Next-Generation Fixed Income

Investing in a low interest rate environment

Originally published in the January 2015 issue

The start of the year clearly lends itself to taking stock of the year that’s just passed, and we all engage in this kind of seasonal activity, of trying to make an assessment of the outlook and themes for the year ahead. So, the first part of my discussion will look at, briefly, 2014, pick up on some of the points that have been made, and then give some perspective on our views on the outlook, and then to move on to talking about some of the next-generation fixed income strategies that we think are a response to a low interest rate world.

You may well recall that, going into 2014, there was a very broad-based, very strong consensus, and that consensus was that equity would comfortably outperform fixed income. Within fixed income, short-duration credit would outperform long-duration, safe government bonds, and that emerging market assets, and in particular, emerging market debt, was actually the least favoured asset class amongst many strategies going into the year.

It didn’t play out according to the consensus playbook. In fact, those who were invested in long-dated, long-duration US treasury bonds had a very good year, returning in excess of 24%, which was more than twice the best performing equity major which was the S&P 500. We can also see that emerging market debt (EMD) actually outperformed European equities, as well, and European equities were the favoured asset class of many strategists going into 2014.

But one of the big features of 2014, in the latter part of the year (and one that continues to remain a key source of volatility uncertainty) was clearly the development of commodities, and in particular, oil prices. If you were long commodities, that, generally, has not proved to be a very profitable position in the latter part of 2014 and going into 2015.

The great surprise of 2014 was that the core rates, short-term interest rates, and bond yields on safe government bonds, benchmark government bonds, ended the year significantly lower. So, at the beginning of 2014, as you know, the yield on the US 10-year was 3%. The forwards were actually pricing, at that time, that they would end 2014 yielding around about 3.4%, and a number of strategists had a higher yield target. As you know, the US 10-year is yielding somewhere below 2%. The miss on bunds was even more spectacular. The 10-year bund is supposed to be yielding 2.5% if we were using forwards as a guide at the beginning of 2014, and again, as I’m sure people in this forum are aware, it’s yielding around 50 basis points.

Why did core rates earn significantly lower and why were yield curves overall flatter than had been expected? I think there are a lot of answers given to that question. I’m going to summarise what I think are, just very briefly, some of the key ones. Firstly, actually, global growth was weaker than had been expected. It was highlighted that there were a number of global growth scares and shocks, starting with the US at the beginning of the year, with the severe winter. But then, also, at the heart of concerns about the global economy, and increasing worries about deflation, has been Europe, and associated with that have therefore been other episodes of volatility, which have created a bid for safe haven assets. As the European economic recovery stalled and inflation fell, European government bond yields fell to all-time lows.

Now, I think what this experience in 2014 has also illustrated is that, the usual rules of the game don’t really play very well in an environment of quantitative easing and zero interest rate policies. Long end rates are supposed to be driven by the US treasury market; historically, that’s been the case. But, actually, what we saw in 2014 was that the bund market was the driver of the US treasury market, and the driver of global rates more generally.

Then the third factor which has influenced this decline in core government bond yields during the course of 2014 and at the beginning of 2015 has been this notion of secular stagnation, which has certainly gained, I think, a lot greater traction amongst investors. As we start 2015, you have to recognise the way that investors are positioned, as opposed to some of the rhetoric.

Investors don’t have any real conviction at this point in time, in terms of the global economy and the sustainability of global economic growth. And, as a result of that, the growth-sensitive assets (credit as well as equity) are pretty fragile and vulnerable at the moment, reflecting that lack of conviction. Now, the severity of the fall in global oil prices, and the absence of a floor, is clearly weighing very heavily on global credit and emerging markets in particular. Developed market, investment-grade and high-yield credit spreads have widened appreciably since July. Spreads on emerging market sovereign bonds have also increased.

Oil has actually fallen faster and further than the ability of markets so far to actually price what that means for different asset classes and for the global economy – and, frankly, faster than investors are able to adjust their portfolios. The speed and the severity of the oil price fall has meant that this is going to be a continuing source of volatility, and a headwind to risk assets, even as we get a stabilisation of oil prices.

