As investors it is important we frequently ask ourselves a basic question: Why am I holding this? The question is particularly important for fixed income investors at the moment. Yields are near record lows, central bank actions have caused widespread volatility, and concerns persist over the prospects for the global economy. Faced with such difficult terrain, bond investors can be forgiven for not knowing which way to turn.
Why hold bonds at all?
The main argument for remaining invested in fixed income is that domestic interest rates in most developed economies are likely to remain low for some time to come. There are a number of reasons for this, including anaemic economic growth, falling labour productivity, and slowing population growth.
Also important are the structural adjustments taking place in emerging markets (EM). The end of the commodity-driven investment cycle will leave many emerging countries looking for a new business model as they can no longer rely on oil and gas exports to China. And until it is clear what those new business models are, the demand for credit from EM countries will remain low, keeping interest rates down.
There are also growing signs the US may be in the late stage of its business cycle – and may even be on the verge of a downturn. Economy-wide revenue growth is down to zero, profits peaked in late 2014, and retail margins are under pressure. Forward-looking guidance on margins and profitability remains weak, which is putting downward pressure on investment spending.
Fortunately, credit cycles do not move in tandem: At any given time, individual countries will be at different stages of expansion and contraction. This means there are always likely to be pockets of value for investors with the scope to invest across markets and regions and the flexibility to move into and out of positions quickly. A number of developed market bonds have performed well despite offering low yields at the beginning of the year, including Australia, Sweden, Japan, and Germany. While not long-term buy-and-hold positions, it shows it is possible to make money even in a low-yielding environment.
Moreover, the widely held perception we are in a low-yield environment is somewhat misleading. Higher rates can be found in EM countries – such as Brazil, Russia, and the Philippines. What is more, rates continue to move in different directions: Last year, there were a total of 77 central bank rate cuts and 66 rate hikes; by the end of August this year, there had been 51 cuts and 30 hikes. Investors with global reach can benefit from these differences.
The role of fixed income in the future
People own fixed income for two main reasons: to generate income or to diversify against equities. But the combination of deleveraging and excess liquidity from central bank quantitative easing programmes has resulted in some fixed income assets – EM debt and parts of credit – moving in tandem with equities. This has led to the formation of a bubble, in which some ostensibly ‘safe’ bond assets have become equity substitutes rather than equity diversifiers.
This is not the case for all fixed income assets, however. Some developed world sovereign debt markets – while offering low or negative yields – continue to offer effective diversification from equities. Fixed income investors therefore have a simple choice: Do you want your bond portfolio to generate returns or provide safety?
If the preference is for the former, there are plenty of pockets of value available in EMs and corporates. However, this bond portfolio will be correlated with equities and highly vulnerable in the event of a downturn. If the latter option is chosen, there are options available to provide effective diversification against equities, which will mean accepting lower yields.
In the future, it may be possible to once again hold bonds that pay income and diversify away from equities, but for the time being, investors must choose one or the other – attempting to straddle the middle is likely to be an uncomfortable experience, with little obvious gain.
Arif Husain is portfolio manager of the T. Rowe Price Global Unconstrained Bond fund