FIXED INCOME: Conference of the bonds

Last year was challenging for fixed income investors. Which types of bonds did well and which did badly? And how should investors position their emerging market and Asian exposures?

It’s not an easy time to be a bond investor. While equities continue their bull run, barring a few hiccups, bonds yields are still volatile as a result of the partial withdrawal of US Federal Reserve bond buying.

What is worrying is that most people expect interest rates to eventually return to historical averages, well above their current abnormal lows. Strategies to reduce interest rate risk are therefore at the forefront of investors’ minds.

Torsten von Bartenwerffer of Aquila Capital (see right), believes not only that a rate rise is inevitable, but that a global currency crisis is a real possibility – the result of competitive currency devaluation which cannot work for all countries at the same time.

However, it is not all doom and gloom. Bond investors who have the flexibility to switch their money between different instruments have been able to generate relatively good performance in the past 12 months, by capturing the good returns of, for instance, high yield or convertible bonds.

Elsewhere, emerging market bond investors are starting to see pockets of value after a punishing correction. Mark Capstick of BNP Paribas Investment Partners has seen structural improvements in the “fragile five” countries (Brazil, India, Indonesia, South Africa and Turkey) and, having raised his exposure to these countries, has already seen a performance benefit.

Meanwhile, Andy Seaman of Stratton Street believes the Chinese renminbi, Korean won and Malaysian ringgit are all substantially undervalued, meaning investors in these countries’ bonds should expect a helpful currency uplift in the coming years.

Perhaps the most interesting country to watch is Japan, which is engaged in some of the most ambitious quantitative easing seen in global markets, with knock-on effects for sovereign bond yields. Ben Bennett, of Legal & General Investment Management, says the programme known as Abenomics will need to result in higher wages for Japanese workers and improved economic data in the coming months, or the Japanese people will call for Abandanomics.



Should bond investors prepare for a rise in interest rates now the Fed has begun tapering?
That is hard to tell as various scenarios could play out. Over the long-term, interest rates in the developed world average between 5-7%. While it might seem hard to envisage rates returning to those levels given their current historic lows, it will happen. This is some way off because the Fed and other central banks are cornered since cheap money is not filtering into the real economy. It is causing asset price inflation, especially in equities. Because of quantitative easing, the Fed owns a chunk of treasuries, which it will keep to maturity. Either it buys all remaining T-bills or ends quantitative easing. Either way, the long end of the yield curve will be hard to keep down forever.

How should investors position themselves if they assume a rate rise will eventually happen?
Holding a laddered portfolio of bonds to maturity to reduce nominal interest rate risk is one option. But investors are thinking harder about their exposure to bonds and seeking strategies less sensitive to interest rates. One alternative is a risk parity approach, which invests in fixed asset classes that are uncorrelated and can deliver returns throughout the interest rate cycle.

Will Fed policy continue to be the main determiner of returns in the bond market or are there other variables?
The central banks generally, not just the Fed, have skewed the markets with their quantitative easing interventions. But while they can make money available cheaply they cannot ensure it gets to those businesses supporting growth or to the people on the street. The next big event could be a global currency crisis because competitive devaluation cannot work for all at the same time. Trying to time or predict markets is futile, investing for the long-term in a portfolio diversified across assets and geographies is one of the few wise options.



Which factor has been the best source of fixed income return this year and why? And the worst?
Within our multi-asset funds, emerging market local currency assets generated the worst returns while the best returns came from our allocation to convertible bonds, which benefited from a strong equity bull market over the course of the year.

What has been the single most influence on your asset allocation in recent times and how has your portfolio changed?
In recent times, the state of the broad macroeconomic environment (low rates, hunt for yield followed by prospect of rising rates) has been the key factor behind our asset allocation, which has been intimately linked to the direction of the Fed’s monetary policy. The reduction of monthly asset purchases by the Fed has acted as a catalyst for a period of turbulence within certain asset classes. One of the advantages of asset-allocation funds is that we were able to reduce our allocation to those sub-asset classes that were particularly affected by this volatility.

Why should investors choose your fund over a traditional bond fund?
The primary attraction for investors is to access ‘total returns’, that are not linked to traditional bond benchmarks. Also, by focusing on the higher-yielding areas of the fixed income market, we expect to generate returns of 5-10% per year over a cycle. BlueBay takes a very active role in asset allocation and capital preservation which enhances and smoothes returns over time. Our approach is to only select high conviction securities and we do not have a benchmark-relative mindset, hence we only purchase securities we wish to own, rather than being constrained by a benchmark that dictates a portion of the holdings.



Which are some of the safest emerging market countries for fixed income investors at present and why?
Last summer, investors rushed out of emerging market fixed income into so-called “safe haven” assets in developed markets. This is what happened to the “fragile five” countries (Brazil, India, Indonesia, South Africa and Turkey) that had large and worsening current account deficits. These countries have made considerable structural adjustments and are, at the margin, fundamentally and structurally safer now. We have marginally added to risk to some of these countries and seen them start to perform already.

