Combatting bond market volatility with global diversification

12/04/2019

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​Nick Maroutsos, Co-Head of Global Bonds, explains why it is important to focus on quality bonds in periods of potential bond market volatility.  

The backdrop for global interest rates has changed significantly since last autumn, but that does not mean risks for bond investors have diminished. While the threat posed by interest rates may have subsided, an extended credit cycle, weakening corporate profitability and myriad geopolitical risks are all factors that could potentially spell upheaval for bond markets. Possibly aggravating the situation are real yields having reset to a higher level, which – as we saw in 2018 – can be an ingredient for increased market volatility.

But with real yields at the end of March 2019 back below 1% in the US and negative across much of the developed world, bond investors still face the challenge of generating sufficient income. Consequently, we again find ourselves in an environment in which a fixed income strategy must work harder to find risk-adjusted return opportunities. This challenge, in our view, is most acute within core bond strategies, especially in regions where benchmark rates hover near 0%. We believe one tactic that merits consideration under such conditions is increasing one’s allocation to short-duration strategies not tethered to traditional bond benchmarks. The combination of greater flexibility in calibrating duration and credit exposure, along with the potential for geographical diversification, may help a portfolio to absorb another round of elevated market volatility. And given the risk factors delineated above, such an eventuality would not surprise us.

Not your parent’s duration

With last autumn’s concerns about wage-driven inflation a distant memory and the yield on 10-year US Treasury bonds now back below 2.5%, one may be tempted to increase duration. Reinforcing this view is the US Federal Reserve (Fed) dialling back expectations for a 2019 rate increase and inferring that it would likely cease its balance sheet reduction programme. We are not alone in expecting the Fed’s next move to be a rate cut. The re-emerging dovish bias of global central banks is further illustrated in the European Central Bank’s (ECB) recent decision to introduce a new round of loans to financial institutions.

Despite these temptations, we see little upside in increasing exposure to longer-dated bonds. Our caution is based on the current shape of the US Treasuries yield curve, which is the flattest it has been in the post Global Financial Crisis era, as measured by the spread between the 2-year and 10-year notes. With this term structure, we see little incremental advantage to be gained per unit of risk when extending maturities.

Chart 1: Flattening US Treasury yield curve

The recent yield curve inversion means that US Treasury bills up to 1-year in maturity yield more than many longer-dated notes, but with lower duration risk.

 

Source: Bloomberg, as at 27 March 2019.

When comparing the Bloomberg Barclays US Aggregate Bond Index with the Bloomberg Barclays 1 to 3 Year Government/Credit Index, the latter’s yield to worst – at 2.43% – offers 84% of the yield of the broader index with only 33% of its interest rate risk as measured by modified duration (see chart 2). In short, investors are not being sufficiently compensated for taking on additional risk.

Chart 2: Yield-to-worst and duration of core bond market segments

At this juncture, we see little incremental advantage to be gained per unit of risk when extending maturities.

 

Source: Bloomberg, as at 26 March 2019. Note: Duration is a measure of sensitivity of a bond price to changes in interest rates. Yield-to-worst represents the lowest yield that an investor can receive on a bond without the issuer defaulting.

Furthermore, with the Fed’s next move likely to be an interest rate cut, we believe that the front end of the curve has greater room to rally than longer-dated securities. Given the low yields on longer-dated government debt, especially in the eurozone, UK and Japan, we see little impetus for prices on these maturities to rise, unless one believes we are on the cusp of a global recession – a potential outcome that has likely decreased due to the recent dovish pivot by the Fed and the ECB.

Not out of the woods – by any means

A low-growth, low-inflation environment at first glance may appear conducive for bonds. Unfortunately, it is occurring during an extended credit cycle in which riskier assets appear richly valued: after last autumn’s spike, the spread on both investment-grade and high-yield corporate credits and their risk-free benchmarks have returned to levels well below their post-crisis average. Should central bank – and market – prognostications of slower economic growth come to fruition, the highly levered balance sheets of the corporate sector may come under pressure as revenue growth slows. A potential warning sign is aggregate revenue growth of the S&P 500 Index component companies only reaching 6%, year over year, in the fourth quarter of 2019.

