Torsten von Bartenwerffer points out that rising rates do not necessarily mean losses in fixed income, and argues for smarter long-only strategies rather than market-timing or long/short approaches
The economic environment today is radically different from that of the mid-1980s until the outbreak of the financial crisis in 2008. Mostly operating independently of governments, central banks throughout the world were responsible for managing interest rate policy through a period of relatively smooth business cycles and economic growth. In retrospect, this period could be seen as a success – a time of financial innovation, economic development and globalisation.
The pressure on governments and central banks to respond to the financial crisis heralded the end of this era. With interest rates at historic lows, the spotlight is shifting to unconventional monetary and fiscal measures to sustain momentum. This has introduced and will sustain greater volatility in the fixed income markets.
While the use of ‘exceptional measures’ might be far from over, there have already been significant adjustments reflecting expectations that the US Federal Reserve’s use of quantitative easing (QE) may slow. For those investors afraid of the inevitable, it is worth revisiting the behaviour of bonds and equities during former episodes of QE.
Interestingly, bond yields have had a tendency to increase before the end of easing programmes – as we have seen clearly in 2013. The yield on 10-year Treasuries increased from around 1.6% in May to close to 3% by early September – an extraordinarily rapid adjustment (between 2003 and 2006, the 10-year yield averaged around 4.2%). It took less than six months to retrace over 50% of the move, before a further adjustment in response to the postponed QE taper. Contrarily, stocks have always waited until the cheap money stopped before gravity set in.
Although central banks are now attempting to operate with greater transparency, offering ‘forward guidance’, many investors remain puzzled about how to position their portfolio most effectively.
Nevertheless, interest among fixed income investors remains brisk, partly due to the continuing shift towards liability-matching strategies. On the whole, institutional investors intend to retain their fixed interest exposure in spite of short-term uncertainties in the fixed income market.
In a survey by Aquila Capital of 165 institutional investors in Europe in June 2013, nearly a third of the respondents planned to maintain their current fixed income allocation, while a further 29% intended to increase it in future. However, two-thirds of the respondents described the background conditions for bond investors as “challenging” or “very challenging”, with three out of five finding it difficult to generate positive returns within the interest rate cycle. The low-yield environment and diversification, default and inflation risks are considered to be major challenges. These features have led investors to consider alternative investment strategies in the fixed income segment – 44% of the respondents intend to consider risk parity strategies, where the risk of investing in various classes is equally balanced.
As an approach, risk parity is agnostic, recognising that attempting to anticipate events and outcomes within the economic cycle with any degree of accuracy is impossible. Furthermore, even if we knew for sure that the next 30 years would bring rising interest rates only (such as from 1950 to 1980), a short position in fixed income over that time would have reaped a significant loss to investors. While this may be surprising for some, it shows that the features driving fixed income markets are more complex than just looking at the prevailing interest rates and their long-term direction. With the inevitable disconnection that arises between anticipated outcomes and reality, attempting to use market timing or using short strategies in fixed income markets might introduce vulnerability, not enhance resilience. Smart long diversification is the best you can do as a serious investor.
Long-only strategies with the ability to extract smart beta have distinct advantages. For risk parity, the strategy involves allocating capital on a risk-equalised basis to liquid assets that perform differently to one another throughout the economic cycle, without reference to inferences of future returns. Managed effectively, this kind of broadly diversified portfolio can generate positive risk-adjusted returns over the long term, regardless of whether interest rates climb, stagnate or fall.
The same approach can be applied to fixed income, offering investors a diversified and liquid alternative to the traditional fixed income portfolio. Taking risk into account, a balanced investment can be made in a variety of fixed income assets, such as corporate bonds, sovereign bonds, inflation-hedged bonds and emerging-market currencies using a range of instruments offered by different issuers with different yield drivers and durations.
This approach would look to maximise diversification benefits through the careful selection of assets based on the availability of risk premia, for their low correlations to each other and with specific reference to liquidity.
Torsten von Bartenwerffer is director of portfolio management at Aquila Capital