I think the other aspect is, investors have very much focused on the losers from lower oil prices; that basically leveraged US shale producers, and emerging market oil producers which already had relatively weak fundamentals going into this. It was already mentioned in terms of Russia, but also Venezuela and Nigeria are, for example, emerging market oil exporters with weak fundamentals, that are now under additional pressure.

So, the focus has been on the near-term losers, and the pain which they’re suffering, rather than the broader, medium-term gains that we think do accrue to the global economy, from what is, de facto, quite a large tax cut. But it is that concern about the growth outlook and deflation, and the signals that lower oil prices are sending, that’s actually dominating markets at this point in time.

If lower oil prices are reflecting lower global demand, then it is the proverbial canary in the coal mine, and the global economy is rolling over. And, if it’s rolling over, then asset prices at current valuations are not going to be validated by growth through 2015 and into 2016. That’s what many investors are fearing in terms of the signals being sent.

But actually most of the analysis suggests that it has primarily (although not completely) been a supply-driven shock; that’s the conclusion also of the IMF analysis. They show that if you assume that 60% of the decline in oil price is basically due to supply, then the positive impact on global growth is anywhere between 0.3% to 0.7% of GDP in 2015. The lower figure reflects a faster response in terms of supply to the reduction in oil prices.

Fiscal and monetary policies, including central bank balance sheet expansion, underpinned the V-shaped recovery from the great recession in 2009 and 2010. But, thereafter, fiscal policy actually became contractionary. Governments did implement austerity, with varying degrees of success. Central banks had already gone to, effectively, zero, so there wasn’t much scope there, so the only offsetting policy response has been in terms of central bank balance sheet expansion, and we saw that with QE2 and then QE3 in the end of 2012, going into 2013.

But the overall global policy mix has actually become more growth-friendly. Fiscal austerity has actually eased significantly over the last year or so, including even within Europe, reflecting, to some extent, austerity fatigue, and despite the end of QE3 by the US Federal Reserve, the expected acceleration in asset purchases by the Bank of Japan, and also by the European central bank, have meant that the overall level of central bank liquidity into the global economy was actually set to increase.

There is a qualification to that: we do think that you get a bigger bang for your dollar-equivalent buck, if you like, as a result of Fed QE, than you’re going to get from ECB or BOJ QE, but nonetheless, central banks are more worried about inflation being too low, rather than too high, and monetary policies are still extraordinarily accommodative and supportive, both of global growth and of asset markets. I think, combined with lower oil prices and the strong momentum in US economic growth, we do think that the pessimism at this point in time around the global economic outlook and fears about outright and persistent deflation are somewhat overdone.

Now, the Eurozone, as I say, has been very much at the heart of these concerns and has consistently disappointed in recent years; you’ve consistently had this situation where economic growth forecasts, each month as you move through the year, have been lowered for the Eurozone. But 2015 might just be the year when the Eurozone surprises to the upside. There is so much pessimism about the outlook for Europe that, actually, it is not going to take too much to get some kind ofpositive surprise.

The headwinds to growth from fiscal austerity are easing. I think, following the ECB-led asset quality review and stress test, the level, or the intensity of bank-led deleveraging within the Eurozone is also starting to ease. It’s not over yet; there still are pressures on the banks within the euro area, but not to the same degree that there were in 2012, 2013, and through the first half of 2014 in the run-up to the AQR and stress test.

Corporate loan demand in Europe is actually starting to pick up. This is very important: that we have some easing in the supply of credit, as well as in pick-up, and to meet this pick-up in corporate loan demand. We are starting to see a turnaround on that. Then, combine that with a lower euro, a weaker euro, and lower oil price, then again, we have quite a lot of tailwind for the euro area.

In early 2013, the ECB balance sheet was 1.4 times the size of the Fed balance sheet. That has since shrunk to about 60% the size of the Fed balance sheet, so while the Fed has been expanding its balance sheet through QE3, we know that the ECB has actually been shrinking its balance sheet as banks have been basically reducing their dependence on the ECB for liquidity support.

