Putting bonds to work in private portfolios

In an environment of low growth and low inflation, and an age of political populism, will extremely low interest rates continue to be the norm? And with investors seeking opportunities in riskier parts of the market, what does that mean for fixed income, and its role in client portfolios? These were among the questions debated in January at a roundtable hosted by PWM in Frankfurt.

In 2019, central banks cut interest rates earlier than in previous cycles, hoping to shield the economy from the impact of trade wars and a global slowdown, observed Markus Müller, global head of the chief investment office at Deutsche Bank Wealth Management. But while quantitative easing drives the market, monetary policy cannot fix structural economic problems. 

“Central banks just bought time for policymakers to change their economic policy and adopt a more modern and innovative approach, which they didn’t do in past years. This means that the macro-economic structural problems have not been fixed. There is no real reason to think this world will change.” 

Moreover, long-term secular trends, including globalisation, albeit on a different path, technological advances, and an ageing population, with people consuming less and saving more, will exert downward pressure on inflation.

The bond market outlook heavily depends on rising prices, but panellists clashed on whether inflation will ever raise its ugly head. “Inflation is hibernating, it is not dead and is going to come back,” predicted Bernd Meyer, chief strategist, head multi-asset, Berenberg Wealth and Asset Management. 

The disinflationary force of globalisation is declining as differences in labour costs are shrinking. Also, an ageing population can mean higher consumption, a smaller workforce and more need for labour-intensive care for the elderly, which may help bring inflation back over the next decade. 

“I think the bond bull market may not be over yet, but is likely to run out of steam in the not too distant future,” said Mr Meyer, questioning whether the consensus that bond yields are not going to rise may be the signal they have hit the bottom. 

In an age of political populism, challenges to central banks’ independence were a key point of discussion. While Donald Trump pushes the Fed to cut rates to boost the US economy, with an eye on this year’s presidential election, the key challenge for the ECB is that European countries have very different levels of economic strength. ECB president Christine Lagarde, who called on European governments to co-operate more closely over fiscal policy to boost the faltering eurozone economy, needs to guarantee lower rates to drive fiscal stimulus and make much-needed structural reforms. 

But while central bank independence is a very important, it needs to be earned, stated Philip Gisdakis, CIO, Private Banking & Wealth Management at Hypovereinsbank, wholly owned by UniCredit. This explains the Fed’s recent initiatives to better explain its monetary policy to the public and the same strategy must be adopted in Europe. 

Also, political populism is leading to opposing demands. In the US, there is pressure to lower rates, while in Germany the focus is on increasing them, on the basis that the ultra-low yield environment is hurting savers. But it is important to educate people that low yields are supportive of certain areas of the economy, notably the manufacturing sector. 

These conflicting pressures also stem from the different investment culture of the two countries, with US investors more focused on investing in equities, while Germans tend to buy bonds, life insurance and other bond-related solutions. 

Expansionary monetary policy has prompted more than a decade of economic expansion, and while it may have driven rising inequality, participants also stressed the role of structural issues as a driver, as well as the importance of using an updated basket of goods to measure inflation, including asset prices, such as equities and real estate. 

Investment opportunities

With central banks supporting buying bonds and lowering interest rates, and with inflation not expected to be an issue for the next 12 months, the prospects for fixed income look positive, believes Marc Tetzlaff, head of product solutions Germany, at HSBC Private Bank. 

Political risks are the biggest threats this year, including the US presidential election and the Brexit negotiations between the UK and EU. In a risk-off scenario, liquidity is of particular concern for certain lower quality fixed income segments, such as emerging market debt and high yield, which are proving very popular. 

Emerging market debt is still heavily dependent on the Fed’s monetary policy. When it increases rates, making US bonds more attractive, EM investors leave these markets, which are perceived to have higher political risk, and invest in the US. But the stabilisation of the economy, with the signing of the “phase one” trade deal between the US and China, and continued quantitative easing, offer good prospects for this asset class, according to Mr Tezlaff. 

The overall environment is both positive for emerging market debt and currencies, noted Antoine Lesné, head of SPDR ETF Research & Strategy EMEA. Speakers agreed that local currency EM debt brings more volatility to the portfolio, but may offer good returns, being supported by the Fed’s dovish monetary policy and the current environment of stable growth. 

Moreover, central banks in emerging markets have learned from the past and their strength should not be underestimated, as indicated by the speedy response of the Indonesian central bank which in 2018 unleashed several rake hikes to protect its local currency against a strengthening dollar. 

