November, 2012 Print
Andy Howse, Investment Director, UK Institutional Fixed Income, Fidelity Worldwide Investment.
The financial crisis of 2008 and the ongoing eurozone debt crisis have altered the investing landscape. Sovereign credit risk has become the dominant driver of risk in European and global fixed income portfolios and a key influence on financial markets generally. Bond investors are being forced to recast long-held assumptions about risk. The concept of “risk free” has been shaken and the present combination of indebted sovereigns, challenged economic growth prospects and low interest rates seems set to become an all-too familiar backdrop for investing in capital markets.
This new risk landscape offers risks and opportunities. However, investors must ask fundamental questions about what they want from their bond portfolios. Sovereign risk is urging a shift away from traditional marketweighted benchmarks towards more flexible alternatives. We are also seeing a reassessment of corporate versus sovereign credit risk, with investors increasingly embracing the idea that corporate bonds can trade inside sovereigns.
Bond investing in a new risk landscape
The investment environment has changed markedly in recent years. The risk environment has been transformed by the 2008 credit crisis and the ongoing sovereign debt crisis (see Figure 1). The crisis actions taken by developed world governments and central banks have dramatically increased debt-to-GDP ratios around the world, tipping some economies, such as Greece, into an economic tailspin. In the periphery of Europe, sovereign risk has been dramatically re-priced upwards. Meanwhile, interest rates and bond yields in parts of the developed world seen as most economically and fiscally robust have fallen to record lows, increasing the price of safety (see Figure 2). Indeed, major government bond yields have trended down strongly since 1982.
However, the scope for this trend to continue is clearly now constrained by the present low yields.
History suggests that major credit crises require multi-year workouts. Indeed, the combination of debts, challenged growth prospects, low interest rates and deflationary forces that we see today could be sustained for a prolonged period – becoming “business as usual” for the foreseeable future. Secular growth drivers continue to reshape the global balance of economic power, with many emerging markets now offering more attractive fundamentals than their developed world counterparts. As a result, bond investors are expanding their horizons by both asset and geography, increasingly considering higher yielding bonds and emerging market issuers.
A historic reassessment of risk
“Risk-free” assets were, until recently, a key cornerstone of financial market and investing theory. They provided a starting point, or a comparative anchor, for investment decisions. The realisation that some of the largest risks in the bond universe resided in what was seen as the lowest-risk end of the spectrum has been a watershed moment for investors.
In the last two years, we have witnessed a massive 70% reduction in the pool of risk-free assets.1 In August 2011, US debt was downgraded from triple A; this was followed by downgrades to France and Austria. While 68% of economies carried a triple A rating at the end of 2007, that proportion had dropped to 53% by the end of 2012. The IMF believes that a further $9 trillion could be removed from the overall stock of “safe assets” by 2016. Safety has become a characteristic that can be lost very quickly if market perception deteriorates. Once questioned, money quickly flows to even “safer” assets.
The reduction in the pool of assets considered safe (combined with greater demand) has had the effect of significantly increasing the price of safety. It has also raised some concerns over herding as investors have crowded into a shrinking handful of “safe-havens” sovereign assets, such as US Treasuries, German Bunds and Swiss government bonds. In hindsight, investors were somewhat spoiled in years gone by; risk-like returns for taking little-to-no risk are over. While the present sovereign issues will eventually recede, this is likely to be a multiyear process.
The safe haven problem
The high price of safe assets reflects their relative scarcity, as well as investor perceptions of the risk associated with the European debt crisis, and their concerns over the stuttering recovery in many OECD economies. While the Federal Reserve has made it clear that it expects to keep interest rates low for some time, forward markets are pricing in an extremely long period of very low real rates. The shortage of safe assets relative to demand has caused a squeeze in a narrower group of safe havens which remain negatively correlated to risk assets, such as US Treasuries and German bunds.
US Treasuries have become an expensive and crowded trade and there is a growing debate over whether the long-term bull market is over and a bear market is now due. The perceived position of US Treasuries as a safe haven has been relatively assured despite the country’s twin deficits and the downgrade of its sovereign credit rating. Indeed, the volatility caused by the downgrade saw further safehaven flows into, rather than out of, Treasuries. Author Jim Grant captured the mood of many investors when he remarked that traditionally risk-free Treasuries now offer a “return-free risk”.
A key issue is that the two biggest buyers of Treasuries, the US Federal Reserve and China, are both relatively insensitive to value. The Fed is explicitly trying to manipulate bond prices as part of its monetary policy framework. China is the largest foreign creditor to the United States, owning around $1.2 trillion of US debt, over a quarter of the $4.5 trillion held by countries outside the US. The reason that such a significant part of China’s $3 trillion in foreign currency reserves is held in dollars is that other there are few liquid alternatives with sufficient market depth that would not introduce a higher level of currency risk.
The yields on US Treasuries can stay low given these factors, supporting their ongoing status as a genuine “safe haven” in an age of uncertainty. Some commentators point to the danger of a liquidity trap where bond yields drop towards their lower limits and remain there, following the example of Japan. Regardless, such low yields send a clear signal to value investors. With yields lower than 2% in the major economies, there is limited prospect of matching past returns in government bonds from this starting point. A reversion of yields to their long-term average would result in low or negative returns. Were investors to use the last 30 years of the government bond index as a predictor of returns over the next 30 years they would be doomed to disappointment.
On the other hand, achieving shelter in periods of risk-off volatility has become markedly more difficult – at these times the benefit of being invested in US Treasuries is clear. Strategic fixed income managers will continue to invest tactically in such “safe assets” to provide genuine, liquid diversification and negative correlation to riskier assets.
Practical strategies for bond investors “best issuer” portfolios
The polarisation of government bond markets is creating concentration and liquidity risks among a shrinking set of overvalued safe-haven assets. Yet, many investors will still be looking for a lower volatility bond portfolio, which goes some way to replacing traditional allocations managed to marketweighted sovereign and aggregate bond benchmarks.
There is a clear imperative for investors to consider a broader exposure to high-quality bonds beyond traditional government issuers. By broadening the universe, one can build high-quality, diversified portfolios based on best issuers in the sovereign and investment grade markets. First, by including sovereigns which score highly on solvency, liquidity and currency strength, such as Australia and Canada, one can bring about sensible diversification and introduce currencies that reduce overall portfolio risk. Second, one can include the high-quality investment grade bonds of multinationals, such as Proctor & Gamble and Johnson & Johnson. Such companies benefit from global reach in relation to national risks, as well as strong cash flows and healthy balance sheets. They offer better credit risk characteristics than many sovereigns and allow investors to offset sovereign concentration risks.
Bond investors are having to adjust to a very different risk/return environment in the light of the financial and sovereign crises. Debt and deleveraging will remain powerful themes for the next decade as indebted sovereigns, led by the US, attempt to reflate their economies. Over the next 10 years, real returns for investments in government bonds are likely to be below average.
These changes require investors to think afresh about investing in fixed income. Investors should review the risks and returns they expect, and question the benchmarks and portfolios in which they are invested. Traditional rule-based approaches to bond investment have had the foundations torn from under them. The traditional practice of measuring portfolios against market weighted indices has been exposed as flawed. Meanwhile, the idea that ratings agencies provide investments with a stamp of safety has been weakened. Ratings downgrades – typically well after bond prices had already deteriorated significantly – have become a recurrent feature of capital markets in recent years.
In building bond portfolios, an active, fundamental approach to security selection, the ability to disaggregate risks and a focus on diversification and flexibility provides a toolkit for avoiding blowups. Investing in best issuer portfolios can be an attractive solution for investors looking for income but unwilling to introduce significantly higher risk.