Low interest rates, flattened or inverted yield curves, and central bank policy dominated economic headlines throughout 2019. Caught in the crosshairs are traditional core bond allocations. Nick Maroutsos, Co-Head of Global Bonds, and Adam Hetts, Head of Portfolio Construction and Strategy, discuss the role of global fixed income strategies in the face of these market shifts.
- We believe investor goals – not projections of hard-to-predict rate moves – should drive the investment process.
- We also think reports of the “death of global bond strategies” are greatly exaggerated and that investors should diversify their bond exposure globally.
- Whether rates go up, down or oscillate in between, we believe the role of fixed income remains unchanged: It should serve as the ballast of a broader asset allocation.
Low-to-negative rates can entice investors to extend duration (a measure of a bond price’s sensitivity to rate moves). Under normal conditions, such moves could result in incrementally higher returns. But with the U.S. yield curve having flattened, investors are getting little term premium for holding longer-dated – and, thus, riskier – securities.
Bond prices move inversely to yields. As such, if rates go down or stay flat, bonds with short and intermediate duration (i.e., less sensitivity to rate moves) will likely still deliver positive returns. If rates go up, intermediate duration could see negative returns, while short duration has more potential to either not go negative or be less negative than intermediate.
While it’s certainly possible rates could go lower, we disagree with many who are looking to add extra duration to what is likely an already duration-laden portfolio. We believe investors should diversify their duration and let financial goals drive the investment process, not projections of unpredictable rate movements.
The Death of Global Bond Strategies? We Don’t Think So
After a quick glance at global rates, some investors might think there’s little reason to invest in fixed income outside the U.S. But we think reports of the “death of global bond strategies” are greatly exaggerated.
In fact, today, U.S.-based investors can potentially boost return through currency hedging. That’s because with a hedge, investors earn (or pay) the difference between the domestic and foreign risk-free interest rates used to price the hedge (typically, a foreign exchange forward contract). With U.S. rates higher than those of many other countries, a U.S.-based investor stands to earn an added return that can make lower-yielding global bonds attractive. Furthermore, the hedge helps eliminate the risk that currency fluctuations erode a foreign bond’s return (which, in our opinion, is reason enough to hedge currency risk in foreign bonds).
Regardless of the rate environment, we’re advocates of globally diversifying one’s bond exposure for a couple of strategic reasons. One, over half the global aggregate bond universe is outside the U.S., creating ample opportunity for security selection. Two, throughout long-term rate cycles, we believe it’s best to diversify duration exposure beyond just the U.S.
Case in point: Today, different regions are at different stages of the economic cycle and are not easing monetary policy in lockstep. While capital may be flowing to the relatively higher yields of the U.S., other regions that are likely to skirt recession can offer more reasonable valuations. It’s yet another reason why we think in this low-yield environment bond investors should take a global approach.
Global Opportunities in Corporate Credit
In the corporate credit space, rather than chasing yield by gaining exposure to lower-quality issuers, we believe it’s possible to find attractive opportunities in investment-grade credits outside the U.S. For example, in the Asia ex Japan region, utilities, telecoms and even energy companies are often (at least implicitly) backed by the government and thus can be viewed as relatively safer credits. Furthermore, a low-growth low-inflation environment has historically been favorable for credit.
The key, in our view, is to stay active to avoid regions where recession is more likely and to opportunistically try to capitalize on price dislocations where high-quality names may have been negatively impacted by broad-based negative sentiment.
Where Do Things Go from Here?
We believe global rates will continue to grind lower but that the path will not be linear. In the U.S., we expect positive, but not breakout, economic growth, fueled by a healthy consumer. This may temper the pace at which rates decline, but over the longer term, we believe Treasury yields will head lower.
While the U.S. may avoid recession, other regions may not be as fortunate. With rates already extremely low in Europe, we believe the European Central Bank will have no choice but to re-engage in extraordinary measures to stimulate growth. And economies tightly linked to global trade may have to reduce interest rates further (including Australia).
The upside for core fixed income asset allocators is that it doesn’t really matter where things go from here. Core fixed income’s role in the broader asset allocation is that of a strategic risk manager – a place to focus on diversification, risk management and a sustainable stream of returns rather than market timing and other risky behavior. Whether rates go up, down, or oscillate in between, the role of core fixed income in a portfolio is to serve as ballast – regardless of the next move in markets.