A global opportunity set

With interest rates low, however, credit becomes an ever more important factor in generating sufficient yields. Here, too, a greater reliance on an unconstrained strategy may help investors achieve their objectives. While elevated corporate debt levels are prevalent in the US, and Europe is flirting with recession, there are compelling credit stories in other regions that can be accessed when stepping away from regional benchmarks. These stories often encompass robust secular themes such as the growth of banking in emerging Asia and infrastructure spending – often government backed – in several regions. An unconstrained approach allows investors to avoid, rather than just underweight, segments of a benchmark – either a sector or a region – that may be structurally challenged.

Last autumn, we highlighted the need for focusing on regions where monetary authorities were likely to pause, or even cut, interest rates. The US now fits into that camp. Yet, a flat Treasuries curve dissuades one from holding longer-dated duration in the US. So too does the country’s involvement in the ongoing trade spat with China and the political risk emanating from Washington. Other countries, in our view, offer similar interest rate profiles with considerably less baggage.

With an eye toward volatility

Last autumn’s volatility – after an extended period of tranquillity – served as a reminder for bond investors that capital preservation is no sure thing. Our greatest concern remains market liquidity. While late 2018 may have caught investors’ attention, the post-crisis market-clearing infrastructure has yet to be truly tested. Given the array of risks in the marketplace, any number of scenarios could lead to a liquidity event in which price dislocations are pronounced. Therefore, investors must remain on high alert for signs of potential market stress. In addition to monitoring liquidity, we believe sufficient respect must be paid to traditional volatility metrics such as interest rate volatility, credit default swap pricing and foreign currency movements. The latter takes on elevated importance as exposure to foreign currency-denominated securities increases.

Vigilance with regard to these metrics may give investors the advanced notice needed to dampen portfolio volatility, but portfolio construction may also further the cause. In an environment marked by low growth and high debt, and with central banks remaining a swing factor in markets, a globally diversified portfolio can help moderate volatility by targeting maturities, regions and issuers with the most attractive risk-adjusted return profiles, while avoiding those where the risk asymmetry is too great.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

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  • When the Fund, or a currency hedged share class of the Fund (with ‘Hedged’ in its name), seeks to mitigate (hedge) exchange rate movements of a currency relative to the Fund’s base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • Callable debt securities (securities whose issuers have the right to pay off the security’s principal before the maturity date), such as ABS or MBS, can be impacted from prepayment or extension of maturity. The value of your investment may fall as a result.

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For institutional/ sophisticated investors / accredited investors qualified distributors use only.

All content in this document is for information or general use only and is not specific to any individual client requirements. The information contained in this document is referential and may not be construed as an offer, invitation or recommendation or investment advice, nor should be taken as a basis to take (or stop taking) any decision.

Janus Henderson Capital Funds Plc is a UCITS established under Irish law, with segregated liability between funds. Investors are warned that they should only make their investments based on the most recent Prospectus which contains information about fees, expenses and risks, which is available from all distributors and paying agents, it should be read carefully. An investment in the fund may not be suitable for all investors and is not available to all investors in all jurisdictions; it is not available to US persons.  Past performance is not indicative of future results. The rate of return may vary and the principal value of an investment will fluctuate due to market and foreign exchange movements.  Shares, if redeemed, may be worth more or less than their original cost.

Janus Henderson Group plc and its subsidiaries are not responsible for any unlawful distribution of this document to any third parties, in whole or in part, or for information reconstructed from this document and do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regards to the results obtained from its use. As with all investments, there are inherent risks that each individual should address.

The distribution of this document or the information contained in it may be restricted by law and may not be used in any jurisdiction or any circumstances in which its use would be unlawful.

Issued in Europe by Janus Capital International Limited (“JCIL”), authorised and regulated by the U.K. Financial Conduct Authority. Janus Capital International Limited (“JCIL”) is an entity registered and operating under the laws of the United Kingdom and Janus Capital Funds plc. is registered under the legislation of Ireland.

