Fixed income investing in a low yield environment
The global financial crisis and its aftermath are changing the bond market. These involve risks as well as opportunities, and we believe fixed income investment strategies must adapt. Traditionally, investors have allocated a portion of their portfolio to fixed income to manage their portfolio’s overall risk and to generate income. However, we believe traditional fixed income strategies may be less able to provide these benefits in the future and that more flexible investment strategies may be called for.
Traditional fixed income allocations tend to be benchmarked to indexes dominated by government-sector debt, which currently provides very low yields. For example, the Barclays Global Aggregate Index currently has approximately 75 per cent of its constituents yielding 2 per cent or less.
While the yield on government-related securities is historically low, we believe the risks have increased. Many developed governments are already running severe budget deficits and still face the difficult choice of increasing fiscal stimulus or risking slow growth, either of which could raise investor concerns about debt sustainability. Thus, even if central banks keep policy rates near zero, credit concerns could still lead to higher interest rates, and declining prices, on government-related bonds.
The total return on a bond portfolio has two components: income and capital gains. At higher yield levels, income can provide a significant cushion against the risk of falling bond prices. Today, that income cushion is much smaller, approximately half of what it used to be five years ago, with bond yields now only needing to rise 1/2 a percent to cancel the income advantage, as compared to closer to 1 percent a few years ago. Meanwhile, yield volatility has not changed appreciably.
We believe many sectors of the global bond market offer a more attractive balance of risk and return potential. Emerging market sovereign bonds denominated in the local currency offer substantially higher yields compared to their developed-government counterparts. At the same time, many emerging countries offer stronger growth to support their debt and budget situations.
Corporate credit is another example. Investment-grade and high-yield corporate bonds offer yields in the area of 3.5 per cent and 8 per cent respectively. In our view, these yields more than compensate for likely default risk, and corporate balance sheet fundamentals are steadily improving. In some cases, securities are trading at significantly discounted prices, resulting in yet higher yield potential. For example, US non-agency mortgage securities have yields in the area of 10 per cent.
We believe all of these sectors can potentially offer higher incomes to cushion against the risk of rising bond yields and yet supported by more robust credit and economic fundamentals than those of government bonds today.
The high level of uncertainty surrounding the outlook for growth, monetary policy and fiscal policy, seems likely to continue for the foreseeable future. As a result, we think that fixed income market are susceptible to abrupt changes in yields and periods of elevated volatility. We believe the less certain macro economic outlook presents new opportunity to add value from active management of interest rate, currency, sector and security level exposures set within a total return framework.
For investors seeking the traditional benefits of a bond allocation, we think the new reality in global bond markets argues for a more flexible approach. Many of the sectors we view most favourably have little or no weighting in traditional multi-sector fixed income benchmarks. We believe investors will potentially be rewarded by exploring the credit, mortgage and emerging market debt sectors and from adopting a more total return approach.
Lloyd Reynolds, Head of Sub-advisory in Asia, for Goldman Sachs Asset Management.
