“Financial crises are all different, but they have one fundamental source. That is the unquenchable capability of human beings when confronted with long periods of prosperity to presume that it will continue."
The financial crisis of 2008 and the ongoing eurozone debt crisis have altered the investing landscape. Sovereign credit risk has become the dominant driver of risk in European and global fixed income portfolios and a key influence on financial markets generally.
Bond investors are being forced to recast long-held assumptions about risk. The concept of ‘risk free’ has been shaken and the present combination of indebted sovereigns, challenged economic growth prospects and low interest rates seems set to become an all-too familiar backdrop for investing in capital markets.
This new risk landscape offers risks and opportunities. However, investors must ask fundamental questions about what they want from their bond portfolios. Sovereign risk is urging a shift away from traditional market-weighted benchmarks towards more flexible alternatives. We are also seeing a reassessment of corporate versus sovereign credit risk, with investors increasingly embracing the idea that corporate bonds can trade inside sovereigns. In the same vein, emerging market debt warrants greater attention.
The investment environment has changed markedly in recent years. The risk environment has been transformed by the 2008 credit crisis and the ongoing sovereign debt crisis.
The crisis actions taken by developed world governments and central banks have dramatically increased debt-to-GDP ratios around the world, tipping some economies, such as Greece, into an economic tailspin. In the periphery of Europe, sovereign risk has been dramatically re-priced upwards. Meanwhile, interest rates and bond yields in parts of the developed world seen as most economically and fiscally robust have fallen to record lows, increasing the price of safety. Indeed, major government bond yields have trended down strongly since 1982, however, the scope for this trend to continue is clearly now constrained by the present low yields.
History suggests that major credit crises require multi-year workouts. Indeed, the combination of debts, challenged growth prospects, low interest rates and deflationary forces that we see today could be sustained for a prolonged period - becoming ’business as usual‘ for the foreseeable future. Secular growth drivers continue to reshape the global balance of economic power, with many emerging markets now offering more attractive fundamentals than their developed world counterparts. As a result, bond investors are expanding their horizons by both asset and geography, increasingly considering higher yielding bonds and emerging market issuers.
“Risk-free” assets were, until recently, a key cornerstone of financial market and investing theory. They provided a starting point, or a comparative anchor, for investment decisions. The realisation that some of the largest risks in the bond universe resided in what was seen as the lowest-risk end of the spectrum has been a watershed moment for investors.
In the last two years, we have witnessed a massive 70% reduction in the pool of risk-free assets. In August 2011, US debt was downgraded from triple A; this was followed by downgrades to France and Austria. While 68% of economies carried a triple A rating at the end of 2007, that proportion had dropped to 53% by the end of 2012. The IMF believes that a further $9 trillion could be removed from the overall stock of ‘safe assets’ by 2016. Safety has become a characteristic that can be lost very quickly if market perception deteriorates. Once questioned, money quickly flows to even ‘safer’ assets.
The reduction in the pool of assets considered safe (combined with greater demand) has had the effect of significantly increasing the price of safety. It has also raised some concerns over herding as investors have crowded into a shrinking handful of ‘safe-havens’ sovereign assets, such as US Treasuries, German Bunds and Swiss government bonds. In hindsight, investors were somewhat spoiled in years gone by; risk-like returns for taking little-to-no risk are over. While the present sovereign issues will eventually recede, this is likely to be a multi-year process.
In August 2011, S&P downgraded US sovereign bonds from triple A.
In February 2012, France and Austria followed.
As a result, the AAA sovereign asset pool has shrunk by around 70% in the last 18 months.
The high price of safe assets reflects their relative scarcity, as well as investor perceptions of the risk associated with the European debt crisis and their concerns over the stuttering recovery in many OECD economies. While the Fed has made it clear that it expects to keep interest rates low for some time, forward markets are pricing in an extremely long period of very low real rates. The shortage of safe assets relative to demand has caused a squeeze in a narrower group of safe havens which remain negatively correlated to risk assets, such as US Treasuries and German bunds.
US Treasuries have become an expensive and crowded trade and there is a growing debate over whether the long-term bull market is over and a bear market is now due. The perceived position of US Treasuries as a safe haven has been relatively assured despite the country’s twin deficits and the downgrade of its sovereign credit rating. Indeed, the volatility caused by the downgrade saw further safe-haven flows into, rather than out of, Treasuries. Author Jim Grant captured the mood of many investors when he remarked that traditionally risk-free Treasuries now offer a “return-free risk”.
A key issue is that the two biggest buyers of Treasuries, the US Federal Reserve and China, are both relatively insensitive to value. The Fed is explicitly trying to manipulate bond prices as part of its monetary policy framework. China is the largest foreign creditor to the United States owning around $1.2 trillion of US debt, over a quarter of the $4.5 trillion held by countries outside the US. The reason that such a significant part of China’s $3 trillion in foreign currency reserves is held in dollars is that other there are few liquid alternatives with sufficient market depth that would not introduce a higher level of currency risk.
