Does investing in fixed income still make sense?
With bond yields at multi-year lows, does investing in fixed income continue to make sense.
Fixed income (or bond) markets have been a stellar performing asset class for a number of years.
The accommodative monetary policy provided by central banks globally as a means to support global growth has provided a tailwind that has seen bond yields fall in all, but the most distressed debt laden countries.
This has resulted in significant gains for investors, as bonds have not only provided the portfolio ‘insulation’ that many investors have sought during what has been nothing short of a challenging period for higher risk asset classes such as equities.
The question now for many investors is whether the fixed income ‘story’ is now beginning to fade, given that bond yields globally and domestically are at multi-year lows.
So with this backdrop is the decision to maintain some level of exposure to bonds in a portfolio a journey into the unknown?
But before we delve into the question of whether investing in fixed income investments continues to make sense, it is important to understand why investors are increasingly more cautious about such a strategy.
And the question that needs to be addressed in this regard is ‘why invest in the fixed income investments in the first instance?’.
This is particularly the case when it comes to sovereign bonds, where across a number of countries real yields (ie, those yields adjusted for inflationary expectations) are actually negative.
While it is true that fixed income investments should be viewed as ‘defensive’ or ‘lower risk’ investments, it is not always the case.
And no investment, however defensive in nature, is not without risk. Therefore, investors need to understand the ‘types’ of bonds available in the market place.
In this regard, it is important to appreciate that the generic (defensive) statement should not be viewed as covering the entire array of fixed income investments that are available for investors (from developed market sovereign debt, to corporate credit, to high yield and emerging market debt), given that some may and do carry quite high levels of risk.
However, the truism that surrounds fixed income investments is that they generally exhibit lower levels of risk (or volatility) when compared to other investments such as equities.
Therefore, for many investors the decision to invest in fixed income products is built around a strategy of lower volatility and capital protection through time.
So with this in mind, what is the market environment that can cause this strategy to unwind, and actually have the opposite impact on an investor’s portfolio?
In fixed income parlance, a ‘negative market’ environment is one where bond yields are rising, resulting in falling bond prices and therefore a negative capital return to investors.
And depending on the ‘type’ of fixed income security, the credit worthiness of the issuer, its duration, and liquidity of the extent of that fall can be quite precipitous.
Therefore, in such a situation this would result in the exact opposite outcome as to the original strategy of the investor.
So, with this context in mind, it is not hard to understand why some investors view many current bond markets as a ‘bubble’ (due to current low and potentially unsustainable yields), and that as the global economy recovers, yields will most certainly rise from current levels, resulting in significant capital losses for investors. So what should investors do?
Take flight and invest in cash, take profits and invest in more attractively priced asset classes (such as equities) or maintain the status quo with a view that over time it will all ‘balance out’ in the end, and there is no point trying to take a proactive approach to managing the investment profile.
While some of these approaches may have merit depending on an investor’s circumstances, it still avoids one of the central aspects as to why an investor made the decision to invest in fixed income initially, and it’s in that context that we believe any future decisions should be made.
So in such market environments, investors must firstly understand the underlying investment, what the risks are, and how can they can mitigate against those risks. In the case of investing in fixed income, can an investor adopt an approach that will assist in capital preservation while not foregoing ongoing investment opportunities?
In this context, it is important to understand the nuances of a bond.
A bond can simply be viewed as a promise by the issuer (borrower) to pay regular income instalments (the coupon) to the lender (investor) over the term of the investment (years).
While the size of the coupon payments is determined by a range of factors that reflect the ‘risks’ associated with the bond, (ie, the borrower’s credit worthiness, the term and type of bond and where it fits in the capital structure of the company), the overall principle remains the same.
Therefore, investors over the term of the bond receive the coupon payments and at maturity the initial investment amount (the face value of the security).
However, as the term, credit rating and structure of many bonds is different, combined with the fact that bonds can be traded in the market, it means that at any point in time during the bond’s term its price may vary from (say) the initial $100 face value (FV).
Now, if an investor does not trade the security, but holds it through to maturity, the risk of loss is really only the counterparty risk to the borrower.
However, as bonds are traded, the prices of bonds do vary over time and investors need to be aware of this and the impact it can cause on portfolio performance.
To this extent, the prevailing market rates at the time of the transaction will dictate the price of the bond, and any potential gain or loss for the seller.