The extract prospectus (edition for Switzerland), the articles of incorporation, the extract annual and semi-annual report, in German, can be obtained free of charge from the representative in Switzerland: First Independent Fund Services Ltd (“FIFS”), Klausstrasse 33, CH-8008 Zurich, Switzerland, tel: +41 44 206 16 40, fax: +41 44 206 16 41, web: http://www.fifs.ch. The Swiss paying agent is: Banque Cantonale de Genève, 17, quai de l’Ile, CH-1204 Geneva. The last share prices can be found on www.fundinfo.com. For Qualified investors, institutional, wholesale client use only. Outside of Switzerland, this document is for professional use only. Not for onward distribution.

This material is strictly private and confidential and may not be reproduced or used for any purpose other than evaluation of a potential investment in Janus Capital International Limited’s products or the procurement of its services by the recipient of this presentation or provided to any person or entity other than the recipient of this presentation.

We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Janus Capital Management LLC serves as investment adviser. Janus, Intech and Perkins are registered trademarks of Janus International Holding LLC. © Janus International Holding LLC. For more information or to locate your country’s Janus representative contact information, please visit www.janushenderson.com.

Specific risks

  • This fund is designed to be used only as one component of several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.

Risk rating

Janus Henderson Absolute Return Income Opportunities Fund

For institutional/ sophisticated investors / accredited investors qualified distributors use only.

All content in this document is for information or general use only and is not specific to any individual client requirements. The information contained in this document is referential and may not be construed as an offer, invitation or recommendation or investment advice, nor should be taken as a basis to take (or stop taking) any decision.

Janus Henderson Capital Funds Plc is a UCITS established under Irish law, with segregated liability between funds. Investors are warned that they should only make their investments based on the most recent Prospectus which contains information about fees, expenses and risks, which is available from all distributors and paying agents, it should be read carefully. An investment in the fund may not be suitable for all investors and is not available to all investors in all jurisdictions; it is not available to US persons.  Past performance is not indicative of future results. The rate of return may vary and the principal value of an investment will fluctuate due to market and foreign exchange movements.  Shares, if redeemed, may be worth more or less than their original cost.

Janus Henderson Group plc and its subsidiaries are not responsible for any unlawful distribution of this document to any third parties, in whole or in part, or for information reconstructed from this document and do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regards to the results obtained from its use. As with all investments, there are inherent risks that each individual should address.

The distribution of this document or the information contained in it may be restricted by law and may not be used in any jurisdiction or any circumstances in which its use would be unlawful.

Issued in Europe by Janus Capital International Limited (“JCIL”), authorised and regulated by the U.K. Financial Conduct Authority. Janus Capital International Limited (“JCIL”) is an entity registered and operating under the laws of the United Kingdom and Janus Capital Funds plc. is registered under the legislation of Ireland.

The extract prospectus (edition for Switzerland), the articles of incorporation, the extract annual and semi-annual report, in German, can be obtained free of charge from the representative in Switzerland: First Independent Fund Services Ltd (“FIFS”), Klausstrasse 33, CH-8008 Zurich, Switzerland, tel: +41 44 206 16 40, fax: +41 44 206 16 41, web: http://www.fifs.ch. The Swiss paying agent is: Banque Cantonale de Genève, 17, quai de l’Ile, CH-1204 Geneva. The last share prices can be found on www.fundinfo.com. For Qualified investors, institutional, wholesale client use only. Outside of Switzerland, this document is for professional use only. Not for onward distribution.

This material is strictly private and confidential and may not be reproduced or used for any purpose other than evaluation of a potential investment in Janus Capital International Limited’s products or the procurement of its services by the recipient of this presentation or provided to any person or entity other than the recipient of this presentation.

We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Janus Capital Management LLC serves as investment adviser. Janus, Intech and Perkins are registered trademarks of Janus International Holding LLC. © Janus International Holding LLC. For more information or to locate your country’s Janus representative contact information, please visit www.janushenderson.com.

Specific risks

  • Some or all of the Annual Management Charge and other costs of the Fund may be taken from capital, which may erode capital or reduce potential for capital growth.
  • This fund is designed to be used only as one component of several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.

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