February, 2016 Print
Karsten Bierre, Head of Fixed Income Asset Allocation, Nordea Investment Management.
Karsten Bierre of Nordea Investment Management outlines the challenges facing fixed income investment today and highlights the importance of robust risk management in a period of volatility
In today’s low yielding and fast changing macroeconomic environment, the need for active management in fixed income is greater than ever. When should an investor take on duration risk? When should an investor bring down credit risk? Should an investor favour government bonds over investment grade bonds? What about currency risks? Is liquidity a major issue in bond markets? These questions are extremely difficult to answer in a rapidly fluctuating investment landscape.
We believe it will be increasingly challenging for a single fixed income sub-asset class to offer attractive returns alongside low levels of overall risk in the coming years. Therefore, it is important to identify which fixed income sub-asset classes, when combined in a truly balanced and flexible portfolio, are best placed to smoothly ride bouts of volatility.
Why constructing portfolios on top-down views is flawed
At the start of every year we are always asked to share our view on markets for the upcoming months. Although it’s understandable that an outlook needs to be provided, this exercise can often be counterproductive, as can be difficult to predict the behaviour of markets over such a short period of time.
This is why our Multi Assets team does not spend too much time trying to guess what markets will do, focusing instead on understanding the behaviour of asset classes in order to find an optimal combination of lowly correlated – in this case fixed income – assets able to generate positive returns over a full investment cycle independently of what market environment finally plays out.
Many fixed income investors manage duration and credit exposure actively, but often reshuffle portfolios according to top-down views: trying to anticipate and interpret announcements of central banks or macroeconomic data. The temptation of strongly tilting a portfolio towards an expected market or macro scenario, hence heavily overweighting a particular fixed income sub-asset class, proves to be a delicate and difficult exercise over the long run and often leads to inconsistent returns and higher risk, as we saw last summer and also early this year.
To avoid those top-down related risks and to deliver a portfolio able to deliver in environments, we rely on risk balancing principles. This means allocating risk evenly between conservative and aggressive fixed income assets.
Flexibility required in today’s challenging fixed income environment
As mentioned earlier, it is our view that the historical risk-adjusted returns of most fixed income sub-asset classes are unlikely to be repeated over the next 12-36 months. And conservative assets, such as government bonds, will particularly struggle to repeat historical risk-adjusted returns.
In this challenging low-yield environment, it is imperative for investors to have even more flexibility to look beyond traditional fixed income assets. The key is it to find the right balance between assets that could protect the portfolio if a downturn were to occur, with investments that can drive the portfolio and its returns when markets are going up.
For protection purposes in government bond markets, the Multi Assets team currently favours US Treasuries and UK Gilts over German bunds. Both US and UK government bond markets offer a much higher level of yield, therefore a higher potential of protection in case of a downturn, for a similar level of duration risk.
On the risky side of the fixed income spectrum, high yield spreads may offer a more attractive risk and reward proposition than investment grade equivalents. The same can be said about US high yield over EU high yield. Despite higher energy exposure, meaning additional sensitivity to today’s volatile oil price, the current spread levels seen in US high yield markets when adjusted for expected default rates make a compelling case to hold these assets alongside US and UK government bonds.
Currency overlays can also provide stability for investors
In addition to the fixed income allocations, it might also be prudent to employ an active currency management overlay for additional portfolio stability. To compensate for the low yields available in today’s safe haven government bond markets – when risk appetite decreases among investors – it may be necessary to find anti-beta solutions.
For that particular purpose the approach we take is to implement relative value trades between the currencies of developed market countries – one long position and one short. The rationale is that certain currencies tend to behave as safe haven assets during stressed markets environments as long as they are considered to be cheap from purchasing power parity perspective. These currency pair trades are expected to protect portfolios as traditional safe government bonds would have normally done – if yields levels were not at the exceptionally low levels they are currently.
Utilising the entire spectrum can provide additional liquidity
Another important consideration for fixed income investors currently is market liquidity. Again, the Multi Asset team believes investors should have the flexibility to invest across the spectrum. Our team looks to allocate to highly liquid physical bonds – such as high quality government bonds from developed markets or European Covered bonds. In addition, we employ plain vanilla derivatives, such as US treasury and German bund futures, as well as credit default swaps on investment grade, high yield and emerging market debt.
It is worth noting over-the-counter derivatives, such as credit default swaps, tend to exhibit higher liquidity during stressed periods than physical bonds. This was evident during the global financial crisis of 2008. This feature means that even if bid/ask spreads increase when volatility spikes, it should still be possible to trade in and out of the assets.
Diverging monetary policies, continued low yields, and higher downside risks are just some of the challenges facing fixed income investors today. In such a situation, flexibility and strong risk management are paramount to navigate through the increasing volatility, while still generating attractive returns.