And while the buyer will continue to receive the instalments, depending on the price paid (relative to the $100 FV), this will reflect whether the actual yield on the bond (as a percentage of the coupon to its price) will be greater or less than the initial coupon payment.
Accordingly, the movement in interest rates (or market yields) has a direct impact on the price of a bond at any point in time. Let’s consider an example.
An investor decides to purchase a bond with a FV of $100 for a term of 10 years, paying a 5 per cent coupon, where current market rates for the same period are 5 per cent.
If the current market rate moves (either in a plus or minus direction), this will impact of the price of the bond.
Why?
Because if market rates move higher, in order to sell the bond the owner must sell at a price below its FV to reflect a yield on the bond that is equivalent to the current market yield, that a new investor could receive.
And if the seller purchased the bond initially for $100 and sold it for $97, then a capital loss would ensure.
The inverse would also apply in an environment where rates fell, and the buyer could only obtain investments with lower yields compared to previous periods, thereby requiring them to pay a higher price (above the initial FV of $100) in order to obtain the coupon payments (of the 5 per cent).
But in paying over the FV of the bond, the effective yield on the bond is lower than the 5 per cent coupon payment.
And it’s in this environment that we now find current bond markets.
Bond yields have fallen steadily over the past few years, and the price of many government bonds is well above the par FV.
As an example, Australian government 10-year bonds are now currently trading at a yield of around 3.3 per cent, with a price of $119.45.
So what does this mean for fixed income investors and how can they look to protect against future losses given the decline in bond yields in recent periods may be followed by higher rates into the future?
In this respect, there are a number of strategies and approaches that an investor could consider as a means of managing the risk of loss in the portfolio.
And while there is no free lunch when it comes to investing, and all investments carry some level of risk, understanding the potential impact of the risks associated with any investment is critical in being able to construct a strategy that can alleviate as many of those risks as possible.
From the perspective of investing in fixed income securities, there are a number of options that can be considered as part of an overall investment approach.
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Consider investments with differing maturity profiles. Rather than holding bonds with the same maturity, by holding an array of securities an investor can reduce some level of market risk, while also ensuring an ongoing level of income.
The differing maturity profiles and ongoing income allow the investor to consider other fixed income investments that can provide a better risk/return outcome.
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Managing the duration risk of the portfolio. Duration is a measurement of the sensitivity of a bond (or portfolio’s) price to changes in interest rates.
Shortening or lengthening the duration of a portfolio will either reduce or increase the level of sensitivity and therefore the potential risk of the portfolio. Within the management of duration there are a number of options that can be considered.
These include aspects such as yield curve positioning (ie, short-dated versus long-dated securities), or the investment in floating rate investments where the coupon paid to the investor will move in line with market rates (plus a margin).
This is particularly useful in an environment of rising rates. And thirdly, investors can consider using other market tools such as derivatives. Generally, these types of investments are for professional investment managers only, and serve to highlight the level of sophistication required to adequately manage a bond portfolio.
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Consider differing types of bonds across differing markets. For example, rather than investing solely in government bonds, investors may consider a mix of corporate bonds.
While corporate bonds generally carry more risk than government bonds, the return profile (on a risk adjusted basis) may actually be higher, and when combined together with other fixed income securities may actually reduce the overall risk of a portfolio.
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Consider bonds that are not just developed market sovereign debt. For example, emerging market economies also issue debt, and many of these countries actually have lower debt to gross domestic product ratios than developed market economies.
Therefore, the ability for yields to move lower in these countries is potentially greater as their economies evolve over time.
While these approaches (either individually or collectively) are not likely to guarantee that an investor will not be subject to some level of price volatility on their fixed income investments, it does at least provide a framework by which an investor can manage the potential for loss.
And this takes us back to our original question.
Are existing investors in bond markets heading into the unknown where there is only a negative outcome?
Our view is that investing in fixed income investments remains just as relevant today as it was prior to 2008.
While the level of investment performance may not be as significant going forward as what we have experienced over the past two to three years in bond markets, to simply take a view that all fixed income investments are poor investments in this current market environment is wrong.
Balance is what is required when considering any investment, whether it is debt or equity.
Understanding market drivers and the impact that it will have on an investment will assist in developing the most appropriate strategy and ensure that even in a challenging market backdrop, investors can still generate a commensurate level of return for the risk taken.
Piers Bolger is head of research and strategy, advice and private banks, BT Financial Group.
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