Returns have fallen short of growth expectations, but bonds remain a key asset class for any investor looking to build a profitable portfolio.
As illustrated in the chart below, the direction and approximate level of bond yields over time are linked to long-term economic growth rates, which is a good explanation of why bond yields remain persistently low today.
The improvement in the macroeconomic trend for about a year suggests a restart in nominal GDP growth and, consequently, in bond yields. However, Chris Iggo, AXA Investment Management's chief investment officer for global fixed income, cautions against expectations of a massive uptick in these yields.
“According to the consensus, bond yields are 'too' low and should tend upwards, but by how much and thanks to what factors? Of course, short-term considerations about synchronized global growth, potential fiscal stimulus in the US, the planned Fed tightening and rising headline inflation converge to suggest an uptick in yields. However, if the long-term trend does not lead to higher nominal growth rates, the magnitude of the increase in yields will likely be limited”.
Investors should rather think about what the bond markets can offer today, in order to prepare for what is to come tomorrow: “In other words, as always, capital protection, a source of income, total return opportunity and diversification instead of promises of equity-led growth. Bonds can be an investor's best friend.
Here are his six golden rules for bond investing:
1. DEFINING A REALISTIC INCOME LEVEL
The right strategy for an income-seeking investor will depend on his risk tolerance, which will determine the realistically achievable maximum income and desired time horizon.
First, you need to have a plan in terms of investment strategy. It must be based on a realistic level of income that you intend to obtain and the time limit within which you need the invested capital. The time horizon is important for defining the duration of the investment: are you happy with keeping the capital committed for ten years or will you want it back in six months? This will affect the level of short-term price volatility investors consider acceptable in relation to their current income needs.
2. DIVERSIFIING SOURCES OF RETURN
Having a diversified stream of income could mean being exposed to all kinds of instruments, from government bonds and investment grade bonds, through the high yield universe to emerging markets around the world. Other areas of attention from investors looking for income are infrastructure debt and real estate funds.
Diversification must also take place at the level of asset classes and sub-classes. A well-diversified bond portfolio, for example, may contain 100 to 120 distinct positions with exposure to segments of the market that boast the best risk/return profile. Currently, this includes emerging market debt, the high yield market and financial corporate bonds.
“We've seen a fairly protracted economic expansion, so it's reasonable to expect some deceleration over the next five years,” Iggo adds. “Having a well-diversified bond portfolio could help limit losses when this risk emerges.”
Inflation poses another risk for investors; index-linked bonds are therefore a key asset class to prevent it from causing income erosion. “It is important to be very diversified and not to stake everything on a few ideas; if something goes wrong with an investment, it won't have too much negative effect on the overall portfolio. You need to hold a large number of positions to diversify each basket.”
3. CONSIDER THE SHORT DURATION
In the fixed income space, a short duration approach has the potential to reduce sensitivity to rising interest rates while maximizing risk-adjusted returns and liquidity relative to the securities market across all maturities . “If portfolio volatility is a factor, a short duration approach is ideal in this phase of the market, in our view,” comments Iggo.
AXA IM's short duration bond portfolios are designed to have 20% of bonds maturing each year. “As well as creating an obviously attractive liquidity profile, this allows us to reinvest the proceeds of maturing bonds into the best current opportunities. If returns increase, we make money,” adds Iggo.
4. KNOW YOUR RISK/REWARD PROFILE
A higher return may be attractive, but be sure you are not taking on too much risk for the reward you would be getting. In bond markets, this means avoiding lengthening duration in an environment of rising interest rates.
“Increasing investment in riskier assets may seem appropriate at the moment, when the macroeconomic environment is quite positive, but it could prove to be quite a risky choice if the situation were to change,” Iggo said.
For example, the yields offered by high yield debt, averaging 3% in Europe and 5,5% in the US, would not be enough to compensate investors if delinquencies moved from their current level of 2% to a more normal 5%. Conversely, market areas that present a good risk/reward profile, with highly rated issuers offering attractive yields, include emerging market debt, subordinated financial bonds and corporate hybrids. Aiming for long-term quality allows you to take correct risks, helping to limit the impact of any negative macroeconomic event.
5. AVOID EXCESSIVE HANDLING
It is important to have the flexibility to underwrite and liquidate investments to seize the best opportunities. However, trades cost money and can quickly erode your earnings. This occurs especially in the bond markets, given the relatively low levels of current yields.
“The bid-ask spread is on average 30-40% of the yield, so excessive trading erodes this margin and obviously reduces the total return,” continues Iggo. “Even holding portfolios with a structurally short duration, allowing short-dated bonds to mature to natural maturity, can improve returns because you will effectively pay the bid-offer spread only once.”
6. BEWARE OF CURRENCY RISK
Global investments expose you to currency risk. High yield bonds and emerging market funds, for example, are usually denominated in US dollars, but the underlying bonds they hold can be issued in any currency. Fund managers can choose to include currency risk in the overall portfolio risk as exchange rates fluctuate, or they can choose to contain this risk through currency hedging.
“Unhedged strategies can enhance returns in the event of currency movements favorable to the portfolio, but adverse movements can easily wipe out the returns of the underlying bonds,” Iggo explains. Keeping your invested capital as stable as possible will also ensure the stability of your income stream, so investors who want to minimize this risk should opt for currency hedged funds.
