Market Views: How are investors adjusting to a bond bear market?
Global bonds have slumped into their first bear market in a generation, spurred by the pressure from central bankers determined to quash inflation even at the cost of a recession.
The Bloomberg Global Aggregate Total Return Index of government and investment-grade corporate bonds has fallen more than 20% from its 2021 unhedged peak on an unhedged basis, in the biggest drawdown since its inception in 1990.
Rapid interest-rate hikes deployed by policymakers, in response to soaring inflation, have ended a four-decade bull market in bonds. This has created a difficult environment for investors, with bonds and stocks sinking simultaneously.
On a hedged basis, the bond index fell as much as 12% from its peak. Combined with MSCI’s index of global stocks, which has slumped 19% this year so far, the combination has undermined the traditional approach of investing strategies over the past 40 years or more.
That has pushed a US measure of the classic 60/40 portfolio split between stock and bonds, respectively, down 15% this year, on track for the worst annual performance since 2008.
Considering this unusual situation, AsianInvestor asked asset managers and analysts how institutional investors are adjusting their portfolios in response to the unusual bear bond market over the coming 12 months.
The following contributions have been edited for clarity and brevity.
Freddy Wong, head of Asia Pacific fixed income
Invesco
We believe that the overall macro backdrop remains negative as growth slows down across major economies, while central banks are committed to raising rates aggressively. Central bank actions over the next couple of months remain the key for economic and market developments. The risk of a policy mistake is higher if the central banks overtighten.
While credit spreads in general offer some value after the widening over the past year, we do not see them fully pricing in recession risk and hawkish central bank policy yet. As such, we expect risk assets to remain volatile and have positioned our portfolios conservatively.
We believe duration should largely be in a range around current levels. However, the spike in short-end rates recently provides good entry levels for high quality short-dated bonds. Within our investible space in Asian and EM credits, while we are overall cautious towards credit risks, we prefer China non-property credits over the rest of the world, given the better valuation and easier monetary policy.
We do not see China high yield property developers out of the woods yet despite the policy stimulus given the slow recovery, Covid situation, and lack of refinancing channels. We remain cautious towards general EM credits given their sensitivity to US rate hikes. We are also closely monitoring commodity prices, which could trend lower if recession risks play out and have negative impacts on the issuers from commodity-exporting countries.
We believe under the current market conditions, it’s important to maintain a diversified portfolio with a decent cash buffer. Given the weak market sentiment, it’s better to wait for good over-sold opportunities in the market, for example the recent sector-wise corrections on the China Asset Management Companies sector and Indian Renewables space. These could create good buying opportunities for better quality names in the affected sectors. Bottom-up credit selection remains the key to differentiate better candidates within sectors.
Jonathan Liang, head of Asia ex-Japan investment specialists, global fixed income, currency and commodities (GFICC)
JP Morgan Asset Management
While capital markets have been choppy this year with many equity markets down by 15-20%, bonds are also down meaningfully over the same period. Besides the commonly cited reason of unexpectedly high and sticky inflation, the other culprit for this breakdown in the negative correlation between stocks and bonds is the prevalent use of quantitative easing (QE) and tightening (QT) by global central banks.
Just as QE pushed asset prices broadly higher, all asset prices then started to decline following the pivot to QT. Therefore, it is important to develop a framework to understand these shifting patterns of correlations under different monetary policy regimes.
According to our “Three Phases Framework”, we just experienced phase 1, when central banks pivot from QE to QT. In this phase, most long positions will underperform (except for the USD). In preparation of phase 1, we had established duration shorts across our fixed income strategies coming into this year.
However, the following phase (phase 2) is characterised by the return of “right-way correlation”, where bonds resume negative correlation to risk assets and duration can once again provide some stability to portfolios during risk-off periods. As central bank tightening starts to slow economic activities and bond yields return to more reasonable levels, we believe it is once again time to cautiously add back duration.
Aninda Mitra, head of Asia macro and investment strategy
BNY Mellon Investment Management
It has been a tough year for bonds undoubtedly. Moreover, the coincidence of a sell-off in equities as well as bonds, which is quite rare, has left investors with few places to hide.
