Kipp Cummins, head of EMEA fixed income and vice president at Dimensional Fund Advisors, talks about how fixed income can continue to play an important role in portfolios even with rates at all-time lows.
The role of fixed income in portfolios has come under greater scrutiny over the past decade as interest rates have fallen to – and stayed at – all-time lows. But investors concerned only by bond yields may be underestimating the versatility of fixed income and the key part it plays in a diversified portfolio.
Kipp Cummins, head of EMEA fixed income and vice president at $660bn global asset manager Dimensional, says investors shouldn’t assume that the asset class has less to offer in the low-rate environment.
“A lot of people get fixated on just the short-term interest rate, but the yield is not the entire story,” he says. “By default, people look at what the Federal Reserve or the Bank of England are doing, but central banks are only setting short-term interest rates. Across any respective yield curve, central banks are only one of many market participants that serve to set current bond rates.
“Equities are quite a blunt object. They’re used for one thing, to maximise returns. Fixed income is very multi-faceted. It’s less volatile than stocks on average over longer periods and can produce a stream of cash flows for many years from now.”
Yields and interest rates continue to dominate market rhetoric, so how can investors make the most from an allocation to fixed income?
A globally consistent approach
This is where Dimensional’s systematic fixed income approach can help. Overseeing $120bn in fixed income assets globally, Dimensional has close to 40 years’ experience of investing in the asset class, across a range of different securities and geographies.
“A lot of people ask ‘How did you get to where you are today?’,” says Cummins. “40 years is a long time to manage money and, certainly, there have been a lot of enhancements along the way. But the underlying principles are much the same.”
Cummins explains that the Dimensional approach is underpinned by its research-oriented nature and work done in the late-1960s and early-1970s by board member and Nobel laureate Eugene Fama.1
“In a nutshell, Fama said you can’t time the direction of interest rates,” says Cummins. “In trying to understand returns in fixed income markets, he was able to identify that forward rates – the combination of yield and the shape of the yield curve – are a very good proxy for expected returns.
“Essentially, when yield curves are upwardly sloped, there’s additional compensation for extending out the yield curve. When yield curves are flat or inverted, that compensation is not as high, and the expected premium – the excess returns on top of a risk-free rate – is quite low.”2
When premiums are low, Dimensional managers know to shorten duration – or interest rate risk – in their portfolios as they are not being compensated for taking on excess risk.
A constantly evolving process
While the approach has served Dimensional well and helped it deliver a proven track record of outperforming indices in its fixed income strategies, Cummins says the firm continues to research other ways of generating returns.
As well as a disciplined approach to fixed income investing, Dimensional is also staying on top of developments in the bond marketplace and the intermediation process in an effort to deliver better returns to investors.
“The bond market continues to be decades behind the equity market in terms of technology and transparency,” says Cummins. “But I’d like to think that we’ve made great leaps and bounds, particularly in the past 10 to 15 years.”
Indeed, greater price transparency leads to more efficiency and better outcomes for investors, says Cummins, who began his career as a bond trader before moving into portfolio management after joining Dimensional.
“Broker-dealers drive nice cars for a reason; because they have historically made a lot of money extracting bid-ask spreads from buy-side asset managers like us,” he explains. “We are trying to deliver excess returns to clients. The last thing we want to do is subsidise somebody because they’ve been buying and selling our client’s bonds without taking on much capital risk.”
A systematic approach in practice
Dimensional’s disciplined approach to fixed income paid off during the Covid-19 pandemic. Before the coronavirus took hold, investors were buying riskier bonds in search of yield, says Cummins. However, Dimensional’s research into global bond markets told it that credit spreads – the additional compensation paid by the market to own riskier bonds – were near all-time lows.
“We stuck to our systematic process and, when March arrived, certain segments of fixed income markets got upended, and credit spreads blew out to levels not seen since the great financial crisis of 2008,” he says. “All those people who were searching for more yield and bought riskier bonds, they saw spreads widen out quite quickly. They really suffered.”
But as soon as the spreads widened, Dimensional started to buy those riskier bonds.
“When credit spreads are wider, the market is offering a premium for taking more risk, and you’re compensated for owning lower-rated bonds,” he explains. “People were getting out of these names and putting downward pressure on prices, forcing the yield up.
“We started systematically buying these corporate bonds in March and April, and we held them through the summer when credit spreads came back down; so we did well in this period.”
Why markets work
While terms such as ‘systematic’, ‘factor-based’ and ‘smart beta’ are relatively new concepts in the fixed income space, Dimensional’s process has been proven during its four decades of managing money.
“If I had to describe our process in two words, I would say ‘markets work’,” he explains. “Markets do an excellent job of incorporating information into current prices. And as a systematic, factor-based investment manager, it’s our job to extract information embedded in market prices to inform us about when and what the expected premiums are for investing in various parts of fixed income markets.
“Whatever the sub-asset class of fixed income, we use information in market prices to inform us about when these premiums are more likely to be higher or lower.”
For example, Dimensional has been successfully combining its systematic approach with more sustainable outcomes for the past 15 years. The key, says Cummins, is understanding investors’ sustainability goals and how fixed income assets can help meet those.
“But we also need to recognise that people do care about returns and that you don’t have to sacrifice one for the other,” he explains. “As a systematic manager, we’re only as good as the data we consume. Without good data which can show measurable results, how can we, in good conscience, tell our clients that we’re delivering the outcomes that they’re looking for?”
Cummins says as Dimensional relies on raw data from a range of different providers, it comes up with aggregate scores to help it deliver on targeted sustainable outcomes. But like the systematic fixed income approach, sustainability investing is a constantly evolving area.
“What we were doing several years ago is not what we’re doing today, and what we are doing several years from now will probably be different than what we’re doing now,” finishes Cummins. “It’s like our approach to fixed income: it really evolves with our clients, with the research, and with the marketplace.”
1 Eugene Fama is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP.
2 Fama, E., 1984. The information in the term structure. Journal of Financial Economics, 13(4), pp.509-528.
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