Fixed Income – alive and kicking
Insights
Much has been written over the past few years about the death of fixed income, and with upwards of $18 trillion of global debt at one point offering negative nominal yields, no wonder. After all, who wants to own a negative yielding asset which – somewhat simplistically – can only go down in price? The impact on asset allocation decisions has been profound, with investors fleeing traditional fixed income investments in favour of riskier (but higher returning) equities on a TINA (there is no alternative) investment case. The narrative today could not be more different. Global negative yielding debt has dropped to a mere $2.46 trillion notional, the lowest since 2015, and even that will disappear quite quickly once, as the market expects, the ECB starts hiking rates.
Figure 1. a) Notional amount of global bonds with negative yield; b) 10y Australian Government Bond Yield
Moreover, yields are back to levels rarely seen in the past 10 years. The last time 10y ACGB yields were above the current 3.50% was 2014. The AusBond Composite 0+ index (BACM0) returned north of 14% between November 2018 and March 2020, and that was with 10y yields starting a good 75bp below current levels. Regardless of what you think about the RBA, inflation, growth or equities, it’s now impossible to argue that bonds are a one-way bet down.
One (sensible) approach many of our clients took over the last few years was to reduce their duration exposure by exiting long-only, benchmark aware fixed income managers in favour of low duration unconstrained bond funds. Almost no matter what the absolute return posted by such managers was over the past year or so, it should have been better than the -12% return for the Ausbond Composite since August 2021.
However, there is an increasing risk that from current yield levels, such managers might not be able to keep up with benchmark indices in the event of a bond market rally. To the extent investors are happy with the performance of their unconstrained bond fund managers – and many have performed well in the post-COVID world – we don’t see any pressing need to allocate away from them.
Rather than allocating back to benchmark aware fixed income funds, we think a sensible approach might be to retain unconstrained bond fund holdings and add back duration via an overlay, for example, by buying bond futures. The bond futures act as a proxy for the duration ‘beta’ in the benchmark, and the unconstrained bond manager provides the ‘alpha’.
The chart below shows how combining a well performing unconstrained bond fund with a simple duration overlay can easily match and even beat the benchmark. That is even more the case when you consider the recent divergence between the unconstrained bond fund (dark blue area) and the benchmark (green line) which represents the fund level ‘alpha’ captured over the past 9 months or so for an investor who had previously shed their duration exposure in the fashion outlined above.
Figure 2. Unconstrained bond fund + duration overlay compared favourably with bond benchmark.
The Solutions Team
The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.
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