The big issues facing bond investors

How will fixed-income markets fare as major central banks begin to retreat from monetary easing? Should investors cut their exposure to bonds? And does the rationale for passive investing apply to bonds as much as stocks? Mike Gitlin, Capital Group’s Head of Fixed Income, shares his outlook on the asset class and the investment implications.

What are the main risks facing fixed-income investors today?

Two risks to consider are interest rate risk and credit risk. We’ve had exceptionally loose monetary policy in major developed economies for close to a decade. Bond yields, too, have been on a prolonged downward trend. The prospect of monetary policy normalisation therefore exposes investors to some interest rate risk. We don’t think that poses a severe threat, however.

The global economy, in our view, is in a late-cycle stage. Bear in mind that the typical growth expansion lasts about five or six years; we are nine years past the Global Financial Crisis. We don’t know when this phase will end but we do know that it’s late in the cycle. We are at or near full employment in the US, for instance, and the bond market is already signalling the possibility of a recession in the next few years. Overall, we think interest rates should remain fairly anchored (and forward market pricing would suggest the same).

Credit spreads, meanwhile, are very tight. Investment-grade and high-yield spreads are both close to historical tights. When there’s limited room for credit spreads to compress further, the risk is asymmetric. A risk-off event could trigger a sharp widening in spreads, while a continued risk-on bias won’t lead to material spread tightening. Accordingly, we are cautious on credit risk and valuations.

Some ask whether political risk is another cause for concern. There are, indeed, idiosyncratic political risks around the world, from turmoil in Venezuela, to the UK and Brexit, to the events in North Korea, to challenging politics in the US. But political risk is hard to price well or at all. We prefer to focus on risks that we can measure and monitor better.

So what should bond investors consider against such a backdrop?

Stay balanced. That is our key message. Don’t overly skew the portfolio to equity or fixed income. Ultra-easy monetary policy since 2008 has caused risk assets to do extremely well and distort asset prices across the entire asset spectrum. There are no cheap asset classes right now. Whether equity, fixed income, or real estate, we think markets fall somewhere between fair and full value. And in this late-cycle environment, investors need to be mindful of asset prices and their overall risk profile.

We also encourage investors to own some duration as we believe monetary policy normalisation will be slow and measured. There are additional global forces, such as muted global growth and inflation, and strong technical for US fixed income, that favour lower interest rates for longer. As noted earlier, we think credit markets look frothy, and would therefore suggest a more conservative and balanced approach.

Does that mean fixed-income opportunities are fairly limited?

Not at all. There are always attractive opportunities in fixed income. Investors can, for example, generate low– to mid-single digit returns in a US core or a global core portfolio. We also like emerging market debt where credit quality, on average, is superior to high-yield corporates. Plus it offers a higher yield, which is unusual because bonds with better credit quality typically have lower yields. Emerging markets, however, tend to be more volatile, so investors are compensated for taking on greater volatility. v In particular, emerging market debt strategies that allow managers flexibility to find relative value across multiple asset classes can offer good returns. We also see attractive opportunities in parts of the interest rate markets, as well as idiosyncratic names in the corporate bond sector. Munis, too, especially high-yield munis, remain an attractive sector for yield in our view. In short, there are opportunities for investors, though there are also areas where valuations worry us.

Can you elaborate on the markets that are vulnerable?

There are a number of areas with stretched valuations, notably bank loans and private debt. Both of these illiquid asset classes have experienced tremendous inflows. When there are huge sums of money chasing illiquid opportunities, particularly in a late-cycle phase, investors should be cautious. These markets may not be able to withstand the stress of significant outflows if and when they come.

Bank loans are, more often than not, issued by companies rated below investment grade. They lack call protection, which means they could at any time be paid down, repriced or refinanced at par value. Repricing risk appears high, given that the majority of loans are now above par. There’s also the illiquidity risk of settlement. Bank loans lack a contractual settlement date; settlement times could be weeks rather than days. Private debt tends to be loans to companies that either do not want, or cannot, borrow from a bank. They are mostly small-sized deals. Challenges here include inadequate protection in the bond covenants and the difficulty of due diligence on very small companies.

Private debt has risen partly because investors were keen to exploit the inefficiencies of the funding gap left by traditional banks. But a manager requires vast dedicated resources to carry out comprehensive research and due diligence on the small companies, and a strong legal group to ensure solid and protective bond covenants. There seems to be too much money chasing the sector, resulting in a difficult risk-reward paradigm for the investor.

Let’s turn to the topic of passive bond investing. What are your views?

Passive investing has made some inroads in fixed income but not by a lot. In the world of equity, passive funds have taken significant market share. Their market share in fixed income is less than 20%. There are structural reasons for that. First, it’s extremely hard to replicate fixed income benchmarks. Take the widely recognised Bloomberg Barclays US Aggregate Index – there are nearly 10,000 individual securities in that benchmark. So right off the bat, passive strategies have tracking error relative to the benchmark because the benchmark is impossible to truly replicate.

Even if a passive strategy can find all the bonds needed, it would have to buy the same bonds at exactly the same price at which the bonds enter the index to reproduce the index’s return pattern. But not all bonds are readily available in the market. According to our estimates, less than 60% of the index is available for purchase on any given day. This is further complicated by the fact that new issues are not added to the benchmark on the day they are issued. Between the time of issuance and the addition of the security to the benchmark, the prices of newly issued bonds could have changed. This gives active managers a timing advantage. They can buy bonds in the primary market when a large amount of bonds are available, whereas passive funds may wait until month-end. That helps active funds produce excess returns versus the benchmark and passive competitors.

The inability to mitigate interest rate shocks is another limitation of passive strategies. When you own the benchmark, you own the benchmark’s duration. In other words, passive investors are unable to protect their assets when rates increase. Active managers, by contrast, can reduce a portfolio’s duration in order to position for higher rates. All else being equal, therefore, active funds can potentially produce stronger returns than passive funds if rates rise.

Another drawback is the fact that passive funds own more of the debt of the most indebted companies, since these companies comprise a larger portion of the index and the benchmarks tend to be weighted by market capitalisation. Instead of blindly owning more of these companies, we would rather have our dedicated team of corporate bond analysts conduct thorough, bottom-up fundamental research and intentionally make that decision.

And finally, it is worth noting that historical results have shown that most active bond managers beat passive bond strategies, net of fees, through a full cycle.