By Bill Eigen, fund manager, JPMorgan Funds – Income Opportunity Fund
It is news to no one that central bank action has broken the interest rate market. Rates do not respond to traditional factors like economic growth or inflation fundamentals; instead they react to statements from the US Federal Reserve and the ECB. And with central banks showing no sign of easing off the accelerator, the race to zero rates continues. Under a zero-rate scenario, it has become almost mathematically impossible to make money in traditional fixed income.
Europe, which has become the global epicentre of the hunt for yield, is pushing the forefront of the zero bound, testing fundamental tenents of investing. Six weeks into an 18 month programme of ECB stimulus and the effects are already profound. German 10 year Bunds are yielding just a few hundredths of a percentage point above zero (7.5 bps).
It’s conceivable (even likely) that soon investors will effectively be paying for the privilege of borrowing money from core European governments. And there is no reason to think that we can’t go further down the rabbit hole in Europe.
In the US, the Federal Reserve continues to find reasons to delay the process of returning to rate normalisation, even after seven long years of no rate increases. While they are slowly edging closer, unfortunately we think rates will continue to be range bound for the balance of the year, if we’re being realistic. Our concern is that the longer that the Fed puts off the initial lift-off, the worse the potential impact on bond investors.
As a global illustration of the disruptive consequences of a potential rate move for investors, consider a common global sovereign bond index, where the current average yield is at an all-time historical low of 1% with a duration (or interest rate sensitivity) of about seven years. If interest rates were simply to normalise from here, even just edging back towards where they were during the heart of the financial crisis, investors long on this index would stand to lose 10% to 20% of their principle, depending on the duration.
Investors cannot afford to be complacent in this environment. They have to grasp that traditional fixed income can’t do what it was supposed to do anymore. Fixed income was meant to do three things: provide income, preserve capital and offer diversification benefits compared to other commonly held asset classes like equities. Clearly when rates are at nearly zero, there’s no provision of income in fixed ‘income.’ Correspondingly, capital preservation is no longer assured when bonds carry such high interest rate and duration sensitivity. Even the diversification benefit has faded away as asset classes move in lock step thanks to central bank stimulus.
With the case for traditional fixed income eroding, an absolute return strategy makes sense for investors. Taking a flexible approach to move between sectors depending on the market can help to preserve capital and outperform cash. The ability to capitalise on relative value between various instruments as well as market (beta) exposures means investors can be well positioned in a rising interest rate environment. And absolute return strategies can exploit price anomalies across traditional and alternative markets to generate alpha across market cycles.
So where are the opportunities to generate uncorrelated returns, irrespective of prevailing conditions? The rewards granted for risk taken look unfavourable in most areas of the market for an absolute-return oriented investor – capital should only be deployed when investors are well compensated for undertaking risk. Holding cash is a sensible hedge and preserves liquidity to be activated opportunistically and on a contrarian basis.
That said, there are reasonable pockets of opportunity such as US high yield, which seems selectively mispriced. Default rates are low and the asset class continues to benefit from extremely accommodative monetary policy and offers an attractive 7% to 8% coupon. There are also more esoteric areas of the market like select non-agency mortgages securities that don’t have direct interest rate sensitivity that look interesting.
In today’s highly distorted bond environment, no one has a map to safely navigate the path back to normalisation. We are truly in unprecedented territory. Investors would be wise to focus on stability, reducing the likelihood of capital losses and preserving capital. Above all, recognise the mathematical realities facing traditional fixed income and get diversified.