Fixed income investing has come a long way since I first started in the business, back in 1986. In fact, the growth is truly astounding: The overall bond market has grown more than six times, from $15 trillion in 1989 to $92 trillion in 2012. The number of investable sectors has similarly grown, from core governments, investment grade corporates and a relatively new mortgage-backed security market to a full spectrum of sectors, sub-sectors, countries, currencies and derivatives across the capital structure today. If back then, investors were primarily judging risk based on average maturity, average quality and, for those at the cutting edge, duration and convexity, today’s risk measures are far more sophisticated and more specific. Calculators have been replaced by super computers, with yield-to-maturity calculations giving way to all the different algorithms that bond traders and asset managers use to measure and assess risk. Indeed, a lot has changed.
What hasn’t changed much are the underlying reasons investors look to fixed income. Yes, there’s been some evolution over time, and yes, investors are increasingly differentiating among types of fixed income based on their own unique situations and needs. Yet, in general, investors have continued to own if not increase their allocations to bonds for one or more of the following reasons:
- Total return/absolute return
- Inflation/deflation hedge
- Liability management
At least some of this may change going forward, however, given today's low-yielding environment.
At PIMCO we talk about the need to “pivot” in terms of changing the way we think about markets and investment strategies as well as the way we serve our clients. For example, while some investors may be tempted to move away from their traditional core fixed income allocations into equities and higher risk alternatives, they may be better served by first rethinking or redefining their definition of “core.” For most investors, core fixed income means a benchmark-driven allocation to intermediate-duration, multi-sector, multi-country and/or multi-currency bonds – an approach that has basically served them very well over the past 10, 20, or even more years. But is this the best way forward? For some, perhaps, especially those who are willing to expand their opportunity set and consider more forward-looking (e.g., GDP- rather than market value-weighted) indexes. But, for many, probably not.
Figure 1 attempts to capture the concept of pivoting, albeit in a simplistic manner. It starts with the 20-year to 30-year super-secular decline in longer-term government bond yields; the 10-year U.S. Treasury yield, for example, fell from a yield of 10.8% at the beginning of 1980 to less than 2% today supporting many asset classes. For the most part, this was a great time to be in a wide variety of securities – including a variety of bonds, first governments, then credit, emerging markets, mortgage-backed and asset-backed securities, as well as equities all of which had broad outperformance and provided robust real returns during this period. But now, with interest rates near historical lows, and return expectations broadly diminished, investors seeking to meet yield or return targets may want to include strategies that specifically target income and flexible, relatively liquid absolute inflation-adjusted returns in their investment portfolios. And at some point in the next few years, they will likely want to pivot further and add more sectors traditionally viewed as inflation hedges as the impact of accommodative central bank monetary policies worldwide takes root. Indeed, we’re already seeing some investors moving in this direction.
A Journey Back in Time
To better understand the context for this shift, it's helpful to take a look back in time.
And let's start by considering the role of bonds prior to the 1960s, before the inflation era of the late 1960s and 1970s. Back then, bonds were primarily viewed as income-generating instruments and as a diversifier to equities. We sometimes joke about “clipping coupons,” but that was what bond investors did and how they viewed the bond market: as a relatively low-risk and stable − if not boring − market, where the primary skill was to pick a bond that wouldn’t default, clip coupons and earn income over the life of the bond.
Things changed significantly, however, beginning in the mid- to late 1960s as inflation began to take hold. This was not a cyclical phenomenon, but a secular one, with businesses, consumers and investors all making major adjustments to their view of the world and how they hired, manufactured, purchased and invested. Bonds were out, dubbed by many as “certificates of confiscation,” with equities, cash and real estate becoming the investments of choice. Why buy bonds when you could put your money in a local bank account and earn a 20% deposit rate for three months, many would ask. Looking at the list of potential investment benefits – income, total return, liquidity, diversification, deflation hedge and liability hedge – bonds didn’t tick many boxes.
But things changed again, starting in the early to mid-1980s, with Paul Volcker and a more hawkish group of central bankers around the globe. While it didn’t happen overnight, inflation became a thing of the past, and disinflation – defined as steadily declining rates of inflation – became the new policy and the new norm. Bonds enjoyed a renaissance, not for five to 10 years, not for 10 to 20 years, but for 25 to 30 years, as shown in Figure 2.
In fact, bonds outperformed equities for much of this period, with the most striking span being the 13 years from the beginning of 2000 through the end of 2012: A diversified basket of global bonds (as represented by the Barclay’s U.S./Global Aggregate Index) returned roughly 118% versus a loss of 5.8% for a basket of global stocks (as represented by the MSCI World Index on a cumulative). Bonds moved from income and diversification to the realm of total return, as investors initially tiptoed into long government bonds and then, more aggressively, into corporates, mortgage- and asset-backed securities, high yield, emerging markets, bank capital and all the other spread sectors and yield-providing instruments. There were plenty of mines and missteps along the way, with Orange County, Argentina, Mexico, Russia, WorldCom, Enron, Bear Stearns and Lehman perhaps being the most notable. Yet investors continued to snap up bonds, and they continued to pursue attractive total returns through a combination of yield and price appreciation.
