Fixed-income investing used to be so simple. You just needed a nice balance of high-quality and high-yield bonds, with some foreign bond exposure tossed into the mix for good measure. But aggressive moves by leading central banks have decimated global bond yields in many regions, which has forced investors to step up their efforts to find decent payouts.
Of further concern, a multi-decade surge in bond prices, which boosted total returns for fixed-income investors, has largely played out. The 10-year Treasury, for example, began 2016 with an already-low 2.3% yield. It now yields around 1.6%. Equivalent bonds in Europe and Japan yield less than that. Any reversal in bond prices offset the income from whatever yields may be on offer.
That doesn’t mean bonds can simply be shunned. In fact, the right fixed-income strategies can deliver decent yields and preserve capital. That’s not a small consideration if you think that the current bull market in equities may be in the late innings.
Negative Interest Rates: Not Such A Good Idea After All?
To build a fixed-income road map for the years ahead, it pays to assess the current monetary and fiscal policies, and how future moves may impact inflation—and interest rates. While all eyes have been on the U.S. Federal Reserve in the past half-decade, thanks to its pioneering moves in bond buying (quantitative easing) and race to the interest rate floor, it’s the central bankers in Europe and Japan that are now holding sway over bond market sentiment.
Their move into negative interest rate territory, which would have been inconceivable just a few years ago, has created a range of distortions in fixed-income markets, and bond strategists are divided on whether the policy has been effective.
Unintended Consequences
The goal of negative interest rates is to force savers to become spenders, boosting economic growth and kindling a bit of inflation. Rick Rieder, BlackRock’s global chief investment officer of fixed income, thinks the policy has had the opposite effect. “Consumers grow concerned about their income from fixed-income investments and start to save more instead of spend,” he says.
Negative rates are also hurting the financial sector. Joe Higgins, a fixed-income portfolio manager with TIAA Global Asset Management, notes that “pension plans are having a hard time closing funding gaps.”
Negative interest rates “should have steepened the yield curve, but they have had the opposite effect,” says David Lafferty, chief market strategist at Natixis Global Asset Management. As a result, banks now have less incentive to lend. That’s especially a concern in Europe, says Higgins, “where 70% of capital formation comes from banks,” roughly twice the rate seen in the United States.
Dan Ivascyn, lead portfolio manager for PIMCO’s income strategies and credit hedge fund strategies, says that “our financial system isn’t that well-equipped to handle negative rates.”
John Lovito, senior portfolio manager at American Century Investments, summarizes the view of many strategists when he suggests that “central banks are now being pushed to look to other mechanisms to support their economies.” These include stimulus spending on infrastructure, as well as tax reform and immigration policy reform (the latter move may be especially needed in Japan).
Still, not all agree that negative interest rate policies aren’t working. European purchasing managers’ indexes have shown modest improvements recently, and German business sentiment is back up at two-year highs.
The picture remains cloudier in Japan, which has pulled out all the stops to reverse a decades-long slump, to no avail. In addition to negative interest rates, the Japanese government has flooded the country with stimulus, and more recently announced plans to pursue “yield curve control” (pushing long rates noticeably higher than short rates), which is aimed at boosting bank lending and corporate spending.
The Japanese economy grew just 0.2% in the second quarter and remains perilously close to recession. That would create deep concerns about the world’s third-largest economy—which is already saddled with massive government debt. Still, “the Bank of Japan won’t let up on the gas pedal anytime soon because the nation’s demographics problem is so acute,” says Lafferty.
Needing to raise cash at a time of global economic strain, Japan, China and Saudi Arabia, our three largest creditors, have been net sellers of nearly $200 billion in U.S. Treasurys thus far in 2016, according to the Fed.
Inflation Or Deflation?
“There are risks that policies become more aggressive, which could lead to higher inflation than many anticipate,” says PIMCO’s Ivascyn. If that happens, he thinks Treasury Inflation-Protected Securities (TIPS) likely offer one of the best hedges against rising rates.
Still, for now, Ivascyn thinks “the deflationary risk remains the slightly greater risk,” and bond markets are even less prepared for that than inflation.
A potential economic slowdown is on the minds of Morgan Stanley economists. Matthew Hornbach, head of that firm’s global interest rate strategy, expects “real economic growth in the U.S. to inch lower over the course of 2017.” His firm is among the most bearish on Wall Street, predicting that the yield on U.S. 10-Year Treasury bills will fall back to 1% in the first quarter of 2017 (down from a current 1.62%).
Weak GDP growth, in Morgan Stanley’s view, will lead the Fed to sit on its hands for the next two years and keep short-term interest rates where they are. The current consensus view calls for one rate hike this coming December, two hikes in 2017, and three more in 2018.
If the consensus is on the mark, strategists broadly agree that U.S. long-term bonds hold diminished appeal. “The interest rate risk in relation to yield [for these bonds] is a very poor trade-off right now,” says Natixis’s Lafferty.
In response, many fixed-income strategists think bond portfolios should reduce exposure to duration (as short-term bond prices are much less sensitive to interest rate changes than long-term ones).
But Ashish Shah, chief investment officer of global credit at AllianceBernstein, thinks that many investors are poorly positioned for that shift. He notes that passively managed bond funds have an average duration of 7.5 years and an average yield to maturity of 1.8%. In contrast, actively managed funds hold bonds with an average duration of 5.8 years and offer a 3.3% yield, according to Shah. “Many people are unaware of the risk that these longer-duration funds bring,” he says.
His firm’s AB High Income Fund advisor class (AGDYX) has garnered five stars from Morningstar and has an average duration of four years and a 5.11% distribution yield, thanks in part to an emphasis on lower-quality bonds.