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Magazine Issues » December-January 2014

FIXED INCOME: A curve in the road for bonds

Off-roadThe prospect of rising interest rates or yields is the biggest challenge to bond funds right now. A rising rate environment may benefit the absolute return sector, but also test it, writes Nick Fitzpatrick.

How much uncertainty can bond investors take before they are forced to do something drastic? In 2012, any fixed income fund would have returned double digits. It’s not the same now. The ground under the boots of fixed income investors in 2013 became a lot looser.

“For traditional fixed income investors, it has been fantastic for the past 30 years, with yields continually falling and duration being a stable driver of returns,” says Paul Nicholson, an absolute return bond portfolio manager at Switzerland’s Vontobel.

In recent years, bond investors have picked up yield from corporates, emerging market debt, and by increasing the bond duration in their portfolios. So well have bonds performed, there has even been talk of a bubble.

This is not the case now, though. The second quarter of 2013 brought to the fixed income sector a “mini-bear market”, says Tanguy Le Saout, head of European fixed income at Pioneer Investments.

Uncertainty has increased ever since, bond returns have fallen, and flows to bond funds have slowed, if not reversed.

“In 2012, any fixed income fund would have returned double digits. It’s not the same anymore,” Le Saout says. “One more negative leg for long-only bonds, and bond investors may then really shift assets.”

But what would they switch to? Regulatory reasons will mean some institutional investors cannot move into equities. Some may simply not want to.

Le Saout claims interest in absolute return bond funds – which seek positive returns in any market environment – is high, yet he acknowledges that the move into this sector is almost non-existent.

Absolute return managers are counting on the changing economic environment that bonds are in, the possible end of double-digit returns, and the ongoing quest for yield in a still-low return world, to attract flows.  

Falling unemployment as economies improve could create inflation if consumers become confident enough to spend more. Normally, this would spell a rise in interest rates, and there is no investor more concerned about interest rates than the bond investor. Existing bond prices fall as rates rise, so even if monetary policy is universally expected to remain loose in the next few years, rates have still become viewed as the largest bond risk.

Bond duration – which expresses a bond’s price sensitivity to a change in interest rates – has moved stage-centre for some managers of bond funds. Long duration bonds, which have high interest-rate sensitivity because it will take the bondholder longer to get their money back from coupon payments, are out; short duration – and even negative duration – are in.

Bond markets have been unsettled since May, when an abrupt rise in yields and a fall in prices followed the Federal Reserve’s hint at a reduction of its bond-buying programme of quantitative easing. Even though the Fed has indicated that near-zero rates would remain until 2016, arguably confidence has still to re-settle. Returns from fixed income have been largely negative, though US and euro high yield have been notable exceptions.

Pioneer’s Le Saout says the big question for the market now is whether there is going to be a more sustained bear market in fixed income.

Some managers and advisers say traditional fixed income portfolios are not up to the task of dealing with the changing environment. The almost hedge fund-like absolute return bond sector has seen a number of funds launched in the regulated Ucits regime in 2013. Many absolute return bond funds use derivatives to increase returns and limit losses. In this sense an absolute return bond fund might be able to shorten duration in a portfolio that holds longer duration – therefore riskier and higher yielding – bonds.

Nicholson at Vontobel says his fund invests in global bonds and uses derivatives to tilt duration profile.“Duration can be made negative on a 10-year US government bond with a duration of six years. If yields go up, you would normally lose money as bond prices go down, but altering the duration to short or negative duration with futures means you make money as prices fall.”

This happened in May, Nicholson says, when the Federal Reserve discussed tapering, sending bond prices down. It was a signal to absolute return bond funds to go to short or negative duration. “It’s not about being opinionated on whether tapering is going to happen or not, it’s about being flexible.”

Duration can be a weight around the ankles of many vanilla fixed income strategies that use traditional benchmarks.

Richard Phillipson, principal at Investit, an asset management consultancy, says: “Standard indices pick up a built-in duration, sensitivity to changes in rates. Bond index funds or funds with index relative benchmarks will have a lot of exposures you might not want. The absolute return funds use the asset class but escape the issues of bond indices as the basis of a portfolio. They could have negative duration and benefit from a rise in interest rates.”

Absolute return funds tend to reference a cash benchmark, like Libor, with an extra return on top.

Brad Boyd, co-manager of the absolute return strategy at Payden & Rygel, says: “In the relative return world where the fund references a traditional index, the index is constantly extending duration every month when it is re-weighted and new bonds are added. A traditional bond fund will always have sensitivity to interest rates.”

In the context of history, bond investors today are getting paid very little to assume interest rate risk, says Boyd.

It would be no surprise if fixed income investors were fearful at this time. The average UK FTSE 100 pension scheme bond holding in 2013 was 56%, according to JLT Employee Benefits. Six years ago, it was 36%.

Yet after this massive shift, in 2013 investors have heard much talk of a “great rotation” to equities. They heard constantly of a “rising rate environment”, and it must have raised heart rates, too. And not forgetting the Fed tapering, which will shunt prices down and impact investment in bonds at the riskier end of the curve.

Any claim that traditional approaches to bond investment are not up to the challenges of the next year or two if rates rise, has to be countered by pointing out there do exist short duration funds of a more vanilla kind for investors not enamoured of derivatives.

Also, Oliver Boulind, head of global credit in Europe, Middle East and Africa at Aberdeen Asset Management, recently told investors in a webinar: “We have found that credit is a good offset at many points in the cycle to rising interest rate risk.”

And an improving economy will lower the default rate in credits, too.

Boulind also pointed out that emerging market bonds have improved in quality over the last 15 years, with some moving to investment grade. Perhaps it is absolute return bond managers who should be fearful. They aim to create positive returns in any environment and the next year could be the time to prove it.

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