Deutsche Bank prefers hard currency EM corporate bonds, particularly those generating revenue streams in US dollars, which make them more independent from any local currency and political issues. While from a pure yield level perspective hard currency EM debt does not look particularly attractive, it offers yield pick-up and price potential supported by favourable fundamentals. Emerging markets are heavily investable through passive products, which contributes to make them a volatile asset class, but EM bonds, notably Chinese ones, are supported by rising weightings in major fixed income indices. 

“Even if investors’ flows towards EMs dries up, some emerging markets will continue to be supported by this continued inclusion story,” said Berenberg’s Mr Meyer. “Frontier markets, which are less prone to swings in global investor risk appetite, may benefit from a convergence towards an emerging markets status.”

China is a very long-term story, with Chinese RMB-denominated government and policy bank securities added to the Bloomberg Barclays Global Aggregate Index from April 2019, with other indices expected to follow. 

“The inclusion of China is improving the quality of the emerging market index overall, it is lowering the yield but it is still higher than US Treasuries and bonds,” explained SPDR’s Mr Lesné. Chinese bonds represent 5 per cent of assets in SPDR’s EM debt ETFs. Demand for EM Treasury bonds is supported by the growing number of domestic pension funds, banks and insurance companies. Moreover, institutional investors are still strongly underweight emerging markets, and there is room for this asset class to grow in private portfolios. 

However, a scenario different from stable growth could be risky for emerging markets. “Low and stable growth is Goldilocks for emerging markets, at least for hard currency instruments, but left and right of that scenario there is risk,” said Hypovereinsbank’s Mr Gisdakis. A higher than anticipated growth rate in the US will trigger higher interest rates, which could be detrimental. In the case of lower growth in the US, or a recession, the market would collapse. 

High yield also emerged as an area of interest, with remarkable differences across regions. In the US, levels of debt, increasingly used to finance share buy-backs and boost equity valuations, have increased massively, deteriorating credit profiles. This has occurred mainly in the triple B space. While in Europe, corporate credit profiles are sound, in the US there is a high risk of fallen angels, warned Mr Gisdakis. 

“If there was a contraction in the US, not a base case for us in 2020, but it could increase in 2021 or 2022, there could be the risk of corporate balance sheet crisis.” It is very difficult for the high yield market to absorb fallen angels, and this could create a wave of risk and spread through markets. 

Bethmann Bank favours EM high yield corporates relative to US high yield corporates which have 20 per cent lower leverage, reported Fidel Kasikci, senior portfolio manager at the bank. 

Shock absorber

As the ultra-low yield environment forces investors to move up the risk curve, clients who no longer hold this asset class to protect their portfolios may face serious risks if stockmarkets slump.

Educating investors about the different roles bonds play and how to manage the different segments in an active way is paramount. 

“Whilst we hardly find opportunities to preserve the real value of portfolios, we need to be ready to buy high quality government bonds, even with negative or very low yields or yields that are below inflation targets, to have the component of fixed income as a portfolio diversifier,” said Hypovereinsbank’s Mr Gisdakis.

Yet, while long duration sovereign bonds are negatively correlated to stockmarkets and will provide diversification in an economic downturn, in a liquidity-off scenario, such as in the case of a ‘taper tantrum’, both fixed income and equities will fall, warned Berenberg’s Mr Meyer. In this case, investors can get a better insurance premium through currency pairs, gold or derivative instruments. 

Other panellists pointed out that central banks are more aware of the risk of committing policy mistakes and of hiking interest rates prematurely. 

With all the negative yielding debt in the world, private clients have moved out of government bonds, covered bonds and even out of corporate bonds, to some extent, and have gone into emerging markets debt and high yield, because these are the two big asset classes that offer an attractive yield, explained HSBC’s Mr Tetzlaff. “This could be a problem in a market downturn, from a portfolio perspective, as the segment of fixed income which acts as shock absorber, such as sovereign bonds and treasuries, are missing.” 

But investors are just not willing to invest in negative yielding 10-year German government bonds when they could invest in a high yield bonds, yielding three to six per cent, depending on the currency.  

However, yield is just a part of the story and carry played an important role in 2019. Deutsche Bank started offering strategic asset allocation (SAA) portfolios based on a 10-year capital market assumptions, where triple and double A government bonds are also part of the SAA. Incorporating these bonds can provide some cushion in a diversified portfolio in case of market downswings, as witnessed during the recent outbreak of the coronavirus in China. 

If interest rates are not expected to fall further in the longer term, but instead slightly increase, short dated government bonds, cash plus, or gold would also work, pointed out HQ Trust’s Mr Neukirch. “Clients do not want to hold government bonds or low yielding bonds anymore. If they go opportunistically into high yield or emerging market debt, they will have to accept higher risk,” adding that less liquid assets such as hedge funds have replaced some of the bond allocation. 

