Market Views: How will the bond rout affect allocations?
Warren Buffett’s warning in his annual letter to shareholders on Saturday (February 27) that investors move away from fixed income came just days after a global bond rout wreaked havoc across markets.
The Berkshire Hathaway chief executive and legendary investor declared "bonds are not the place to be these days” and warned of “a bleak future” for global fixed income investors, whether institutional or retail.
The 10-year US Treasury bond yields stood at 0.93% as at the end of 2020, almost half their level at September 1981, the letter highlighted. In some countries, sovereign debt yields negative returns, it added.
Days earlier, investors had sold off US Treasures on inflationary worries and fears of tightening monetary policy, sending 10-year yields soaring to a 12-month high of 1.6140% at one point on February 25. They stood at 1.47% yesterday (March 3).
“What happened ... was a complete dry-up of risk appetite in the fixed-income space,” said Gang Hu, founder of US hedge fund Winshore Capital.
There was a major knock-on effect on stocks worldwide, particularly in the tech sector, as higher interest rates tend to have a negative impact on equity valuations, as they lower the present value of future earnings.
Asian and European central banks have pledged to buy more bonds in an effort to contain the rout.
AsianInvestor asked investment experts how these events would affect asset owners' allocation plans.
Denis Resovac, head of insurance strategy for Asia Pacific
Robeco
In recent years one of the main concerns for insurance investors has been the hunt for yield in the fixed income space. Insurers have tended to invest in longer-dated, lower-rated, structured and more illiquid fixed income assets globally to enhance returns.
For the investment departments of insurance companies, the recent sharp rise in nominal government bond yields across developed markets has not changed their long-term investment strategy.
If we compare the current bond yields in US investment grade (2.35%) and US high yield (4.40%) with those of recent years, we find we are still in a relatively low-yield environment. Hence the recent increase in interest rates might provide some relief for new money that needs to be deployed. However, the overall trend still remains intact.
With the implementation of local risk-based capital frameworks in Asia and the growing importance of sustainable investing, we have seen an increased trend for ESG integration, impact investing, decarbonisation in fixed income portfolios and capital-efficient credit solutions.
Stephen Tong, client portfolio manager for multi-asset solutions
Franklin Templeton Investments
The recent bond rout was driven by concerns around the possibility of central banks tightening monetary policies and liquidity risk. But it has little impact on the macro backdrop, where we expect the next 10 years to be generally less rewarding for bond investors than the last 10.
Nominal yields from developed market government bonds remain low, and this forces investors to rethink their asset allocations, both tactically and strategically. There are a few themes we have observed when talking to Asian asset owners.
1) Tactically investors remain optimistic on riskier assets such as equities over bonds. Even with increasing chatter about mounting reflationary pressures, we doubt inflation will lead to an early reversal of the accommodative central bank stance. It makes sense for investors to have a meaningful overweight to equities over bond in their allocation plans.
2) China government bonds offer attractive yield and return potential compared to their western counterparts. Given their low representation in global indices, more clients in Greater China are adding China government bonds as a separate component in their strategic asset allocations.
3) Investors should add illiquid assets when permitted. Asian asset owners used to be more conservative about allocating to illiquid assets such as private debt, infrastructure and real estate. This has changed as these asset classes offer diversification to equity, especially for investors looking for income and sources of portfolio resilience.
Thomas Poullaouec, Asia Pacific head of multi-asset solutions
T. Rowe Price
The rise in yields is a reminder that the traditional role played by bonds in asset allocation – namely income and diversification – should be re-evaluated. The income component is almost non-existent at such low yields, while the risk mitigation aspect is challenged when yields are rising in tandem with equity falling.
One way for Asian asset owners to adjust their portfolios is to incorporate longer-dated government bonds and lower-quality bond sectors – such as high yield bonds, and emerging market debt – that offer higher yields. Since these come with higher volatility and stronger correlation to equities, investors need to carefully calibrate their investments.
Another option is a larger allocation to stocks. Stocks have typically generated superior total returns than bonds. We recommend investors to add tail risk strategies to protect against potential drawdowns.
Finally, investors should look for alternative strategies designed to benefit from increased volatility or from negative trends in asset prices.
Andrew Zurawski, associate director for investments
Willis Towers Watson
The recent run-up in longer-term government bond yields has been largely driven by investor optimism for the economic growth outlook, particularly in the US. The approval of the next fiscal stimulus may have added to this.