The yields on US Treasuries can stay low given these factors, supporting their ongoing status as a genuine ‘safe haven’ in an age of uncertainty. Some commentators point to the danger of a liquidity trap where bond yields drop towards their lower limits and remain there, following the example of Japan. Regardless, such low yields send a clear signal to value investors. With yields lower than 2% in the major economies, there is limited prospect of matching past returns in government bonds from this starting point. A reversion of yields to their long term average would result in low or negative returns. Were investors to use the last thirty years of the government bond index as a predictor of returns over the next thirty years they would be doomed to disappointment.
On the other hand, achieving shelter in periods of risk-off volatility has become markedly more difficult – at these times the benefit of being invested in US Treasuries is clear. Strategic fixed income managers will continue to invest tactically in such ‘safe assets’ to provide genuine, liquid diversification and negative correlation to riskier assets.
Aggregate bond indices and funds benchmarked against them now entail significant concentration risks within sovereign bonds. These indices are invariably market-capitalisation weighted, which means the more debt an issuer has outstanding, the larger the weighting that issuer has in the index. Unfortunately, this tilts indices toward indebted countries regardless of their ability to service that debt. This problem is exacerbated by the fact that debt ratings typically lag fundamentals.
Accordingly, around half of the risk in the Bank of America Euro Aggregate Bond Index now comes from sovereign bonds (see chart below left). The same phenomenon is true of market-weighted indices in the corporate bond sector. The ITRAXX Corporates Index provided investors with a growing exposure to financials over the course of the last decade, increasing from just over 30% in 2002 to a peak of 55% in 2008. Since 2008, of course, investors have realised this was not an exposure they wanted and dissatisfaction with a system that predisposes them to concentrations of risk has grown. A similar problem blighted equity investors when the technology sector of the S&P 500 grew from 10% to a massive 33% by 2000. The subsequent crash in technology stocks had a similarly negative bearing on market-weighted US equity indices (and portfolios) as European sovereigns and financials had on bond investors invested with reference to aggregate bond indices.
The key point is traditional market weight benchmarks no longer reflect the needs of investors. Outflows from these products and indebted sovereigns have already begun, yet much of the money appears to have flowed toward a small set of safe havens, driving yields to levels which imply there is little value left. This strongly encourages the use of alternative benchmarks and strategic approaches.
GDP-weighted indices offer an alternative route to investors, allowing investments to be directed to the world’s most established economies. A material problem is that GDP-weighted bond indices cannot fully reflect the world economy – China, the world’s second largest economy barely has a public debt market. Another difficulty is that some of the other largest economies are also the most indebted in the shape of the US and Japan, so the problem of being constrained is simply recast in another form.
Replacing one benchmark constraint with another does not solve the underlying issue, which is allowing your portfolio manager the freedom to invest according to their conviction, with the ability to avoid unfavoured areas of the benchmark universe completely if they so wish. Strategic portfolios, which allow zero weightings to countries, and unconstrained portfolios can unshackle portfolio managers from the constraints that benchmarks impose. These approaches allow managers to invest in securities on the basis of their own merits and not because of their size in a benchmark index and to focus on absolute rather than relative risk.
Strategic and unconstrained investing both play to the strengths of investment management companies that can generate an abundance of ideas across the full investment universe. Each position in the portfolio needs to pass either an explicit hurdle on returns or it needs to play a role in ensuring sufficient diversification.
While aggregate market weight benchmarks still make up the bulk of the bond market, we should see growing consideration given to alternatively weighted, high-quality benchmarks, going forward. There will be greater interest in more flexible, ‘strategic’ bond portfolios that balance risk and return, as investors move away from products that unnecessarily tilt investments to over-indebted areas. The performance of bonds in recent decades certainly illustrates the need to be strategic (see table below). The difference in calendar returns from the best to worst bond class can be significant, reaching 60% in 2009.
Most investors are now familiar with the emerging market investment story. But, it’s easy to forget that the positive developments have been just as transformative for debt investments as they have been for equities. Emerging country debt markets have developed considerably in recent years. Emerging market debt is now a deeper, more diverse market, offering US dollar, local currency and corporate issues.
The fundamentals of many emerging economies contrast sharply with the debt-laden OECD economies. Emerging market governments have significantly improved their financial positions, boosted by trade surpluses from commodities and manufactured exports. Responsible monetary policy, often incorporating inflation targeting, and independent central banks have brought greater macroeconomic stability to previously boom/bust economies. Moves from fixed to floating currency regimes have also provided a greater level of protection from contagion effects from banking and balance of payments crises. This has paved the way for more stable exchange rates and the development of local currency bonds. In the last decade, corporate issuance has expanded dramatically, so that it now outstrips sovereign issuance.
Given the incidence of the recent financial crisis on developed economies, along with strong projections for continuing robust economic growth in emerging markets, it can be argued that yields on emerging market bonds still over-compensate investors for the risk of default. This is encouraging many investors to introduce greater investment in emerging market bonds into their portfolios.
