The fixed income investor of the future will have to look beyond the conventional to uncover the yield they so desperately crave today.
Over the next 20 years, investors will have to cast a wide net to find the best risk-adjusted returns for their portfolios. Fixed income investors will still need core investments – such as US Treasuries and other highly rated sovereign debt – but they’ll also need to have the flexibility to invest across the global fixed income markets to make sure they’re maximising returns while still being mindful of preserving capital.
This isn’t to say investors need to take on more and more risk. Rather, they’ll need to be smarter, more active investors that aren’t constrained by their home bias.
On paper, the news in the past 20 years has been largely positive: the global debt markets have quadrupled to nearly $ 100 trillion, opening up a host of new investment products, geographies and opportunities. Economic growth and the capital needs of companies, homeowners and governments have spawned a deep and sophisticated marketplace for investors searching for fixed income.
Yet, unfortunately for investors, this expansion has coincided with a dramatic decline in interest rates for core bonds, with the Barclays Capital US Aggregate Index, for example, dropping from a 7% yield two decades ago, to 1.9% today.
And, if investors think they’re having a tough time now, this low-rate environment is likely to persist for the next few years as a large global debt burden, muted growth and modest inflation put pressure on central banks around the world to keep current interest rates low in order to stimulate economic growth.
In such an environment, it is crucial for income oriented investors to have the flexibility to look for opportunities outside of their core market where a continued economic slowdown may lead to additional interest rate cuts and price appreciation for government bonds, or turn to non-core sectors, such as in non-agency residential mortgage-backed securities.
Although central banks have been relatively effective in reducing volatility in financial markets, there are still risks of a disruption. The financial markets’ violent response to the UK’s vote to leave the European Union is an example of what may lie ahead.
Extraordinary monetary policy – including zero bound (or even negative) interest rates and massive quantitative easing – runs the risk of becoming less and less effective the longer it’s deployed. This environment of “insecure stability” is likely to be more prone to bond market volatility in the years ahead, particularly in assets where central bank intervention has been greatest – namely core and highly-rated debt. Investors must also focus on capital preservation as record high global debt levels, low nominal growth rates and increasing political uncertainty will lead to far greater risk of capital impairment.
At the same time, while volatility can be negative for investors, it may also give rise to opportunities. We’ve seen it before. Following the financial crisis, non-agency mortgage-backed securities proved to be an investment of a lifetime, yet they weren’t found in any of the popular indexes, which still reflected the bond market of 20 years ago.
These securities, most of which had been downgraded to speculative grade by rating agencies following the collapse of the US housing market (as measured by Bank of America Merrill Lynch US Fixed Rate Home Equity Index), returned 11.6% per year between January 2009 and June 2016 versus the Barclays Capital US Aggregate Index’s 4.5%.
Other fixed income sectors will provide opportunities during periods of global economic uncertainty and fragile market sentiment. Investors must be vigilant, as small policy actions or market events may have an outsized impact on market repricing.
What we do know with certainty is that the bond market of the future won’t look like the one of the last 20 years. It is likely to have lower yields, potentially less liquidity and more frequent bouts of volatility, at least for the foreseeable future.
That may sound daunting for investors who just want to sleep at night knowing they’ll have enough money to take them through retirement. But there are ways to cope. Investors should seek to remain flexible to find opportunities when volatility causes asset prices to overshoot their fundamental value. And, if investors have the ability and inclination to embrace opportunities across diverse areas of the global debt markets, they’ll be much better positioned to ride what could be a bumpy road over the next 20 years.
• Dan Ivascyn, who worked at T Rowe Price, Fidelity and Bear Stearns before joining Pimco in 1998, is group chief investment officer and a managing director in Pimco’s Newport Beach office