As developed-market governments continue to engage in extreme monetary stimulus, investors and savers are becoming more desperate to find yield in core fixed-income portfolios.
The most practical solution is to add enough uncorrelated alpha strategies that the ‘core’ portfolio allocation becomes relatively small, argues Bradford Godfrey, fixed income specialist at Eaton Vance Investment Managers.
The Bank of Japan’s dramatic asset-purchasing programme under new governor Haruhiko Kuroda is yet another example of how governments are trying to wiggle out of massive indebtedness by gradually devaluing their obligations via inflation, said Godfrey, speaking at AsianInvestor’s Japan Institutional Investment Forum in Tokyo.
The challenge for rich-country governments today is how to repair sovereign balance sheets in the face of demographic decline, underfunded or overly generous welfare programmes, and the public adoption of what began as private-sector credit bubbles.
The most responsible methods of dealing with this challenge are also the least popular: engendering real economic growth, cutting government spending and raising taxes. But the politics around such measures are difficult: just look at prime minister Shinzo Abe’s policy address of June 5, which was long on rhetoric about growing household incomes, but short on meeting market expectations about industrial restructuring. The Topix plunged 4% that day as a result of the lack of political will.
So central banks – including in Japan, the US, the UK and among the eurozone members – are instead bailing out their biggest debtors (usually the governments themselves) by keeping real interest rates low or negative. That can allow for nominal GDP growth rates to hover just above nominal yields, so that governments can quietly and slowly repair their balance sheets.
The cost is being borne by pension funds, insurance companies and other investors and savers, many of whom were at AsianInvestor’s forum in search of ideas. They are saddled with extremely low yields on government debt, and traditionally ‘safe’ assets are unable to meet their liability streams. Even some emerging-market institutional investors are grappling with this problem now, notes Godfrey.
“Negative real rates erode the real value of financial capital,” he says, which forces investors to take on new financial risks. With expected real rates of return lower than they should be, bond prices are extremely high by just about any measure.
Interest-rate risk is also high now. “This hasn’t been a risk for many investors for years or even decades,” Godfrey points out. “But we are now seeing traditional bond investors realising that interest-rate risk can be very real. Traditional beta exposures, which all investors rely on, have been bid up, so forward-looking returns in fixed income cannot be what they have been historically.”
One way to mitigate the worst of financial repression, he argues, is to ditch notions of core/satellite asset allocation. Beta asset classes are overvalued, so alpha strategies, which until recently have been considered niche, need to become the ‘new core’. This is achieved prudently if many such alpha strategies are blended together, as on their own, individual strategies or asset classes remain high risk.
Another implication of this ‘new core’ approach is it favours conviction bets and off-benchmark positions. Traditional benchmark approaches will mire investors in traditional beta positions – too much of which now generates higher risk, rather than providing stability.
Godfrey says within fixed income, because the reach for yield is failing to pay investors for the actual risks they are assuming, a better approach is to generate alpha from currencies instead. He recommends using short-dated instruments such as T-bills to play currency pairs instead of investing in government bonds.