The hunt for yield has again intensified as central banks and governments maintain rates at record lows to stimulate economic growth. With yields at rock-bottom levels, it might be tempting to think there’s nothing left in fixed income – but one asset manager says “not so fast”.
Robert Tipp, managing director, chief investment strategist and head of global bonds at PGIM Fixed Income, explains how to take advantage of investing in one of the broadest opportunity sets, including rates, spread and currencies.
Q1. In an ultra-low yielding world, is there potential left in the bond market, or is it just all risk?
Despite incredibly low interest rates, most yield curves around the world are positively sloped rather than inverted. As a result, if cash rates stay muted for several quarters, if not years – as many expect – then potential returns for government bonds are likely to exceed cash by a fair margin.
Additionally, the markets will fluctuate – rising and falling globally – in response to major macro themes and relative to each other. In a global fixed income portfolio, the fund manager can tactically add value by increasing and decreasing overall duration and adjusting weightings across countries to take advantage of the inter-market fluctuations in term structures on a currency-hedged basis.
Granted, expected returns are lower given lower yields. But expected returns for bonds across most countries appear likely to exceed cash over the intermediate to long term. Further, managers that have access to all the world’s rate markets can add value through inter-country and intra-country strategies, plus benefit from multi-market diversification.
Q2. How do you view the credit markets amid challenging economic growth?
It’s true that today’s slow growth, high-leverage global backdrop is much more challenged than 10, 20 or 30 years ago when growth was fuelled by more favourable demographics, debt levels were lower and central banks had room to cut rates in the event of a slowdown. Downside risks are now more extreme, markets are more volatile and strong credit skills are required to identify issuers with risks that are too high relative to the incremental spread.
Q3. Downgrades and defaults are widely expected over the next 12 to 24 months. Is it worth wading into the spread sectors?
No doubt, the virus and oil shocks have raised credit risks. But in many cases, and on average, credit spreads are outsized, too, leaving the potential for above-average returns if one can avoid deteriorating credits. Two actions can help.
First, diversify. This involves two parts:
- Look across all fixed income sectors – sovereigns, both developed markets and emerging markets, agencies, securitised products, both agency and private label, as well as corporates, both investment grade and high yield bonds.
- Look across currencies. Often, different issues of the same issuer will trade at different levels on a fully currency-hedged basis depending on the currency denomination of a given issue. As a result, investors with the ability to take risk in a given credit in whatever currency is cheapest should be able to improve their risk/reward ratio.
Secondly, in-depth research is essential – both fundamental analysis of sovereign and corporate issuers, as well as the fundamental collateral underlying securitised products. Additionally, many complicated securities like securitised products have embedded options requiring sophisticated analysis of their cash waterfalls as well as default stress testing.
Q4. Why risk exposure to international bonds if your liabilities are primarily domestic?
When investing internationally, it’s possible to isolate risks – currency, term structure and credit – taking risk only along the dimensions where the risk/reward equation is favourable. That is, if a bond trades cheaper in euros than in US dollars, for example, a US investor could buy the bond in euros and hedge the interest rate and currency risks back to US dollars, isolating just one element: credit risk. Similarly, if US interest rates are attractive versus those in Japan or Europe, a non-US investor can take US interest rate risk through futures and swaps without taking material credit or currency risk.
So, while investing internationally can be more complex, it can also increase a manager’s opportunity set, opening the way for better risk-adjusted returns over the long run.
Helen Chang CFA
Head of Asia Pacific ex Japan
Client Advisory Group
PGIM (Hong Kong) Limited
T: + 852 3769 8283 M: + 852 6898 0982
The information represents the views and opinions of the author as of June 4, 2020, is for informational purposes only, and is subject to change.