These factors combined suggest that near-term returns will be reasonably good for risky assets such as equities. We recommend being a little overweight on these assets, even though market volatility is likely to remain elevated. In addition, yields on Chinese government bonds remain attractive relative to bond yields in developed markets.
Inflation expectations have increased, and they are now more in line with central bank targets. So despite a slightly higher discount rate, a stronger economic outlook is supportive for cash flows for risky assets in the near-term.
In addition, central banks in developed markets have strongly reiterated that the current policy stance will be retained for a few years to come.
Tai Hui, Asia chief market strategist
JP Morgan Asset Management
Headline inflation could pick up in the months ahead as the US economy improves and higher commodity prices kick in, but the Federal Reserve and other developed market central banks are unlikely to abruptly change their policy stance.
Stronger growth, low rates and a steeper yield curve are positive for US equities, especially for the cyclical sectors badly hit by the pandemic. This calls for a more diversified approach in allocating to global equities, instead of solely focusing on the US and China and on technology and healthcare.
For fixed income, the picture is more complicated. The prospects of higher US treasury yields continue to force investors to the riskier end of the market. Corporate credit spreads are already at a cyclical low. Room for further compression is limited.
This means investors will need to maintain short duration, and the coupon is the main buffer to offset the drag on return from a fall in bond prices due to higher risk-free rates. This puts high-yield corporate debt in a more advantageous position relative to investment grade, even though its ability to hedge against an equity market correction is relatively weak.
Michael Dale, head of Asia Pacific ex-Japan client services and marketing
Western Asset
Institutional investors with a longer-term investment horizon, such as Asian insurance companies and pension funds, actually prefer higher interest rates.
Importantly, it allows them to better match their liabilities by locking in higher bond yields. Higher bond yields may also provide investors with an attractive entry point to reduce their underweight to fixed income amongst their overall asset allocation.
The recent rise in US treasury yields has also pushed the Asian local-currency yield curves higher. At the same time, however, Asian currencies have remained resilient. Consequently we continue to see prospects move from lower-yielding developed market bonds to quality Asian local debt, such as China government and policy bank bonds that yield above 3% for five- to 10-year tenors. Investors remain confident that Asia FX will remain strong over the medium term.
A gradual uptick in government bond yields also benefits our client’s allocation to investment-grade credit which offers an attractive pickup over government bonds. We consider this sector to be a cornerstone investment for our clients and investors generally.
Matthew Merritt, head of investment strategy
Insight Investment
From an asset allocation perspective, government bonds have held a unique attraction in recent decades. The Covid-19 crisis has pushed interest rates towards their lower practical bound, and this implies less return potential from here.
This background sets us on a quest for more diversifying investments to help spread portfolio risk and generate return. There is greater scope for alternative investments to add value both from a risk-mitigation and return-generation perspective. The importance of active asset allocation is also likely to be of more value.
By widening our horizon and embracing a wider range of asset classes and investments we can find alternative investments that can help better diversify our portfolios and be additive from a return generation standpoint. In that context, the prospect of lower absolute returns from a range of traditional asset classes raises the importance of asset allocation as a source of value creation.
Arthur Lau, head of Asia ex-Japan fixed income
PineBridge
The recent spike in US treasury yields has raised concerns about the outlook for the global fixed income market. While there has been a rise in risk-free rates and the subsequent implication that US treasuries will raise the volatility of the fixed income market, we do not think such risk will have the same degree of impact on all fixed income asset classes.
For one thing, we still don’t believe there is notable inflationary risk, which seems to be one of the concerns behind the recent spike in US treasury rates. We think there is still excess capacity in the major economies as they continue to recover from the Covid-19 impact, so near- to medium-term inflationary pressures should be contained.
Moreover, we do not see major central banks relaxing current accommodative monetary policies any time soon until economic conditions are back to more steady ground.
In short, the further upside of interest rates due to inflationary pressures should be limited. We expect interest rates to move sideways from current levels as the economic outlook gradually recovers.
In the fixed income space, given the volatility of interest rates in the near term, we prefer short-duration and credit spread products. We think credit spreads have room for further compression on the back of improving economic conditions, while shorter-duration assets will provide a much better cushion in a rising yield environment.
As such, we think Asian fixed income should fare better in the current investment environment and within this asset class, we favour high yield and sectors including commodities, which should benefit from the economic recovery.