Investors and the FX market had actually responded to the €1 trillion expansion in the ECB balance sheet already with the weakening in euro/dollar. That, clearly, is one of the key channels and mechanisms through which QE is going to work, and to help to adjust in terms of expectations.

That being said, there clearly are some significant political and policy risks around this relatively bullish view in terms of Europe. Clearly, there are a lot of angry and frightened voters in Europe (that includes in the United Kingdom) and they are turning to populist and anti-establishment and extremist parties. So political risk is clearly on the rise across Europe.

In addition, we are somewhat concerned about the potential for policy complacency. We are a little bit disturbed by some of the reported thinking that has been coming out of Berlin, for example, with respect to the potential risks that would arise from a Greek exit from the Eurozone. We do think that that would be a systemic risk event; we are much less confident than some policymakers seem to be that that would be very manageable, and it’s not something we need to worry so much about, or to the same degree as was the case in 2011 and 2012.

So, there is potential for policy mistakes, whether that’s from the ECB or whether that’s from policy more generally within the euro area and elsewhere, as well as from, as I say, political risk not just in terms of Grexit, but also, for example, the emergence of parties and the fragmentation of the political scene in countries like Spain as well.

I mentioned that, in terms of the outlook for 2015, despite some of the rhetoric and some of the commentary that you’re seeing, investors actually aren’t positioned for stronger global growth; they’re not positioned and pricing in the benefits of lower oil prices. Investors, at this point in time, are very fearful and defensively positioned, and we are seeing that reflected in the continuing rally in core rates and in quality credit.

We do actually think that the Fed is going to start hiking interest rates in mid-2015, and that actually, US 10-year treasury yields will reach 2.5% or more during the course of this year. The increase in rates in the US will be a source of market volatility, but we also think it will be a signal that growth and deflation risks are actually overdone. It will be a statement of the strength of the underlying US economy.

Despite QE, given the balance of risk, this is not an outright conviction call, but we do think it’s increasingly asymmetric when we look at, for example, 30-year bunds yielding just over 1% – do we really think that Europe faces two decades of being the same as Japan? I thinkEurope either faces a better future than that, or I’m not sure Europe, as currently constituted, in terms of the single currency, will still be around over that horizon, if it has to experience two decades of effective deflation and stagnation.

It is consensual, in terms of the US dollar, but we still think that there’s a lot of momentum behind the US dollar which will be supportive of US dollar assets more generally, and that actually includes emerging market dollar-denominated credit, which we think will remain relatively well-bid. Potentially, what will be, I think, an interesting contrarian view and opportunity for 2015 is actually in terms of emerging market FX, and in particular, local currency bonds, which have had a very tough time over the last two or three years, and actually posted another year of negative returns in 2014.

We are starting to express that view in some of our portfolios by actually going into local EM bonds markets. We’re actually not funding that out of dollars; we’re funding that out of euros. Euro investors into emerging market local currency debt did reasonably well last year, and also looking at some other G10 currencies, we do think that, with yields where they are in emerging markets, it’s actually against a disinflationary backdrop. There’s quite a lot of positive outlook in terms of rates markets within EM at this point in time.

In terms of developed market credit, the widening in credit spreads and higher yields, especially in the US, is creating some value. I have to say, we’re pretty defensively positioned, and hesitant at this point in time, in terms of the US high-yield  market, including the non-energy segment. The reason for that is, we don’t think that the energy segment of the US high-yield market, and the US high-yield market more generally, has actually priced in the level of default rate that we would get if oil prices stay at $50 or lower.

They’re basically pricing in something like $65 as a sustainable medium-term oil price level, where you will get an increase in default rates on the back of that, but that will be manageable. At $50 or lower there are a lot of business models in the US energy sector that simply will not be able to sustain that. As hedges run off, you’ll see them basically going into Chapter 11 towards the end of the year, and into 2016. So, until we get a settlement of the oil price, and a further re-pricing, despite the fact that we do think there’s value in terms of the non-energy sector of the US high-yield, we are pretty defensively positioned.