But that being said, over the past few weeks, we have been recommending cutting underweights in global bonds and shifting to neutral. This is because signs of an inflation peak are starting to become visible. Inflation break-evens have eased significantly to below 3% in the US, and real yields are at five-year highs of around +1%. Indeed, US real yields could stay elevated for longer if the Fed stays hawkish even at the cost of growing economic pain. The resulting strength in the USD and volatility in global risk assets has further to go as the Fed continues to hike rates and as it intensifies the pace of its quantitative tightening.
We think these conditions will spur a flight to quality global bonds, especially USTs, and drive a flattening bias across the yield-curve. This, after the biggest sell-off since 1990, warrants a reduced underweight. We would turn more positive on confirmation of a disinflationary trend in US CPI, which underpins a peak in the Fed’s rate hiking cycle.
Geoffrey Lunt, senior investment specialist, Asian fixed income
HSBC Asset Management
Institutional bond investors, who tend to think in the long term, may not take any notice of the Bloomberg Agg falling into a technical ‘bear market’, not least because the corollary of a fall in bond prices is a rise in yields. And therein lies the main reason why the market has been so challenging over the last year - the starting point for sovereign yields was exceptionally low and spreads were extremely tight.
Chairman Powell’s speech at Jackson Hole seemed to persuade more dovish market participants that rates would have to stay higher for longer in order to lean down on excess demand. This certainly maintains upwards pressure on US treasury and other government yields in the short term.
However, the higher government yields rise, the closer we get to the point that they discount the entire tightening cycle, while uncertainties remain, the currently discounted effective Fed Funds rate of nearly 4% would certainly - on our estimation - take rates well into restrictive territory. We would therefore say that current yields are getting close to fair value for the medium to long term.
Meanwhile corporate spreads are now wide of their long-term averages. While there is a potential to lead to deteriorating credit fundamentals, we are not expecting the kind of downgrade and default rates which would imply significantly wider spreads from this point.
Ramon Maronilla, fixed income portfolio specialist
T Rowe Price
So far this year, traditional fixed income has failed in its role as a diversifier to risky assets and an anchor of stability in market sell-offs. This is leading institutional investors to rethink their approach to fixed income investing and seek innovative ways to achieve their desired outcomes.
First and foremost is a more flexible and tactical approach to duration management through a greater ability to hedge or protect against rising interest rates. Second is to pursue greater diversification of risks by expanding their investment universe: By combining a wider and more diverse set of risk premiums across rates, credit, liquidity, convexity, and structure, investors are able to capture higher levels of return while lowering overall portfolio volatility. Third is by paying more attention to shifting correlations between interest rates and spreads.
Rates and spreads typically have low to negative correlations, but it’s not uncommon for both to move in the same direction such as when unconventional central bank policy actions dominate markets. We’ve been discussing the concept of Empirical Duration with clients so they can better understand the evolving dynamics between rates and spreads and its implications on the true rate sensitivity of their portfolios.
Mabrouk Chetouane, head of global market strategy solutions, international
Natixis Investment Managers
Risky assets have seen significant re-pricing over the past month, with equities and fixed income in some cases experiencing significant declines. Going forward, we believe that the adjustment in asset prices is not yet over. The sovereign rate risk remains tilted to the upside and may retest prior highs around 3.5% for the 10-year US Treasury, pulling global yields alongside.
Nevertheless, the current level of long-term rates already offers an attractive carry for bonds, first in the US and to some extent in Europe, particularly in Italy where rates are close to 4%. The TPI (The Transmission Protection Instrument) recently deployed by the ECB acts as a cap on Italian rates.
The energy crisis, fueled by the war in Ukraine, which is not expected to show any signs of abating in the short to medium term, is expected to continue to push up prices and in a context where the ECB is firmly committed to bringing inflation close to target.
In this context, we favour short-term European break-evens, as the inflation peak is still ahead of us and offers a hedge against the worst-case energy scenario; as well as strategies that take advantage of a flattening of the yield curve in Europe in the medium term.