Bonds also provided liquidity, and for some, actually became a new cash alternative. After all, why own cash if rates were heading lower? And with mutual funds in the U.S. and UCITS vehicles in the European Union on the rise, who needed cash when there was liquidity for your fund holdings? While most investors still kept some cash as a true liquidity buffer, they increasingly began to tier their liquidity holdings from the most liquid, highest quality investments that could meet their immediate needs to progressively longer maturity investments, such as short duration bonds, to take advantage of term, credit, volatility and liquidity premiums.
While bonds were always seen as portfolio diversifiers, this became even more important after the equity tech bubble burst in the early 2000s, with investors owning bonds not just to help meet their income, total return and liquidity needs, but to dampen volatility as they correspondingly increased their allocations to equities, hedge funds and higher risk sectors. What many didn't realize, however, was that not all bonds behave equally in terms of providing diversification. This became a harsh lesson for those with large positions in corporates, high yield, emerging markets and non-agency mortgages during the financial crisis, as these sectors carried significant equity-like risk. And it was a similarly costly discovery for those who viewed their eurozone peripheral government bond holdings as a means of diversifying equity risk during the recent eurozone crisis. This is not to say that diversification doesn't work; it just means that bond investors need to do their homework.
The benefits of diversification become most clear during periods when markets are worried most about deflation, and we need to look no further than the 2008 financial crisis and the 2011 eurozone crisis to see the benefits of owning high-quality government bonds, which are perceived as a safe haven and frequently rally as many other asset classes decline in tandem. In 2008, for instance, 10-year U.S. Treasury bonds returned 20.1% versus U.S. equities at -36.55%, as measured by the S&P 500. In 2011, 10-year Treasuries again outperformed U.S. equities, returning 16.04% versus 2.07%.
Long bonds, and/or derivative overlays meant to mimic long bonds, have also come to be viewed by many as the best way to hedge liabilities, particularly by pensions and others fearing a mismatch to their longer duration liabilities as interest rates have fallen and increased the value of their liabilities versus their assets during much of this period. LDI, or liability driven investing, got its start in the late 1980s and has since become a major part of institutional investing in the U.S., U.K. and Netherlands.
In short, regardless of whether investors have sought income, total return, liquidity, diversification, deflation hedging or liability management, bonds have been viewed as “king” for much of the past 25 to 30 years.
Investing in the New Era
But now we’re entering a new era when bonds will likely struggle to fulfill at least parts of their primary mission. This isn't to say that bonds won't continue to play an important role in portfolios. They most certainly will. But in anticipation of secular shifts in the years ahead, including eventual rises in interest rates and inflation, we believe investors can benefit from pivoting and rethinking their approach to the fixed income sector – particularly as they look to achieve their income and absolute return objectives.
For investors who are concerned with low yields and an inability to meet their income needs, pivoting toward an income- or yield-based approach may make sense. This doesn't imply a wholesale shift toward high yield and riskier sectors, but it does suggest potentially moving away from a portfolio built using the standard intermediate duration benchmark toward a portfolio that is less tied to a benchmark in an effort to more effectively meet specific income targets with the goal of delivering income rather than simply matching the bond market’s total return over time.
For those with intermediate benchmarks who worry about the risk of rising interest rates, a more flexible duration approach may make sense – one that is still multi-sector, multi-country and multi-currency, but one that also has the ability to go to a short or even negative duration to hedge against, if not benefit from, rising rates. This would be more of an absolute return investment style targeting a specific return goal over Libor, depending on an investor's objectives, along with ample liquidity such that it remains a key component of the core bond allocation.
Investors with intermediate credit-based benchmarks may also want to hedge against rising rates, or widening spreads, and similarly shift to a more flexible, benchmark-agnostic style that allows for shorter durations, short credit positions and/or the ability to move across different spread sectors, such as investment grade versus high yield. Again, this would be an absolute return strategy with ready liquidity and relatively modest single-digit return targets, rather than the double-digit targets generally found in the hedge fund or alternatives space.
Those worried most about inflation might look to shift their core nominal bond positions toward real return-oriented strategies by moving directly from nominal instruments into inflation-linked securities. Alternatively, investors might consider an allocation to emerging market currencies which may respond positively to inflationary pressures in the developed world. If inflation stems from a decline in reserve currencies like the U.S. dollar, euro, and Japanese yen, EM currencies—particularly in countries with healthy fundamentals—are likely to appreciate in response, providing a hedge.
Investors may also simply allow portfolio managers more investing flexibility in their portfolios. This always sounds counterintuitive. Yet, if yields have indeed troughed and are destined to embark on a secular journey higher, adding additional tools is probably the best, if not the only, way to provide necessary income, meet required return objectives and hedge against downside risk.
In summary, fixed income investors need to think differently in this environment, potentially pivoting to strategies that are less focused on traditional benchmarks and more oriented to generating income and providing greater flexibility to hedge against rising rates, widening credit spreads or higher inflation. The same can be said for equity investors – and even more so for multi-asset investors – in terms of expanding the opportunity set and moving away from traditional benchmark investing. It's a new era ... and it may be time to pivot.