Fixed income ETFs

While the bulk of exchange traded funds are in the equity space, bonds are rapidly catching up, having passed the $1tn mark in 2019 for the first time, out of the $6tn in total assets held in these vehicles. 

One of the reasons they still lag their equity counterparts is that bond ETFs were only introduced in the early 2000s, while the first equity S&P 500 ETF was launched in 1993. On the eve of the financial crisis in 2008, fixed income ETFs totalled just $50bn. 

But unlike in the past, when benchmarks were narrowly defined, today investors buy a fixed income ETF the way they would an index or active fund, as long-term holdings, explains SPDR’s Mr Lesné. Last year was very positive for fixed income ETFs, with a ratio of 2.2 versus equities, for funds sold on the open market. 

Increasing client demand for low-fee investment solutions is a key growth driver of ETF growth, and these instruments are easily tradeable and offer daily transparency on underlying holdings. 

Bond ETFs have also benefited from investor disappointment in active fixed income managers. But unlike equity ETFs, which have grown at the expense of actively managed equity funds, the rise of fixed income ETFs is part of the overall fixed income growth story, said Mr Lesné.

Deutsche Bank uses fixed income ETFs in client portfolios “to replicate its strategic asset allocation and make it very competitive and accessible for clients,” reported Mr Müller. 

ETFs also represent a good way to diversify instruments in client portfolios. For example, in December 2018, direct investments in US high yield suffered big outflows, whereas the same segment replicated by ETFs experienced high inflows. 

Moreover, bond ETFs enable wealthy investors to diversify portfolios, given that over the past couple of years corporate bonds have tended to go back to the €100,000 denomination, making it difficult to achieve diversification. 

However, both in equity and fixed income, a more active approach is beneficial in specific market phases. “In an environment where liquidity dries up and there is anxiety about credit profiles of individual companies, being in an ETF that simply buys the whole market can be problematic,” warned Hypovereinsbank’s Mr Gisdakis.

The practice of excluding less liquid bonds from ETFs may make sense, but also explains why some ETFs may generate a worse performance than active managers or passive funds, ventured HQ Trust’s Mr Neukirch. 

When building an ETF, it is important to understand the underlying liquidity, but managing those individual credits is not a job for the index or index manager, explained SPDR’s Mr Lesné. “When we create ETFs, we make sure we include minimum ratings, and indices tend to have a monthly rebalancing which is followed by the portfolio. It sometimes makes it easier for us to do it than for an active manager to go in and redeem.” 

However, introducing rating thresholds is part of the problem, warned panellists, because these convert ETF providers into forced sellers as soon as things deteriorate, which is the worst point in time. Passive and active management are not exclusionary, it was agreed, and passives should be used actively to cater to client needs. 

While ETFs are also useful for tactical calls, the biggest risk of fixed income ETFs is that they provide a false perception of liquidity, attracting investors that may have not invested in the asset class had they understood underlying fundamentals and liquidity of the market, said Berenberg’s Mr Meyer. In a distressed environment, if all investors want to get out at some point, the door is going to be very narrow. “I fear in such an environment, passive ETFs will have problems, particularly illiquid segments like high yield.” 

To face redemptions, ETF issuers will have no other choice but to sell, while active managers can, to some extent, meet investors’ demand through the cash quota they hold in the fund.  

 “When those times of stress happen, the cost of getting out may be higher, as there is going to be a price for liquidity – but you will get a price,” insisted Mr Lesné. But during tail risk events, like the Lehman Brothers’ collapse, when credit market freezes and market liquidity evaporates, all types of investment vehicle will be hit. 

Sustainability 

Sustainable ETFs represent a significant growth area, with sustainability a form of factor investing, believes Mr Lesné. “The rules-based approach is increasing as a proportion of the fixed income world. ESG is a factor that is probably going to do very well in 2020 and beyond, from an investors’ interest standpoint, accelerating the trend that started in 2019.”

But some panellists were sceptical about how to implement ESG in the fixed income space. Whilst ESG standards are welcome, they are generally more complicated to implement in fixed income than equities because bonds can end up in an ESG product for different reasons, be it the profile of the issuer or because proceeds are used for, say, building windmills. “The difference between traditional and sustainable bonds is only in the use of proceeds,” pointed out Bethmann Bank’s Mr Kasikci. “Investors will still have credit and duration risk.”

How to implement the sustainability strategy was a hotly debated topic, whether by excluding bad offenders or by supporting bad firms to improve their sustainability profile. The importance of the EU taxonomy regulation was also highlighted.