflation – where the risks are tilted towards the downside as commodity prices fall. 2008 could be a good guide here. Oil peaked in July 2008 at $160 per barrel, falling to $60 per barrel by year-end with dramatic consequences for inflation. Likewise, any bond that has a significant element of interest rate risk – investment-grade credit, covered bonds, etc – should participate in this rally. Conversely, inflation-linked bonds, with break-even inflation rates at elevated levels, look vulnerable.
More debatable are those areas of the bond market that rely on growth – high yield and emerging market debt. Here, there remains a tension between the growth outlook and valuation.
By committing to keep rates low for a few years (albeit conditionally), the Fed’s view on economic growth is pretty clear and generally this is an environment where corporate profitability could come under pressure. Against this, valuations for both high yield and emerging market debt are now looking pretty attractive.
Two issues need to be highlighted:
1. A low-growth environment is one where differentiation between issuers will increase and security selection becomes paramount. The gap is likely to be large between the best and worstperforming bonds in high yield and emerging market debt.
2. Systemic risk – with central banks starting to respond to the lower-growth environment and with other tools at their disposal – the Fed, for example, could cut interest rates paid on negative reserves, extend the duration of holdings on its balance sheet as well as launching QE3, does offer some reassurance to investors.
Offsetting this, events in Europe are by no means solved. The European financial stability facility proposals remain unratified, the ECB is reluctantly buying Italian and Spanish bonds and political tensions are increasing. Any spillover that causes a double dip and genuine growth scare would be detrimental for high yield and emerging market debt prices.
Bond investors have two enemies – high interest rates and higher inflation – but both are unlikely to present much of a challenge for a while.
This is an environment where fixed-income returns are likely to continue to (positively) surprise investors. Portfolios remain well positioned with a modest long duration bias and low risk levels. As we get greater clarity on the evolution of the eurozone response, we will also look to tentatively deploy our cash pile into riskier assets – investment-grade corporate bonds, high yield and emerging market debt.
Nick Gartside, international chief investment officer for global fixed income, JP Morgan Asset Management
Emerging markets come of age
Emerging market bond markets have finally come of age. Emerging market economies have proved not only able to withstand the worst financial crisis since the Great Depression but have emerged as the main drivers of global growth.
Local currency bonds now dominate emerging market financing and are the focus of our strategy. Like any good student, emerging market countries have learned from previous mistakes and used earlier crises as an opportunity to implement radical policy changes from which they are now benefiting.
One of the most important of these is the switch from issuing bonds in foreign currency to issuing in local currency. This shift has greatly reduced vulnerability to capital flight resulting in significant rating upgrades – the average country in our universe is now investment-grade. Yet yields are still well above those of the major developed markets despite the increased risks associated with developed economies.
Emerging bond markets differ from developed markets in one key respect – they still suffer from a lack of research which means there is more scope for active management to make a difference. That is why we target a higher level of outperformance than in our developed market bond strategies.
Our strategy is run against a benchmark which is well diversified geographically and encompasses Asia, Eastern Europe, Latin America and Africa. Individual country weights are capped at 10 per cent so that no one country dominates. This selection of countries has performed well over the last three years and stands out from other asset classes in terms of delivered return for the level of volatility. The asset class offers very good return potential with an attractive yield and the prospect of currency appreciation over time.
Sally Greig, co-manager, Baillie Gifford emerging markets bond fund
Allocation, allocation, allocation
Asset allocation is an increasingly important part of fixed-income investing in a two-speed global economy.
The diversity gained by having the access and liquidity afforded by the US treasury market, despite a recent downgrade by Standard & Poor’s, is tremendous. The US is still the biggest and most liquid bond market in the world.
Asian bond markets offer fantastic opportunities – GDP growth in Asia is far higher than the US or Europe. Asian credit and sovereign bond fundamentals look good right now, so it makes sense for investors to diversify into this region. Although slowing growth, sovereign risks and currency imbalances might concern investors, they can still benefit from remaining diversified and making careful credit selection decisions.
Investors should look carefully at the benchmarks that their managers use as the starting point of their investment process. The idea of a “risk-free asset” has been dethroned. Investors should be particularly wary of excessive exposure to governments and financial companies with poor or deteriorating finances.
Current global benchmark construction means the increased funding needs of these institutions could dominate portfolio risk.
The old adage seems to stand up well today: “Only lend money to those that don’t need to borrow.” Investors should look for bond managers who use thorough fundamental research to generate diversified sources of investment return. A multi-strategy approach like this means that no single position is allowed to dominate overall risk.
Andrew Wells, global chief investment officer for fixed income, Fidelity International