Investors took a punt on the riskier sectors of the fixed income market in the second quarter of this year. But diversification into different bond markets will protect the investor in volatile times.
Bond market developments have highlighted the advantages of investing in more broad-based fixed income strategies. The outperformance of the riskier fixed income sectors, such as global high yield and emerging market debt, came to an end in mid-2007 and global government bonds took the lead. The riskier market segments recovered as investors’ appetite for risk returned early in the second quarter of 2008.
However, the cautious recovery in non-government bond markets had a setback. With performance of the different bond markets varying, the fixed income world offers investors scope for attractive returns and risk diversification. Managers with the scope to rotate between fixed income sectors have the potential to take advantage of market changes and protect investors’ capital in volatile market conditions.
Against such a backdrop, investing in a multi-strategy bond fund may minimise the negative impact of fluctuations in the various asset classes that make up the fixed income market. Active bond management within the wider bond universe can deliver similar or even higher returns than riskier asset classes with a lower overall volatility.
The global bond universe comprises a wide risk spectrum, from safe government bonds to high yield and emerging market investments. Performance returns of fixed income sectors vary, depending on the economic backdrop and investors’ appetite for risk.
Traditional fixed income strategies that focus on one or two segments suffer from varying performances over different economic cycles. These strategies are limited to a particular benchmark and leave the manager with little flexibility to deviate from it to boost returns.
Meanwhile, managers with scope to invest in and switch their allocation over wider fixed income sectors can adjust their portfolio’s risk profile in response to the changing market.
They can take on the return potential of the higher-risk sectors in a robust market, but offset the volatility in returns in a weaker market by holding positions in other sectors that have little or no correlation with the former assets. This flexible sector allocation approach allows the manager to take advantage of market changes and minimise the negative impact of fluctuations in the fixed income market. Rotation across various bond market segments provides more stable and consistent returns than those generated by currency or interest rate strategies.
These include duration management, which affects the sensitivity of a portfolio to interest rate changes, or yield curve strategy, which takes advantage of differences in performance between long-, medium- and short-dated bonds.
Within the global fixed income universe, there are long-term opportunities in the non-government bond sectors. Prices in these segments have been driven down by investors’ low appetite for risk and a lack of liquidity resulting from the credit crisis.
But the interest rate cuts implemented by America’s Federal Reserve and the Bank of England, as well as the extra lending facilities offered by the major global central banks, should result in a gradual return of liquidity, helping these bond prices to recover in the medium term.
There is particular value in American mortgage-backed securities and select American and European corporate debt. The difference in yields over government bonds (spreads) on investment grade and high-yield corporate bonds continues to reflect a pessimistic view on the economy and default rates, compared with ours.
The global economy will avoid a recession and the aggressive interest rate cuts by the Federal Reserve will feed through into the American economy in the second half of this year, resulting in a gradual economic recovery later in 2008.
Within emerging market debt, dollar-denominated corporate issues offer more opportunities than government bonds. Local currency markets also offer value relative to foreign currency-denominated sovereign issues, especially as some currency appreciation is expected across most regions. With inflation still a threat, central banks are likely to accept a stronger currency as part of their policy intervention.