The elephant in the room in fixed income markets is the ongoing addiction to stimulus. The US is driving the global narrative, but it is a feature globally. There has been a coordinated effort by central banks and governments, in quantitative easing (QE) on the monetary side and spending on the fiscal side, to prop up markets and stimulate them in a multi-dimensional way.

 

Lending conditions in advanced economy bond markets have been kept extremely lax and policy rates are near or even below 0% while government stimulus often comes in the form of lending packages. In fixed income markets, these polices suppress volatility, support prices, support risk-taking and promote liquidity. It has created very strong demand for yield. As conditions start to tighten, there will be an ongoing impetus to issue large amounts of credit risk and investors likely gobble it up.

 

Investors are rightly preoccupied with exit strategies. It will be led by central banks, reducing purchases of bonds and later adjusting up interest rates as growth becomes entrenched. The US market has a strong expectation that the September Fed meeting will provide a signal for when tapering will begin. The consensus is that it would then begin in November or December – and the last thing the Fed would want to do is surprise the market.

 

As longer term rates rise, lending conditions will become stricter so there may eventually be less appetite to issue new debt and volatility is likely to reappear. But this is not necessarily a problem. I like to think there are two ways to view this market: through yellow-tinted or rose-tinted glasses.

 

Through yellow-tinted glasses, fixed income is a low-volatility, income-preservation market. There are areas of massive stability such as US high-grade corporate credit. There are global investors that need this stability, not least in liability-driven investing. Index funds and core bond portfolios are exposed to interest rate risk, which would be a source of negative performance as interest rates tick higher. But it is a well-broadcasted concern for global investors and any losses would likely be relatively light as central banks play a strict balancing act to avoid an extreme sell-off.

 

Creative approach

Alternatively, there is the rose-tinted perspective. This is a growing and evolving way of investing, where managers are more creative with return profiles. As stimulus comes off, investors will look for places to earn a return, control macro risk and diversify. Rather than making a black-and-white risk-on/risk-off distinction, such bond funds fall in between. There is a lot of demand for using bonds as an opportunistic tool, not just for stability.

 

With creative approaches, care needs to be taken around liquidity. But conditions are far removed from the global financial crisis – back then there was a homogenous market issue revolving around housing, with sloppy lending and high degrees of bank leverage. The situation is now materially different.

 

Nonetheless, investors need to pay attention to liquidity; knowing who the players are is the key. If the Fed is the main player, keep an eye on its intentions for QE. If it is international investors, are they sovereign wealth funds, retirement funds or speculative investors?

 

Bond fund managers need to be multi-dimensional in how we discuss opportunistic products. It is not as simple as yield-based investing – there is far more to it than cashflow analysis. Liquidity analysis is very important, as we have seen repeatedly.

 

The evolution of fixed income has been very synchronous. Across the globe, regulators and investors have been getting more sophisticated. Regulation has continued to improve with lots of safeguards for investors, helping to protect them from black-box products with hidden exposures.

 

It is difficult to imagine liquidity problems in the largest and most liquid market in the world, US Treasuries, yet we should not be complacent about volatility – it has direct implications for the liquidity of other markets. As rates likely rise, it will add pressure elsewhere and have a trickle-down effect on liquidity.

 

If the Fed steps back, government issuance will also have to adjust. The Fed has been a huge source of demand for US Treasuries and agency mortgages so how it chooses to back out will have a big impact. We may also see some traders selling in anticipation of falling prices. But there is also natural demand internationally – so there is a ‘stability line’ somewhere above the current yield curve preventing a runaway market.

 

It is certainly reasonable to be wary that we could see a version of taper tantrum a la 2013, when the Fed spooked the market with it’s intention to exit QE. It is a precarious situation, but there are also good reasons to think it will not happen. Central banks are now much more aware of the sensitivity of market participants. And we only need to put a little bit of faith in central banks; after all, they are holding all the cards. I believe the exit strategy is going to be very cautious and well communicated, which should keep broad market volatility under control.

 

Liquidity issues in US high-grade corporate credit are extremely unlikely. Problems may only realistically emerge among small issuers and in structured markets where there are far fewer players. But there is massive demand from rose-tinted opportunistic investors, which stand ready to invest if there are dislocations. Investors are ever more likely to view fixed income this way. If you are willing to take some risk and wait for a good entry point, there will likely be ongoing opportunities.

 

We believe the trend for innovation is sure to continue. If the aim is to generate positive returns on an absolute basis, there are active ways to avoid interest rate risk. And there are many ways to utilize fixed income within a portfolio, complementing equities with, at times, a negatively correlated risk allocation.  There is a wide variety of funds structures – it is just a matter for investors to decide their objectives.

Stanley Mavromates
Erin Lefkowitz
Senior Fixed Income Portfolio Manager

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