Bond investors beware. The current fixed income market is a wildly different beast to the benign thirty year-old animal to which global investors have grown accustomed. More volatile and unpredictable, investors need to tread carefully if they are to successfully tame an asset class loaded with uncertainty.
Across the fixed income spectrum, global investors face tough allocation calls. A convergence of macro-economic headwinds and shifting fundamentals has created the most unforgiving environments in decades. Historically low spreads, rising rates and the curtain call on the biggest experiment in monetary policy in history mean investors must reset their expectations and call into question the validity of previous convictions.
Avoiding reward-free risk
Investors can work to mitigate the effects of rising rates, but there are no longer any free lunches in this new bond environment, as investors who have been holding government bonds as a safe haven asset and diversification tool have found out – to their detriment. Moreover, buying options instead of bonds has grown less attractive. To avoid falling into pockets of reward-free risk in this brave new world, investors need to be flexible, tactical and creative.
To mitigate the impact of rates, we have adopted a two-sided tactical strategy. The first strand of this strategy is to look at carry without taking large degrees of duration risk. The second is to gain exposure to alternative forms of duration. For example, we like financial credits which are shielded from interest rate rises as banks tend to perform in this type of environment – although we have begun taking profit on this trade as markets have factored in rate rises. We are also seeing some very good opportunities in emerging markets, even after hedging currency risk.
Flexible in fixed income
At this point, we prefer emerging market hard currency bonds over local currency bonds, but this is more of a tactical positioning, given the recent market sell-off. However, there are very interesting investment ideas in the emerging market local space as well. Here, we introduce our first strategy to bond investment, looking for carry without taking too much duration or currency risk.
Brazilian local bonds are a well-orchestrated investment theme and widely held by investors, but investments are generally done by taking on a great deal of currency risk. Up until six months ago, owning FX risk was the only way to access the high yield levels Brazil has to offer. However, persistent interest rate cuts by the central bank has brought the currency hedging cost down by a significant degree.
At the same time, the Brazilian yield curve has risen in absolute terms but remained fairly flat, allowing investors to access comparatively high levels of carry without taking much duration risk. For a GBP investor, a fully currency hedged five-year Brazilian bond yields approximately 4.6% and for a EUR investor, the yield level is roughly 3.8%. These are very good levels given the overall duration of such a position is 3.5 years. Brazil is a low-risk way of getting carry into the portfolio, while limiting the duration exposure.
Tactical opportunities in treasuries
In terms of accessing mainstream fixed income exposure and duration risk, investors need to be prepared to take contrarian positions. A thirty-year bond bull run with a downward yield slope has clearly come to an end, but that does not mean we have entered a bear market that will progress in a straight line. Investors need to take advantage of tactical opportunities as the market oscillates – and we are already exploiting mis-pricings.
The US treasury market is illustrative. While bond investors have systematically underestimated the monetary policy path orchestrated by the Fed for most of 2017, market expectations for interest rate hikes in 2018 are in our view still at the lower end of the spectrum. Moreover, the vast majority of investors expect inflation to rise from here – thus there is a fair amount of inflation expectation built into current bond yields.
This tells us there is more risk to the downside rather than the upside, meaning that if growth and inflation numbers come in a bit weaker than expected, the downward move in yields could be much sharper than a potential upward move from here if US growth and inflation surprise on the upside. As a result of this potential asymmetry, we have started to re-enter treasuries, for the first time since mid-2016. Within our Diversified fund range, we hold 12% and 8% in our EUR and GBP versions respectively.
Asset allocators face a challenging fixed income environment, as a new bond era takes shape. However, if investors are prepared to challenge preconceptions, hunt in unloved areas of the market and take a tactical approach, there is an opportunity to generate returns while mitigating duration risk.
Hartwig Kos, co-head of multi-asset at SYZ Asset Management and portfolio manager of the Oyster Diversified GBP fund