In terms of European credit and high-yield, on a valuation basis, by historical standards, frankly it’s not that attractive, but when you have five-year bunds at zero, or gone through zero to yield negatively, something like 4.5% yield on European credit, and the ECB entering into the market as asset purchasers, that reach for yield and that search for yield for euro-based investors is going to be a very, very powerful dynamic.

Although we’re tending to be invested in more of the crossover and higher-quality names, both from the investment-grade and into the high-yield space, nonetheless, we actually do expect some reversal of the decompression trade that occurred last year, and some compression of credit spreads going through 2015.

Every market rally climbs a wall of worry. When investors actually stop worrying is when markets go parabolic, and that’s actually when you ought to be de-risking, you ought to be moving into cash. We’re not there yet; in fact, there are a lot of things to worry about, and investors are worried about many of those things. The geopolitical risk, the policy and political risks that I’ve already alluded to, the regulatory decline in secondary market liquidity, the one-eyed focus on risks that sit within the banking sector, which are also potentially pushing risks out into the non-bank sector as well.

More fundamentally, I could just be plain wrong. If lower oil prices are really telling us that global growth is rolling over, then 2015 is going to be all about capital preservation, because after $6 trillion plus of asset purchases, if the global economy cannot still sustain some level of growth, then asset prices where they currently are, particularly risk assets and growth-sensitive assets, simply aren’t validated. So there are a lot of things to worry about.

Fundamentally, though, we think that those concerns, at this point in time, are exaggerated, and we have a continuation of the global growth recovery, which is going to be weaker, but more prolonged. Also, lower inflation means lower rates for longer, more generally.

Let me just now take a step back, as it were, from looking at 2015 and the near-term outlook, and actually just try to address how we’re thinking, in terms of our clients, how to manage their fixed income and credit portfolios in a world where you think that interest rates are going to stay low for a prolonged period in time.

Clearly, the decline in nominal real interest rates has been one of the most profound secular shifts for a generation, and we saw that trend become more accentuated post the global financial crisis, but I think the key point to remember is that this has been a trend that predates the global financial crisis. It gave it an extra push, but it actually predates that. Again, there’s a lot of debate and different reasons that have been given as to why we’ve seen this secular decline in real, as well as nominal, global interest rates.

Clearly, it has been reflecting, at least in part, a global shift in investment and savings, the emergence of China and developing economies in the 1990s, the reduction in overall investment rates in the developed world, which we saw at the same time, and also, a greater demand for safe assets that has tended to favour fixed income over equity, over this period.

At BlueBay, we do think that we’ll remain in a low interest rate environment for the foreseeable future. That doesn’t mean that we don’t think we can get some increase in interest rates – I’ve already suggested that we are currently positioning for a hike in US rates from mid-2015 – but that, nonetheless, there are powerful forces at work that will keep interest rates near their historic lows for a prolonged period of time.

In response to that, I think, a lot of investors rightly fear that the returns on traditional government bond benchmarks will be much lower in the future than they have been in the past. Frankly, the beta returns on just being long, core fixed income, have been fantastic over the last two decades; we just don’t think, unfortunately, as a fixed income investor, that you’re going to get that repeated over the next two decades. So, in response to that, many investors are actively reviewing how they think, and how they manage their fixed income and credit portfolios.

David Riley joined BlueBay in September 2013 as Head of Credit Strategy within the Asset Allocation team. He was previously global head of Fitch’s Sovereign and Supranational Group responsible for more than 130 ratings of the world’s largest fixed-income issuers. Prior to Fitch, he was a senior economist at UBS and at HM Treasury where he advised on international economic and debt issues, including representing the UK at international debt restructuring negotiations at the Paris Club of Official Creditors. He has a first class degree in Economics and was awarded an MSc from Birkbeck College, University of London.

This article was extracted from a presentation at the Notz Stucki Investment Conference held in Geneva on 13 January 2015.