Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 327

How to find diversification and flexibility in bond markets

In today’s low interest rate environment, fixed income investors are faced with the challenge of generating meaningful income while seeking to insulate their portfolios from the impact of market forces. In the past 30 years, the fixed income universe has seen profound changes as it has evolved in complexity and geography, and from generally higher yielding to the historically low yields seen today. Fixed income managers need to employ a greater variety of approaches and asset classes to achieve objectives for investors.

The evolution of the portfolio manager’s role

At one time, bond managers could focus on a few indicators and markets to make their portfolio decisions. The landscape is far more complex now. European core market bond yields, for example, can have rapid impacts half a world away. And the amount of data out there is extraordinary. Managers need expertise in far more sectors and across far more geographies than before. Obviously, one or two professionals can’t keep an eye on all of these inputs, so this has put a premium on team-building and coordination in managing investment portfolios.

Investor psychology also creates market hazards. As investors seek yield and move further along the risk spectrum, they go to places that are less comfortable for them. They are not in their usual habitat and are more likely to overreact at the first hint of volatility. Coupled with changing liquidity dynamics, these jittery investors can lead to sharp market responses, which should be considered when sizing positions, considering liquidity and choosing securities that have a better chance of withstanding short-term volatility.

How can fixed income assets provide significant yield at this point?

Co-mingled fund vehicles come in many shapes and sizes. It’s possible to invest in a single fund that provides exposure across the fixed income spectrum, or to narrow your choices to specific sectors. Which you choose will in large part depend on individual circumstances. In our view, investors should generally start with a portfolio that provides broad diversification of fixed income exposure across of range of sectors and exposures. This provides some of the key benefits of fixed income such as portfolio stability and diversification. Investors can then seek to improve their return/risk profile by adding positions in single sectors such as mortgage credit, corporate bonds, senior bank loans and emerging market debt (EMD).

Doesn’t that add risks to a portfolio?

In some ways yes, and in others, no. For example, EMD, although a generally high-quality asset segment overall, will tend to add volatility to the portfolio. On the other hand, bank loans, whose yields are reset frequently, will tend to reduce overall portfolio duration (sensitivity to rate fluctuations) due to their floating rate character, they can provide some insulation from inflation and rising rates. Although below investment grade, they are typically secured against corporate assets.

Combining traditional investment grade fixed income sectors with a broader set of fixed income sectors has historically increased portfolio diversification while lowering overall volatility, improving the risk/return tradeoff. However, investors should avoid sticking too closely to broad market benchmarks. For example, passively taking exposure to the Barclays U.S. Aggregate Bond Index (‘Barclays Aggregate’) gives a heavy weighting to low-yielding US Treasuries and investment grade bonds, which reduces total return potential. These days, a fixed income portfolio needs to do more.

Additional choices in seeking better fixed income returns

There are benefits in investment strategies that afford portfolio managers increased flexibility in seeking returns and managing risks. In multi-sector bond funds, managers may invest in a variety of sectors, across the spectrum of credit, duration and geography. Such funds may also have the ability to take short positions, for example using derivative contracts to profit from interest rates increase.

A diversified relative value approach to fixed income investing capitalises on price anomalies across a broad range of fixed income sectors throughout the market cycle. A globally-integrated fixed income platform and a repeatable and robust process should identify relative value opportunities over time.

Asset prices reflect consensus expectations across various factors - the level and path of interest rates, the shape of the yield curve, credit risk, cash flow patterns, volatility, etcetera. At times, our expectations on these factors differ materially from what is implied by the consensus.

How do you identify and capitalise on market mispricings?

There are three main questions in evaluating any fixed income asset:

(1) What are the market’s expectations?

(2) Where do we have investment insight?

(3) How confident are we in our views?

The answer to the first question provides context, the second considers whether our views are different from market consensus, and the third measures our level of conviction for portfolio implementation.

The outlook for the fixed income market

From 2018 to 2019, the U.S. bond market moved from pricing a Fed tightening cycle to a significant Fed easing cycle, and interest rates on government bonds in Europe have moved into more extreme negative yield territory. Are these changes reflective of changing fundamentals that investors should embrace, or are they reflecting overblown fears of a global slowdown or recession?

