Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 271

There’s more to bonds than buy and hold

In fixed income investing, there are two conventional sources of return that investors are familiar with: collecting interest payments from bonds (i.e. income) and correctly predicting the direction of rates, which delivers capital gains or losses (i.e. duration exposure). The expected returns from both these sources are heavily challenged by the current low levels of interest rates and credit spreads, as well as uncertainty about their future direction.

But what if there was another source of returns that could help restore balance to fixed income portfolios? At Ardea, we believe that source of return is relative value fixed income investing.

Relative value strategies can deliver positive returns from fixed income, irrespective of the current level or future direction of rates and credit spreads. Conventional approaches tend to miss these opportunities. Conventional return sources are challenged at the moment and simply holding government bonds is no longer a reliably defensive strategy.

Conventional fixed income return sources are challenged

For investors seeking a defensive investment, fixed income has traditionally been the asset of choice. The debt markets, by offering a senior claim above equities on the assets of a company or government can provide a safer option for investors’ capital. In addition, bonds can provide a stable stream of income as bond issuers are contractually obliged to make regular interest payments, unlike equity dividends, which can be cut at any time.

However, three challenges currently face those reliant on fixed income to provide reliably defensive returns.

The first is that low interest rates have eroded the yield cushion in fixed income. We can think of the income from a bond as a ‘yield cushion’ because that stream of income (or yield) helps cushion investors’ capital against losses if rates rise. When rates are low, the yield cushion is thin, giving little protection against potential capital losses.

For example, as bond yields rose in late 2016 and early 2017, 10-year Australian government bonds incurred a capital loss of around 10% over 6 months, compared to interest income of just 1.13% over the same period.

Hardly what you expect from a ‘defensive’ investment. Add to this, the fact that central banks around the world are signalling a shift away from the extreme stimulus that has kept rates suppressed since the 2008 financial crisis. Investors are now left with less return for more risk.

The second is that bonds are not as reliable a risk diversifier as commonly assumed. An allocation to bonds is supposed to provide a buffer when equity markets fall, as bond yields should decline and thus bond prices rise.

The starting point of bond yields is already close to zero. In addition, while this bond-equity correlation has held in recent history, a longer perspective shows that it’s actually quite unstable. It is sensitive to shifting interest rate and inflation paradigms, just like the one we’re currently seeing in the US.

The third is that ‘credit creep’ in fixed income portfolios has further compromised the defensiveness of fixed income portfolios. The ‘reach for yield’ means larger allocations to higher yielding credit assets, with more risk in the form of defaults, credit spread volatility and illiquidity.

'Credit tourists' accepting these risks

In the desperation for yield, defensive portfolios that wouldn’t normally take these types of credit-related risks have been forced to become ‘credit tourists’.

In benign markets, credit assets tend to perform independently of equities (i.e. they have low correlation to equities). But in times of market stress, say during a recession, they often become highly correlated and incur capital losses as equities fall, just when the defensiveness of fixed income is most needed. This risk has been masked by the current bull market, resulting in a build-up of hidden equity 'beta' in fixed income.

Particularly concerning is the growing evidence of late cycle credit risks. Corporate borrowers are taking advantage of cheap debt and weakening creditor protection in bond and loan terms. The extreme ‘reach for yield’ behaviour includes a BBB-rated European company issuing a bond with a negative yield. That’s right, a company with real default risk being paid to borrow money! This is the kind of behaviour you might see towards the end of a party. Seems like a good idea at the time, but the next morning not so much. This topic is discussed in Ardea’s publication: “Corporate bonds – More Risk for Less Return”, available here.

What’s the alternative and why does it exist?

Conventional fixed income approaches focus on how much yield can be earned from buying and holding a bond. In contrast, a relative value approach specifically identifies whether that bond is mispriced relative to other related securities with similar risk characteristics and therefore has potential for its price to rise or fall. A profit can then be monetised when the relative mispricing corrects, and capital can be recycled into the next opportunity.

Fixed income markets have a vast range of liquid bonds and derivatives giving diverse opportunities to exploit. Rotating through many modestly sized and uncorrelated relative value positions can deliver more stable returns with lower risk than portfolios with large concentrated bets on market direction. Positions can be isolated from unwanted market risks by using risk management tools such as derivatives, meaning relative value portfolios can seek returns independent of the current level and future direction of interest rates.

Fixed income markets are inefficient. Underlying structural factors such as regulation, investor mandate restrictions, market segmentation and varying investor objectives have always existed in fixed income. These forces give rise to buying and selling flows that are non-economic in nature (i.e. they’re not focused on maximising profit). Examples include banks managing their balance sheets, insurance companies hedging liabilities, passive investors tracking benchmarks and central banks pursuing policy objectives. These drivers of market inefficiency are structural in nature and persistent through time and across market cycles. The reliable source of returns allows for a repeatable investment process.

What can relative value do for you?

A relative value approach does not rely on accumulating bonds to harvest yield or trying to predict market direction or reaching for yield in credit and is therefore not vulnerable to those challenges. It can include specific strategies to protect against extreme negative scenarios, for example, by using interest rate options that profit from rising volatility. The end result is the potential for stable returns exceeding cash or inflation.

The opportunities provide compelling diversification benefits when used alongside traditional government bond, credit or equity investments, as indicated in the diagram below.


Gopi Karunakaran is a Portfolio Manager at Ardea Investment Management and Sam Morris is an Investment Specialist at Fidante Partners, a sponsor of Cuffelinks. This article is for general information only and does not consider the circumstances of any individual.

For more articles and papers from Fidante, please click here.

Jerome Lander
September 18, 2018

Good article. There is an obvious need for greater use of alternative strategies within traditional markets, for which most investors - including most fund managers - are painfully ill-equipped.

September 13, 2018

Bonds are the conservative and defensive foundation of my portfolio. Prefer to buy and hold to maturity and not worry about a regular revaluation.

Warren Bird
September 13, 2018

Good on you Jim. I do the same in my personal investments, using bond funds for the purpose. When yields increase, so does the income my bond holdings generate and the short term unit price decline is irrelevant in the scheme of things.

That said, I do expect the fund managers I use to undertake relative value trading within the portfolio to generate as much return over time as they can. I just don't see this as a strategy for times like now, but it's always been part of the active fixed income manager's armoury. We were doing relative value switches within the semi-government securities market back in the 1980's when underlying yields were in double digits.

September 14, 2018

It's hard to argue with Gopi's underlying thesis. It is a fact that here is very little cushion left in most devt. market sovereign bonds. It is also plain to see that spreads on credit are at historic lows and look outright scary in certain sectors such as high-yield. We have our own fun in Australia where you see unrated high-yield bonds come to market and investors fall over themselves, pushing down yields straight away..

The problem we face is that we are in the unique environment where both equities and bonds look expensive and Greenspan often asserts. Bonds no longer provide the same safe haven where you could run a traditional 60/40 portfolio and clip the coupon at 7% on your bond portfolio knowing they would provide further upside if markets pulled back and there was a flight to safety. The whole space looks challenged IMO and it's hard to know where to look.

Question becomes can relative value actually add value or is it a clever well-timed marketing poly that will cost 60-75 bps for cash-like returns? I am definitely keen to find out more as there is a need to be more open minded against the current backdrop.


Leave a Comment:



Income opportunities in global bonds

Fixed income solutions in a rising rate environment

Inflation? Nothing (much) to see here


Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates


The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.


Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.


The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.


The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 



© 2022 Morningstar, Inc. All rights reserved.

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 ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.