Emerging market debt has historically been considered more risky, although how much more risky than European debt is now open to debate. Given the reduction in the stock of ‘safe assets’ and the likelihood that this shortage will persist for some time, there is a long-term opportunity for emerging markets to become suppliers of ‘safe assets’, going forward. China fits the bill in terms of economic and financial strength, meaning the opening up of Chinese capital markets and the internationalisation of the renmimbi is greatly anticipated. If the demand for safe assets in emerging markets grows with their economies, following the demand pattern in the West, then further growth in emerging markets will quickly outstrip the capacity of advanced economy safe haven assets to meet global demand. This is likely to mean that, in time, emerging markets become part of the solution.
The realisation that some of the largest risks in the bond universe reside in what was seen as the lowest-risk end of the spectrum will have lasting implications for how investors structure their bond portfolios.
Fortunately, fixed income is a wider, deeper asset class than ever before and there are opportunities for investors to find income without necessarily sacrificing quality or taking on more risk. We believe two approaches merit consideration in this dynamic risk environment:
1. ‘Best Issuer’ Portfolios
Problem: The polarisation of government bond markets is creating concentration and liquidity risks among a shrinking set of overvalued safe-haven assets. Yet, many investors will still be looking for a lower volatility bond portfolio, which goes some way to replacing traditional allocations managed to market-weighted sovereign and aggregate bond benchmarks.
Solution: There is a clear imperative for investors to consider a broader exposure to high-quality bonds beyond traditional government issuers. By broadening the universe, we can build high-quality, diversified portfolios based on best issuers in the sovereign and investment grade markets. First, by including sovereigns which score highly on solvency, liquidity and currency strength, such as Australia and Canada, we can bring about sensible diversification and introduce currencies that reduce overall portfolio risk. Second, we can include the high-quality investment grade bonds of multinationals, such as Proctor & Gamble and Johnson & Johnson. Such companies benefit from global reach in relation to national risks, as well as strong cashflows and healthy balance sheets. They offer better credit risk characteristics than many sovereigns and allow investors to offset sovereign concentration risks.
Final thoughts: The ‘best issuer’ approach requires extensive resources in terms of sovereign and credit analysis and intelligent portfolio construction, with needs tailored to investors’ risk tolerances.
2. Strategic mandates
Problem: Many traditional market-weighted bond benchmarks encourage investment in the most heavily indebted areas. European aggregate benchmarks have significant concentration in Mediterranean sovereigns, while corporate bond benchmarks have high weightings in financials.
Solution: By using a more strategic approach to invest in all the bond classes (including investment grade, high yield, inflation linked bonds and emerging market debt), portfolio managers have the flexibility to invest in a combination of assets that aims to deliver more consistent overall returns over time with reduced sensitivity to draw-downs. The improvement in diversification and risk/return profile is made possible by unshackling managers from outmoded market-weighted benchmarks.For example, higher weightings in corporate bonds, high yield bonds and emerging market debt could be made at the expense of government bonds, if the manager felt these offered a better risk/return profile. Conversely, if the manager expects periods of heightened volatility, exposure could be increased to safe haven government bonds, such as US Treasuries.
Final thoughts: Such an approach relieves investors of the asset allocation decision burden between bond classes in a market that increasingly demands a deep and continuous multi-disciplinary research effort.
“HQP” is an equal-weighted best issuer portfolio of Australia, Canadian, Swiss, German, Danish, Norwegian, Swedish, and US sovereign bonds.
“HQP+20%” is an 80%:20% mixed best issuer portfolio of these 8 equal-weighted AAA sovereigns and non-financial AA corporate credit.
Bond investors are having to adjust to a very different risk/return environment in the light of the financial and sovereign crises. Debt and deleveraging will remain powerful themes for the next decade as indebted sovereigns, led by the US, attempt to reflate their economies. Over the next 10 years, real returns for investments in government bonds are likely to be below average.
These changes require investors to think afresh about investing in fixed income. Investors should review the risks and returns they expect, and question the benchmarks and portfolios in which they are invested. Traditional rule-based approaches to bond investment have had the foundations torn from under them. The traditional practice of measuring portfolios against market weighted indices has been exposed as flawed. Meanwhile, the idea that ratings agencies provided investments with a stamp of safety has been weakened. Ratings downgrades - typically well after bond prices had already deteriorated significantly - have become a recurrent feature of capital markets in recent years.
In building bond portfolios, an active, fundamental approach to security selection, the ability to disaggregate risks and a focus on diversification and flexibility provides a toolkit for avoiding blow-ups. Fortunately, the depth and diversity of the fixed income market can reward such approaches with corporate, high-yield and emerging market bonds presenting great opportunities for bottom-up managers. Investing in best issuer portfolios or in flexible, strategic bond funds can be attractive solutions for investors looking for income but unwilling to introduce significantly higher risk.
The value of an investment can go down as well as up so you may get back less than you invested. Overseas investments are subject to currency fluctuations and emerging markets may be more volatile than established markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. This information does not constitute investment advice and should not be used as the basis of any investment decision, nor should it be treated as a recommendation for any investment.