In our minds, it’s a bit of both. The Fed and ECB have shifted toward easing biases, yet it’s largely due to how they want to respond to low inflation rather than significant fears about the growth outlook.

Our central view is that a global soft landing is more likely than negative scenarios. Across the U.S., Europe and Asia, consumption rates in the major global economies are stable, despite weakness in production and trade sectors. Ultimately, structural shifts in many major economies toward services-oriented consumption make them less prone to recession and hard landings over the next 12 months.

We believe that investors should continue to invest for a soft landing outcome but recognise that tail risks are rising and centered on trade policy. Given market volatility and slower growth, incremental sources of yield become an important portfolio contributor, especially over the long run. However, this just reinforces the need to be flexible and look for opportunities globally and across sectors to seek to enhance risk-adjusted returns.

 

Adam Grotzinger is Senior Portfolio Manager, Global Fixed Income at Neuberger Berman, a sponsor of Cuffelinks. Neuberger Berman is the manager for the listed NB Global Corporate Income Trust (ASX:NBI). This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. It does not consider the circumstances of any investor.

For more articles and papers by Neuberger Berman, please click here.

 

RELATED ARTICLES

Why bank hybrids are far too expensive

How to generate income without equity risk

Searching for yield to pay the bills

banner

Most viewed in recent weeks

After 30 years of investing, I prefer to skip this party

Eventually, prices become so extreme they bear no relationship to reality, and a bubble forms. I believe we are there today, not for all stocks but for many in the technology space.

Australian house prices: Part 2, the bigger picture

There is good reason to believe the negatives will continue to outweigh the positives over the next 12 to 18 months. There is more concern about house prices than the short-term indicators suggest.

How to handle the riskiest company results in history

It is better to miss a results bounce and buy after the company has delivered than it is to step on a landmine. With such uncertainty, avoid FOMO by following these result season investing tips.

Australian house prices: Part 1, how worried should we be?

Three key indicators are useful for predicting the short-term outlook for house prices, although tighter lockdowns make the outlook gloomier. There is enough doubt to create cause for concern.

Welcome to Firstlinks Edition 367

There is a similarity between the current health crisis and economic crises of the past. For COVID-19, record amounts of biotech funding from government agencies and private companies are looking for a vaccine. Likewise, central banks once struggled treating recessions but the 'vaccine' now is record amounts of financial stimulus to ensure liquidity. While the world awaits a COVID treatment, markets are purring along, at least until side effects hit.

  • 22 July 2020

Welcome to Firstlinks Edition 369

Imagine you had perfect foresight about COVID-19 at the start of the year. You correctly foresaw that the global pandemic would kill over 700,000 among 20 million infections by August. In Australia, borders would close, cities would be locked down, most mortgagors would be on income support and companies would be allowed to trade while insolvent. You then had to guess how much the stock market would fall. Would you say about 10%?

  • 6 August 2020

Latest Updates

Shares

How to handle the riskiest company results in history

It is better to miss a results bounce and buy after the company has delivered than it is to step on a landmine. With such uncertainty, avoid FOMO by following these result season investing tips.

Shares

The rise of Afterpay and emergence of a new business model

Sometimes the simplest ideas are the best. The founders of Afterpay stumbled on the attraction for consumers of paying by instalments, and now retailers must offer the facility or lose business.

Property

WFH and its impact on Australian offices and tenants

Although most office workers are currently WFH, an energy and a buzz comes from working in the same physical space. Other benefits include team building, relationships, talent mentoring and creative collaboration.

Fixed interest

Why 2020 has been the year of the bond market

Going back to June 2019, investors would have questioned the logic of diversifying away from outperforming growth assets. But when markets feel at their best, it is paramount to keep a perspective on long-term goals.

Investment strategies

Is 5G all hype or real investable opportunity?

While its impact will take time to unfold, 5G will meaningfully change the world. Once adoption takes hold, there is huge potential for its application across a wide range of industries.

Property

Australian house prices: Part 1, how worried should we be?

Three key indicators are useful for predicting the short-term outlook for house prices, although tighter lockdowns make the outlook gloomier. There is enough doubt to create cause for concern.

Property

Australian house prices: Part 2, the bigger picture

There is good reason to believe the negatives will continue to outweigh the positives over the next 12 to 18 months. There is more concern about house prices than the short-term indicators suggest.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.