James Athey, investment director at rates management
abrdn
We believe that we are closer to the end than the beginning with respect to the global monetary tightening cycle. We envisage a very difficult six-plus months ahead as economies globally battle against soaring costs for both producers and consumers and the compounding effects of tighter monetary policy. This environment is likely to see corporate sales volumes and margins contracting which will put significant downside pressure on earnings - pressure which is largely not being priced today by equity markets.
The combination of high base effects, demand destruction, monetary tightening and a strong US dollar should see commodity and input costs falling through year-end and thus absent any further shocks, we expect central banks to begin slowing the pace of their monetary tightening as we move into 2023.
Lastly, we believe that there is likely to be an increase in default events into 2023 as the weakest corporates struggle to remain afloat in an environment of higher policy rates and wider corporate spreads.
This combination of expectations leads us to believe that there is already some value in longer-dated core global government markets - particularly in US treasuries, given the impressive Fed tightening achieved to-date, the lack of reliance on Russian energy there, and the role that US treasuries continue to play as the world’s safe asset of choice, even if that role has been slightly diminished by recent US government actions abroad.
Our medium-term strategy therefore is to increase portfolio duration in anticipation of a less inflationary period of low growth ahead and the commensurate weakness in risk assets which this will create.
Our medium-term strategy therefore is to increase portfolio duration in anticipation of a less inflationary period of low growth ahead and the commensurate weakness in risk assets which this will create.
Benny Gay, head of intermediary clients Asia
Vontobel Asset Management
Investors are concerned about the current interest rate environment, therefore it’s not a surprise the strong flows to fixed maturity products in recent months. Besides returns, investors are looking for liquidity and diversification. To meet such objectives, investors need to remain active, be aware of the risks and opportunities.
I believe the fixed income universe still offers attractive opportunities, market participants will continue to react to recession fears, tighter financing conditions, uncertainty about the timing and pace of disinflation, geopolitical worries, commodity prices and challenging liquidity. These factors all point to elevated volatility and widening spreads between high-yield and investment-grade corporate bonds.
As such, diversification remains crucial. Investors are increasingly looking for managers that can deliver reasonable returns despite the challenging environment; geographic diversification becomes a key consideration when portfolios are adjusted.
Paul McNamara, investment director on emerging market bonds and currencies
GAM Investments
During the careers of almost everyone trading today, inflation has flared up in cycles, generally short in duration and limited in scope. The last comparable rise in global bond yields was in 1994, and the impact of this shock has already hugely exceeded that. It is easy to see the reason – for the first time in the markets’ institutional memory, the movement in inflation has not been a blip of a few percent, but a shock bringing headline levels to double digits in many countries. The US has not seen consumer price index prints of this level since the early 1980s.
There is a rising fear that “this time is different” and it may be necessary to do more than shorten duration and improve asset quality. Portfolios are being transformed by de-risking completely and acknowledging that adding duration is not cutting risk.
Philipp Burckhardt, fixed income strategist and portfolio manager
Lombard Odier Investment Managers
As the cycle matures, we see a tendency to adjust portfolios by moving up in quality and reduce cyclical sectors, as, in particular, our more defensive credit franchises have seen significant inflows so far this year. This isn’t unexpected, as higher-rated segments had underperformed lower-rated ones since the start of the year, largely due to their greater exposure to duration risks. Indeed, central banks reinforced their hawkish messages over the last weeks, but as growth is already slowing markedly, in our opinion so should inflation, opening the door for central banks to reach peak hawkishness.
Every selloff however also offers opportunities for fixed income investors. Looking ahead, we now find ourselves in an environment of significantly higher and hence more appealing all-in yields, driven by both higher risk-free rates and wider credit spreads. In our opinion, over the medium-term these valuations more than compensate for the risks and heightened volatility ahead. We continue to see the crossover and fallen angels segments as a sweet spot for risk-adjusted returns. This view is driven by multiple factors, most notably strong fundamentals, the beneficial interplay of rate and credit risks, plus significant market inefficiencies at the boundary between investment grade and high yield.