While government debt may continue to be a core holding, bond investors need to get creative in the hunt for other sources of return. Betting on a pick-up in volatility appears to be an attractive way of potentially boosting returns with limited downside risk, writes James McAlevey.
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“As long as the music is playing, you’ve got to get up and dance.” So, said the former boss of Citigroup when describing the bank’s situation as a major provider of finance for leveraged buyouts in July 2007.
Within four months of making those infamous remarks, and with the bank beginning to rack up record losses after being caught gyrating long after credit markets had started convulsing, Charles Owen "Chuck" Prince III was gone.
Fast forward nine years and it is reasonable to ask whether bond investors are in danger of falling into the same trap.
It is true that for some time there has been no shortage of commentators willing to call the end of the 40-year bull market in bonds. And it’s also undeniable that to date their predictions have proved inaccurate as central banks have steadily loosened monetary policy further than expected in an effort to turbocharge growth.
But with around $13 trillion1 of government debt worldwide now yielding less than zero, in turn suppressing prospective returns on assets across the risk spectrum, it is appropriate to wonder how much further yields can fall. Long-term investors like pension funds and insurance companies are being forced to take more and more risk to secure ever diminishing returns as they run out of investment options.
Investors in pretty much all types of asset, not least bonds, have enjoyed a golden period over the past 40 years. $100 invested in investment grade US debt in 1976 is now worth more than $2,020. That is equivalent to an annual compound return of 7.55%. Even allowing for inflation, bonds have returned 3.81% a year.
Furthermore, as chart 1 below shows, although the period in question has witnessed a number of extreme events – such as the US savings and loans crisis of the early 1990s, and the boom and bust associated with the dot.com bubble of the late 1990s, to name but two – bonds have performed remarkably steadily throughout. Perhaps most surprisingly, they even produced positive returns during the early 1980s when 30-year Treasury yields reached 15% as the Federal Reserve hiked interest rates to combat rampant inflation.
Chart 1 - Steady rise in total return from US bonds since 1976
But it’s important to recognise that this golden age is not going to be repeated. While the long-lasting rally in bond prices may continue for a little longer yet, bonds are not going to return anything like as much in the next 40 years as they have over the previous 40.
For a start yields are beginning from rock bottom. As of September 2 the yield on the Barclays Global Aggregate Index was 1.18%. That does not augur well because at any given point in time the current yield of a bond is the most important determinant of how much it will return in the future.
And secondly, as chart 2 shows, throughout the past 40 years, with the notable exception of the early 1980s, nominal interest rates have been on a steadily declining trend around the world. That has augmented investment returns by delivering capital growth. The problem is that, although the growing prevalence of negative rates might suggest otherwise, there is a limit to how low rates can go. With the unintended and undesirable consequences of negative interest rates becoming ever more apparent, we are surely approaching that limit. That restricts the potential for capital appreciation.
Chart 2 - Long-running decline in nominal interest rates
So investors, faced with the prospect of returns that are far lower than they have been accustomed to, need to start questioning whether they’re being adequately compensated for the risks they are taking. Indeed with yields now so low, there is very little buffer to protect against any of the risks associated with fixed-income investing, including the risk of default or inflation.
Take the biggest risk of all: interest-rate risk. As chart 3 shows, since 1990 yields have fallen considerably while duration has risen. This means an interest rate shock will have a much greater effect now than at that time. Back then, the Barclays Global Aggregate Bond Index – with a yield of 9.0 per cent and a duration of 4.66 – would have still returned a healthy 4.34 per cent that year even if interest rates had risen one percentage point.
That compares starkly with the situation as of the 2nd Sept 2016 when, with bonds in the index having an average duration of 6.9 years and yielding just 1.2 per cent, a one point rise in interest rates would be expected to lead to a 5.7 per cent loss.
Chart 3 - Rising duration and falling yield of Global Aggregate Bond Index
None of the other risks traditionally associated with investing in fixed income have disappeared either.
Traditionally pension funds and other institutional investors have used fixed income both to stabilise portfolio returns and at the same time to provide an income stream that matches future liabilities. Many will continue to invest heavily in bonds for the same reasons.
After all, there are good reasons for believing government debt will continue to provide one of the ultimate safe-havens in times of market stress. And even if bond yields were to rise, there would be an offsetting benefit in that the value of future liabilities would fall. Nevertheless, with most pension funds struggling to plug deficits, there is no doubt a desire to lock in some of the gains made in recent years.
While government debt may continue to be a core holding, investors need to get creative in the hunt for other sources of return.
Perhaps one of the most striking features of fixed-income markets at present is the extent to which the actions of central banks seem to have lulled investors into a false state of security that volatility will remain depressed for ever.
However, there are plenty of reasons for them to be shaken out of this view. For a start, liquidity is drying up. Take the Bank of England’s August 8 attempt to buy £1.17 billion of gilts. Pension funds refused to sell all the bonds the bank was bidding for, despite being offered prices significantly above market levels. This illustrates that with supply becoming increasingly ‘inelastic’, shifts in demand – both up and down – have the potential to exert an unusually big impact on prices.
This problem is being made worse by the tightening of the regulations covering the risk-taking activities of banks since 2008. That has led to them reining in market-making, in turn reducing their ability to act as shock absorbers during times of market stress.
And there are other grounds for believing volatility is likely to rise. Retail investors have been among the biggest buyers of riskier forms of fixed-income investment such as emerging-market and high-yield debt as they seek a pick-up in yield. But this money is unlikely to prove ‘sticky’. Should sentiment turn, we’re likely to see retail funds exiting their investments en masse.
And finally, and perhaps most importantly, a number of investors, most notably Taiwanese insurance companies, have in recent years been big buyers of US callable bonds as a means of enhancing returns. That has dramatically depressed anticipated levels of volatility in bond markets.
However, investors, rather than viewing this as presenting them with an extra headache, should see it as a potentially lucrative opportunity.
For example, whilst one might not want to call a permanent end to the low-yield environment just yet, the changing structure of fixed income markets means the ‘market price’ of volatility has been depressed to an unsustainably low level. Furthermore, this type of position can provide fixed-income portfolios with a natural hedge against the detrimental effects of rising rates. After all, there is likely to be a measurable increase in volatility as and when yields do begin to rise.
It is true there is no free lunch in investing. But since losing money with a traditional long-only bond portfolio in a rising rate environment is a mathematical certainty, investors may want to start preparing for the moment the music comes to a halt. That will require them to consider an ever wider range of strategies. Betting on a pick-up in volatility appears to be an attractive way of potentially boosting returns with limited downside risk.
1 Source: Bank of America Merrill Lynch