November 2014
For professional investors and advisers only.
Harvesting bond returns as rates rise
The climate is changing for fixed income. Quantitative easing
is winding down. Interest rates look ready to start reversing a
generation of decline. On the face of it, this seems a difficult
background for bonds and, indeed, has already contributed
to market volatility. Yet we believe it will be hard to replace
the diversification, liquidity and security of bonds. In fact, we
believe demand will continue to grow as populations age and
increasingly need retirement income.
Managing bond portfolios in this environment will be harder than in the past. It will no
longer be sufficient merely to be in the market: investors will also need to actively seek
the best returns. Put another way, they can no longer rely on beta, but must now put
much more emphasis on alpha. Intelligently managed, we still believe bond portfolios
can prosper in this environment. This article briefly explains how.
The problem with being passive
While interest rates continued their long decline from the early 1980s, a buy-and-hold
strategy made sense. Indeed, many fixed income investors simply adopted index-based,
passive portfolios, but these investors now face particular problems. Substantial parts of
the benchmarks used to construct their portfolios are comprised of government bonds,
where not only are yields low, they are highly sensitive to rising rates. For instance, over
60% of the Barclays Global Aggregate Index – a popular benchmark to track – is made
up of government and government related issuers (Figure 1, left-hand chart, red bars).
We think this part of the market will be particularly vulnerable as yields rise and the
quantitative easing instituted by the US Federal Reserve (Fed) goes into reverse.
Figure 1: Benchmarks’ make-up can make them unappealing
Barclays Global Aggregate Index:
By Issuer:
Market Value
%
60
By Currency:
Market Value
%
50
50
40
40
30
30
20
20
0
0
Sov
Ca
sh
10
ere
ign
Qu
a
Go si
ver an
nm d F
en ore
t ign
EM
DS
ove
rei
gn
Sec
Co ur
lla itis
ter ed
ali /
sed
Co
rpo
rat
e
10
US
lar
Dol
o
Eur
Based on unaudited data as at 26 March 2014. Source: Barclays and Schroders.
Yen
d
n
Pou
Ca
r
olla
nD
ia
nad
Au
r
olla
nD
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t
Res
Harvesting bond returns as rates rise
2
Other index constituents can also force passive investors into unwanted exposures.
For instance, an investor mimicking a global benchmark is often tying a substantial
part of their fortunes to those of the Japanese market. In the case of the Barclays
Global Aggregate, Japan accounts for around 17% of its value (Figure 1, right-hand
chart, red bar). So just over a sixth of a passive investor’s portfolio would be dependent
on a country where government debt is close to 230% of GDP and whose financial
authorities have constantly to walk a tightrope between raising taxes to reduce debts
and tipping the economy into recession. We think this is a precarious underpinning for a
bond portfolio at a time like this.
Of course, there are ‘smarter’ ways to use beta to increase returns from a passive
investment in government grade bonds. For instance, a buy-and-hold investor can
leverage the minimal returns from high quality bonds to the desired level by using
outright borrowing. Alternatively, they could buy longer dated or lower quality bonds.
Unfortunately, while this increases the upside potential, it has similar – or worse – effects
on the downside, particularly when yields might be expected to rise.
Figure 2 shows the leverage and the possible losses (or drawdown) we calculate a
passive investor adopting these strategies might need to accept to achieve a 4% annual
yield on certain asset classes. (The leveraged approaches are towards the left of the
chart, while the longer duration and/or lower quality strategies are towards the right.)
Figure 2: What price do you pay to gain a 4% yield?
Increase Leverage
%
315
294
270
–5
–8
–16
–20
–35
Required Leverage
to Achieve a 4% Yield (LHS)
ML Global Corporate
10+ Years
Euro High Yield
US Corporate
Euro Corporate
US Government
Euro Government
–40
–26
–29
Emerging Market
Sovereign
–4
ML US Corporate
BBB 15+ Years
137
US High Yield
350
250
150
50
0
Reduce Quality/Increase Duration
0
–5
–15
–25
–35
–45
Maximum Drawdown Over Last
10 Years, Not Adjusted for Leverage (RHS)
Based on three-year data. The four left-hand asset classes (and their yields at 30 June 2014) are represented by the following
four bond indices: Barclays Euro Aggregate Government Total Return in euros (1.3%), Barclays US Aggregate Total Treasury
in dollars (1.4%), Barclays Euro Aggregate Corporate Total Return in euros (1.5%) and Barclays US Aggregate Corporate Total
Return in dollars (2.9%). The drawdown figures represent the annualised standard deviation for the last 10 years in each case.
The other asset classes are represented by the following indices: Barclays Pan-European High Yield Total Return in euros,
Merrill Lynch Global Broad Corporate 10+ Years, Barclays US Corporate High Yield Total Return in dollars, Merrill Lynch US
Corporate BBB 15+ Years, and J.P. Morgan EMBI Global Diversified Composite. Source: Bloomberg and Schroders, as at 30
June 2014.
This is not to say that these can’t be useful strategies if managed properly. Managers
must be allowed the freedom to dynamically adjust and hedge a portfolio’s overall
interest rate and credit risk to reduce the volatility of returns. So risk-averse investors
may find the best way forward is to adopt a more flexible approach, with a strong focus
on managing drawdown risk that doesn’t need to over-allocate to higher yielding assets.
