Do not rely on beta for returns in an environment where yield is no longer your friend, stress fixed income managers.
Inflation appears to be rising and that normally spells bad news for bonds. AsianInvestor is running a series of articles examining the implications this is likely to have on fixed income portfolios. The first article, published yesterday, focused on the outlook for US Treasuries.
Today, we examine which asset classes may perform well in a highly uncertain environment where fund managers believe Treasury yields are likely to rise, but may yet still fall.
Their conclusion is to opt for bond funds with the flexibility to go long and short. In a rising yield environment, they also believe short-dated high-yield paper will do well and tip emerging-market debt to prosper in the second half of 2017.
Beware beta reliance
One thing they all agree on is that income may struggle to deliver the same kind of performance as it has in recent years and investors will need to rely far more on alpha to generate positive returns.
“Investing in a bond ETF is just about the dumbest thing you could do this year,” said Manu George, senior investment director for Asian fixed income at Schroders. “Thanks to the 30-year bull run in bonds, prices are very expensive and they need to adjust.”
Ben Luk, global market strategist at JP Morgan Asset Management, made a similar point: “Not every bond market will deliver positive returns in 2017, even on a total-return basis."
But this does not mean investors should avoid bonds. Indeed, the most recent fund flow data shows that the forecast great rotation has stalled, with inflows of $17 billion over the past three weeks, reversing 40% of the $42 billion of outflows since Donald Trump was elected as US president.
In the week to January 11, investment-grade bond funds attracted $3.8 billion, with $1.2 billion going into high yield and even emerging-market debt strategies seeing inflows of $1.3 billion, according to EPFR data.
Portfolio managers say asset owners should consider unconstrained fixed-income funds as one of the best places to park cash. This is because of managers’ ability to play the upside and downside, which could be the swing factor at a time of heightened uncertainty.
For instance, Taiwanese state pension manager the Bureau of Labor Funds (BLF) is in the process of choosing asset managers to run $3.6 billion in absolute-return bond portfolios. BLF chose this rather than a relative-return mandate against benchmarks, because of expected US rate rises and its consequent wish to be able to switch between different markets and types of debt.
Ludovic Colin (pictured left), head of global flexible fixed income at Vontobel Asset Management, advocates a similar strategy. “Investors need to be extremely agnostic with no significant bias," he said. "There are an awful lot of unknowns right now, and Treasury yields are still in a two-way environment. We’re not out of the woods yet.”
High yield in favour
When it comes to specific asset classes, JP Morgan AM’s Luk likes US high yield and short-dated credit as they are more resilient to rising rates than long-dated instruments.
Last year, global high yield was the best performing fixed income asset class, returning 17.1%, according to the Barclays High Yield Index.
Unlike in 2016, however, Luk says carry, rather than spread compression, will drive returns. “Even if you factor in a 1% increase in Treasury yields, we’re still looking at a yield-to-maturity around the 6.5% level on a medium-duration bond,” he said. “On a net basis, that’s still a 2% to 3% total return.”
James Bateman, Fidelity International’s head of multi-asset, takes a similar view. “We like active selection strategies and short-dated high-yield paper,” he remarked.
Luk’s preference for high yield also extends to euro-denominated debt, which returned 3.38% in 2016 on a dollar-adjusted basis. He argues that it will continue to perform well, as the European Central Bank (ECB) is one of the last central banks still in easing mode and has a limited pool of assets to purchase.
“This will push yields down across investment grade and high yield,” Luk said. “I’m also a bit sceptical the ECB will start tapering towards the end of this year, as it’s currently indicating.”
Core European inflation is only 0.8% to 1%, he noted. “And these figures are being distorted by the base effect of last year’s oil prices.”
Fund managers say they like US investment-grade debt for much the same reason as high yield: US earnings should recover, and there will still be positive carry from yields-to-maturity around the 3% mark.
The picture for emerging markets is more mixed. EM bonds had a very good year, with JP Morgan’s hard-currency emerging-market index returning 10.15% and its local-currency one 9.94%.
However, it is an asset class that tends to underperform when the dollar is rising in a rapid growth environment, noted Jim Cielinski, global head of fixed income at Columbia Threadneedle.
“But beneath the surface there are a number of beneficial factors, such as improving liquidity in emerging-market debt,” he said. “I think opportunities in this space will start appearing in the second half of the year.”
This wait-and-see approach is based on an expectation that the dollar rally will run out of steam.
Luk believes there could be a further 2% to 3% rally in the greenback, while Vontobel’s Colin thinks it could appreciate another 5% to 7%.
Colin said: “If we do have a big dollar rally and Trump’s policies don’t affect growth, local-currency emerging-market debt could start to look very cheap during the second half of this year."
Once the tide does turn, he said he favoured Latin American over Asian debt because the former’s economies would benefit more from an increasingly positive outlook for commodities. Fidelity International’s Bateman likes the region for much the same reason.
In the third and final article in this series, we will examine the outlook for returns in Asia: a region where monetary policy divergence could offer opportunities and challenges.