Clearly, these countries have some way to go before they are “safe”. However, Indonesia has improving trade balances and has already increased rates, so has Brazil. Mexico continues to benefit from economic gains in the US. On the other hand, Malaysia has a tricky fiscal position, high levels of international holders of debt and increased inflation, which leads us to view this country as less safe for investment. Safety is in the eye of the beholder.

What are the advantages of sovereign versus corporate emerging market bonds at the moment?
Our emerging market team prefers quasi-government bonds and corporates over sovereigns due to their better fundamentals and lower level of leverage. The increase
in the premium – the yield spread – over government bonds more than compensates investors for the added risk. Many of these bonds have more than half state ownership and investors can be paid up to 400 basis points on top of the underlying sovereign. Meanwhile, emerging market corporates and financials are more diversified than they were back in 2008.

Is the recent sell-off in emerging market assets a buying opportunity or should investors continue to bide their time?
We’ve passed the retrenchment point for emerging market fixed income assets and think that the buying point is close.



Should investors choose hard or local currency emerging market bonds?
We see better risk-reward in hard currency bonds, because there is no risk involved. Credit spreads are not cheap by historical standards, but with yields of 5.5-6% and spreads of over 300 basis points to US Treasury bonds, there is value compared to developed market credit. Investors should not disregard local currency bonds. There has been significant depreciation in the majority of emerging market currencies and local bond yields are looking attractive. Should the macroeconomic outlook in emerging market countries improve, we could have a significant rally on local bonds.

Are there reasons beyond tapering for European investors to sell out of emerging market bonds?
Tapering was a reason for the sell-off in emerging market assets in 2013. Yet at the same time, macroeconomic indicators such as GDP growth and the balance of payments in several emerging market countries began to deteriorate. A large part of tapering has been priced-in to emerging market bond prices. On the macroeconomic side, we have not seen meaningful improvement. Investors should not be selling out of emerging market bonds, but it is too early to call a significant rally in these assets.

Is the recent sell-off of in emerging market assets a buying opportunity or should investors wait?
A key theme is greater differentiation in performance between different regions, countries and assets. Actively managed portfolios should be able to generate meaningful returns for investors. Some interesting buying opportunities have already been created. Emerging market bonds remains an attractive yield enhancement strategy for fixed income investors.



How is developed market growth affecting Asian fixed income returns for European investors?
For a long time, yields in debtor European countries such as Greece, Spain and Portugal were low, a few basis points above Germany. At the time we warned that they were high risk, and pointed out the higher returns, and lower risk, in Asia. The market has realised the risks, and the peripheral European countries yield more than many in Asia. This still leaves the Asian countries cheap as they should be compared to the creditors in Europe, like Germany and the Netherlands, rather than to the debtors which have not resolved their problems.
What is your outlook for China?
China has been raising interest rates stealthily for a while. It has had significant financial repression, with interest rates on savings low, pushing capital into “wealth management products” and property. This is changing, with the government wanting to normalise returns on saving while restraining rapid growth in credit. We can expect rising rates to continue.
Is it true that Asian currencies are cheap compared to historical averages?
While the renminbi has been appreciating at a gradual rate for the past few years, and has risen in real terms around 35% since mid-2005 when the exchange rate regime changed, before that the currency was weak. The IMF claims the renminbi is 5-10% undervalued. Productivity growth in the manufacturing sector, and the rising trade surplus, suggest it is more. As a creditor country with strong inflows, we expect the renminbi to continue to appreciate. Many other Asian currencies are undervalued, although not by large amounts.



What is your view of the Central Bank of Japan’s drive to create inflation?
Having suffered years of activity-sapping deflation, policymakers have gone for broke. The idea is to create vast amounts of money to buy Japanese government bonds, displacing current holders who move into riskier assets, forcing up prices, encouraging investment and ending deflation. The amounts involved are staggering, but the risks are as enormous. Such action questions what value currency has if its creation can be so detached from economic reality.

What effect has the policy had on European investors?
The first year or so has resulted in a weaker yen, improving the competitiveness of Japanese exporters but undermining the disposable income of consumers who have to pay for expensive imported energy. Japan may be exporting its deflation to Europe via its weaker currency, with European exporters loath to hike wages while they suffer from a stronger euro. This is good for European fixed income investors in the short-term as yields remain low, but may store problems for the future if weaker European economies fail to grow out of their debt overhang.

Will the Japanese policy succeed?
Along with printing vast amounts of money, Abenomics plans to enact structural reforms to free up the economy and improve potential growth. If such structural reform was easy, it would have already taken place. The government is struggling to live up to its promises. Japanese companies have not passed on their windfall to their workers via higher wages. Recent Japanese economic data has been disappointing, which helps explain the fall in Japanese bond yields. The coming months are critical for the success of Abenomics. Companies have to increase wages to offset rising import prices, otherwise the population will call for Abandonomics. Then Japan may have blown its last chance, and the country’s debt sustainability will be called into question.

©2014 funds europe



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