Low yields for bonds held over longer periods are causing problems for investors just as returns become less predictable.
Asset managers love a good ocean metaphor. We have been known to crow that “a rising tide lifts all boats” and equally vociferously, “it is only when the tide recedes that we will be able to tell who has been swimming naked”.
These maxims have been used so frequently that they have begun to lose their meaning. But, just because they are hackneyed doesn’t make them any less true.
In the case of the bond market, we believe they bear some significant weight. Given the ways the world has changed in the past decade and the expectation that low yields to which we have become accustomed are likely to remain in place for some time yet, the need for an active approach is needed now more than ever.
It is perhaps no surprise that we, at AXA Investment managers, would advocate for an active approach. But right now, we believe that a number of traditional valuation metrics and fixed income indices are looking rather risky.
Duration is rising
As interest rates have declined over the past decade, companies and governments have been able to borrow money at a lower cost. The reduced coupon level on bonds has been associated with a higher level of duration. This is because when the overall level of yield is lower, bond prices are more sensitive to changes in yields as a small move has a large impact.
At the same time, in an effort to ‘lock in’ low interest rates, companies and governments have increased the length of their borrowing. The result of this is that the effective duration of bond indices has increased along with a decline in yield, indicating that investors in the broad index are taking on more duration risk and for that burden, receiving a lower yield.
Credit quality across corporate and broad bond market indices has also declined over the past 10 years. The share of BBB bonds (i.e. only just investment grade) in global government and credit indices has also increased. Simultaneously, the extra compensation for investing in credit has dropped as risk spreads have declined. So again, at an index level, investors receive less additional return for taking on more credit risk.
Less predictable returns
With both the level of yield and the level of credit spreads still close to all time low levels, there is a significant risk of capital loss should these move higher. A mere 1% move in yield today has a much bigger impact than was the case 10 or even five years ago.
Additionally, market uncertainties, driven by divergent monetary policy cycles, trade policy tensions, technological change and what that means for production, distribution and inflation, and geopolitical worries all mean that bond market returns are becoming less predictable. As a result, after years of quantitative easing, the bond universe is now offering lower yields but with some meaningful risks.
That is not to say that there is no investment opportunity, but rather that the tide that has lifted all parts of the market for so long is beginning to recede as central banks slowly reduce their influence on bond markets. And, as this influence unwinds, as asset purchases and balance sheets shrink, yields are likely to rise, creating conditions for potential capital losses in some sectors.
To use the ocean metaphor, we are firmly of the view that the fixed income water is likely to get a choppier from here and, in such seas, active management of interest rate and credit risk is more important than ever. At some point, these adjustments to a new normal will offer opportunities for investors to generate positive returns again but, for now, a flexible approach is required.
This article was first published in Financial News