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Rethinking the Fix for Income Returns
Historically, bonds played a reasonably predictable role in portfolios. Fast forward to the current day, where the market environment faces several challenges caused by low and often negative interest rates, increased market risk and fractured liquidity, which is disrupting the ease with which bonds can be bought and sold.
Bonds are now cushioned by vast amounts of cash from supportive central banks, they are much more difficult to get away from and are no longer behaving in the same way. It takes a brave and much more careful investor to tread a path through the new bond markets of today.
We have entered a new paradigm in which the old ways no longer work. In no small part, the change is down to central banks, who are using bonds as a policy tool to keep interest rates low, generate economic growth and avoid deflation. The central banks therefore don’t care too much about the price of the bonds they are buying. They will continue to buy them regardless.
The result is a marked decline in the yields bonds pay out, often into negative territory. But investors still need to find returns to meet their own objectives, which means they are forced to look further afield than they did historically. With that comes greater risk, however, which should prompt a change in strategy for bond investors.
To use an analogy: an investor wants to buy a reliable, but cost-effective car. The most reliable premium-brand cars are all too expensive because a bank is buying them up irrespective of price. The buyer must therefore take a bigger risk with their purchase by considering older, cheaper cars and those made by non-premium brands. As soon as the investor starts down this path, however, the only way to ensure they will still get from A to B reliably is by selecting more carefully based on keener analysis of the actual state an individual car is in.
The same is true of bonds. The further down the quality or ‘credit’ spectrum an investor goes or the longer the period before a bond reaches maturity (‘duration’), the more important it is to understand the genuine quality of the bond in question based on its fundamental attributes.
With interest rates set to remain lower for longer, there is no end in sight for this trend and its impact on the market is profound. Because investors are taking on more risks, they have become more sensitive to changes in the market place, thus questioning the safety role of bonds in a portfolio. As a result, small changes in interest rate expectations, for example, are creating much bigger movements in price, but it has also changed the nature of their relationship with equities. Bonds increasingly trade up and down in unison with equities, rather than counter to them. Thus bonds traditional role in a portfolio is no longer valid in today’s new world.
Now consider that, because of factors like regulation, the availability of bonds to buy and sell has reduced dramatically. This means it is going to be harder to buy or sell bonds and the cost is likely to be higher. The liquidity that dictates how easy and cheap it is to buy and sell bonds is far smaller than it was pre-2008. This means the exit door for investors wanting to sell out of bonds has shrunk meaningfully. It will continue to shrink further as regulation limits the ability and willingness of banks to hold bonds in reserve to deal with any periods of particularly strong buying or selling. Accordingly, the ease of buying and selling bonds, and the costs of doing so, have all changed for the worse.
Despite this tighter exit scenario and heightened sensitivity, investors are increasingly being forced to crowd into the same assets. This has been exaggerated by the over-use of market-capitalization weighted indexes, partly because they are believed to be more liquid. Crowding in this manner has a detrimental effect not just on liquidity, but on market risk – a shock will send more investors rushing for the same, smaller door.
This paints a scary reality. Finding a reliable, cost-effective bond now means selecting from a range of more expensive, older, sub-premium bonds that are less reliable and are more prone to dramatic price changes because investors are only interested in trading on an ever-smaller number of bonds at a higher cost.
Faced with that reality the starting point for selecting a bond simply has to change. Buyers would need to trade less frequently and focus much more on the fundamental quality of the individual bond. The market paradigm is different, which necessitates a rethink when it comes to building bond portfolios.
For over 40 years, investors have relied heavily on market-capitalization weighted indexes as the starting point for their bond exposure, but these indexes are inherently flawed because they favor the most indebted, rather than the most creditworthy borrowers. While this may have ensured better liquidity in the past, with crowding on the increase and the exit doors narrowing, the same cannot be said today.
Investors using these indexes as their starting point could own a higher proportion of poorer quality debt that will be more difficult to sell during periods of particular market stress. Today’s market environment requires that investors rethink their starting point. Trading less and focusing on credit quality should sit at the very heart of bond selection.
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