Of all the asset classes touched by concerns over central bank policies, a slowdown in China and emerging market turbulence, none has been hit more than fixed income. European pension funds stand to be most affected by these market developments if their long-term strategies do not evolve in turn.
The US Federal Reserve is tapering its asset purchase programme which is on course to end by October 2014. It has raised investors’ expectations that an interest rate increase could occur as early as next year.
However, European monetary policy is going in the opposite direction. Investors are expecting that falling inflation and subdued growth will force the ECB to initiate further monetary easing. Deflation is a possibility, with inflation well below the targeted level of 2%, and the central bank has suggested it could introduce non-standard measures in an attempt to stimulate growth.
At the same time, the Bank of England has postponed its first rise in interest rates, thanks to the absence of inflationary pressure and a shift in focus away from unemployment rates. Behind all of these central bank decisions lie mixed economic data that have fuelled concerns about global growth. Bad weather has distorted US growth figures and China’s economy is experiencing a faster-than-expected slowdown.
These divergent monetary policies amplify the pressure on managers of pension fund assets to control and mitigate different market risks – one of which is interest rate risk. Short duration credit has become useful as a result, as it effectively lowers an investor’s exposure to both interest rate and credit risk. Investors can also use interest rate-hedged funds to reduce interest rate exposure, while maintaining full credit exposure to underlying bond markets.
The upshot of changing fixed income dynamics is that investors have to alter their strategies if they wish to achieve anything like historic returns. There remain opportunities in fixed income, but with the current environment set to persist for some time, European investors will need a more unconstrained approach to find yield and capital growth.
Emerging market debt had been a favoured asset class for investors looking for yield enhancement, until a pullback from the retail side sparked reports that this was an asset class in crisis.
But, long-term investors have good reason to continue to choose emerging market debt as an alternative to traditional developed market income. It is not just a yield story but a credit quality and capital growth one, if investors are willing to accept volatility.
Outflows over the last nine months have been from both US dollar and local currency denominated debt and have had an indiscriminate impact on valuations, meaning that the asset class is now trading at a discount to comparable developed market debt. Current valuation levels do not recognise that the asset class’s fundamentals are stronger than in the past, and provide an appealing entry point for many investors looking for capital growth. Credit quality over the last decade has improved, both in an absolute sense and relative to other fixed income investments. There has also been a significant improvement in market liquidity and depth.
Investing in local currency debt requires you to look at each currency and economy separately, from its current accounts, monetary and fiscal policies as well as economic fundamentals. While this area is starting to offer value, some investors may instead choose to side-step its elevated currency risk and find the risk-reward features of US dollar denominated debt more appealing.
As well as which markets to access, an additional consideration is how to access fixed income. Actively managed strategies may be the best route to generating returns for some investors. For others, risk-adjusted returns might be more attractive through beta exposure. But whatever vehicle is chosen, one thing is for certain, the fixed income landscape is changing and investors will have to adapt with it.
Stephen Cohen is chief investment strategist EMEA at iShares