Harvesting bond returns as rates rise
3
Thematic drivers
While we believe active management of bond portfolios is essential in the current
environment, we would question whether traditional approaches will deliver the riskadjusted returns that investors need. Often, traditional fixed income managers adopt a
sector rotation approach, which relies on predicting which sectors will do well and then
emphasising them in the portfolio. However, this strategy still depends on beta – that
growth will be consistent across a sector – which may be less evident in the new interest
rate environment. It also takes little account of alternative scenarios that may lead to lower
returns. We believe a better approach is to identify key investment themes driving global
markets, and then to devise strategies which aim to exploit them to generate consistent
risk-adjusted outperformance.
One theme that is crucial for investors to understand right now is the extent to which the US
economy’s growth has been priced in by the market. We think many are underestimating
the strength of the recovery and that the bond market is therefore poorly positioned with
regard to US yields. It is worth noting here that the ‘Taylor rule’, which uses the divergence
of inflation and economic growth from target to suggest what the level of interest rates
should be, is pointing to higher rates (Figure 3). Pressure should begin to mount on the Fed
to alter its current stance as the economy continues to perform, undermining support for
the US government bond market as rates rise faster than expected.
Figure 3: Taylor rule points to a sharp uptick in US interest rates
%
12
10
8
6
4
2
0
-2
-4
1984
1989
1994
1999
Fed Rate
2004
2009
2014
Taylor Rule Estimate
Taylor rule regression based on US Core Personal Consumption Expenditures (PCE) inflation less assumed core PCE inflation
target of 2%, and US unemployment rate less assumed non-accelerating inflation rate of unemployment (NAIRU) of 6%. Okun
factor of 2. Current implied policy rate = 2.4%. Regression coefficients are 1.53 and 0.47 respectively. Correlation is 0.84.
Source: Bloomberg, as at 14 August 2014.
Such insight is clearly useful, but even more important is what an investor does with it. We
think there are at least four strategies that a risk-aware investor might use to exploit the
mispricing we see as a result of our view of the US economy.
Harvesting bond returns as rates rise
4
Adopt a short duration bias in US bonds. If, as we suspect, rates start to rise
more quickly than expected, then the US bond market looks set for a period of
underperformance. But this is unlikely to be uniform. An active manager can generate
additional returns by adjusting not just their overall exposure to the market, but along the
yield curve. In doing so, they will want to avoid the most interest-rate sensitive areas of
the market, which we anticipate will be at the short end where monetary policy has its
biggest effect. Accordingly, a portfolio manager with a broad fixed income toolkit can sell
duration exposure at the short end and re-allocate it along the curve where the outlook
is relatively more favourable.
Allocate to US ‘growth assets’. The advantage of a more selective approach means that
the active manager can also capitalise on areas of the market expected to do well. One
such area, we think, could be longer dated corporate bonds. Many US companies have
vastly strengthened their financial position, having benefited from the economic revival
and reduced debts. This has come at a time when US pension funds have also seen big
improvements in their funding position. Many are now looking to swap riskier assets, like
equities, for assets that will match their pension liabilities, typically bonds, to help lock
in gains. In the past, these matching assets would have included Treasury bonds, but
minimal yields and pension accounting make Treasuries unattractive. As a result, demand
from pension funds for longer dated investment grade bonds may be expected to support
that part of the US market. Furthermore, allocations to longer duration assets may form
part of a yield curve flattening strategy especially when teamed with an underweight or
short exposure to shorter dated US Treasuries to better manage interest rate risk.
Buy ‘yield curve flatteners’ as risk offsets. Of course, we could be wrong. The US
economy may not be as robust as we think, or there may be an unforeseen event around
the corner which undermines economic confidence. Either way, investors would normally
run for the cover of very short dated Treasuries, traditionally seen as one of the safest
havens in a crisis. But, like pension funds, the chances are they will be put off by the
meagre returns available, driving them into longer dated Treasuries in search of yield.
In such an event, we would expect yields to fall for all longer dated bonds, ‘flattening’
that end of the yield curve to the benefit of holders of corporate bonds (Figure 4). So a
position to take advantage of unexpected strength in the US economy can still work if
things do not turn out as expected.
Figure 4: Yield curve hedge for geopolitical risks
Yield curve flattens as rates fall
%
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2 3 4 5
7
10
Source: Bloomberg, as at 3 July 2014. Jan 14
Years
Mar 14
20
Jun 14
30
Harvesting bond returns as rates rise
5
Put your faith in the dollar. Another asset likely to benefit from a strengthening US
economy is the currency. An active manager can therefore buy dollars and/or reduce
holdings in currencies likely to weaken. Such a policy would nicely complement another
of our themes: that the European Central Bank will introduce quantitative easing
sooner rather than later, weakening the euro against the dollar. So, where investment
agreements permit, active currency strategies offer an alternative way to implement
investment themes.
Conclusions
Risks are rising for fixed income investors. Rates now seem clearly to be on an
upward trajectory, which normally spells bad news for bonds. However, many
investors – particularly those with longer-term liabilities – will find them hard to give
up. We believe they can still enjoy the benefits of bonds, but they may need to adopt
different strategies. Passive benchmark investing will no longer work. We think a
more flexible risk allocation approach will prove to be much more effective. Even
more so as all investors will need to manage interest rate risk in the new economic
circumstances. We believe this will require them to diversify their portfolio by asset
class, time horizon and alpha source. It will require them to determine where is the
best place on the interest rate curve to be, which countries to be in and where is
the best relative value. To juggle all these requirements means having a genuinely
unconstrained, global strategy, that is able to allocate risk wherever it will be
rewarded, without being unduly tied by benchmarks or home country biases. An
investor armed with such a strategy can, we believe, still survive and even thrive as
rates move higher.
Alan Cauberghs, Investment Director, Fixed Income
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