The news did, however, further underline not only the difficult job faced by the European Central Bank if it is to pull inflation up to more ‘normal’ levels, but also the widening gap in terms of policy direction between the ECB one the one side (along with the Bank of Japan and the Peoples Bank of China) and the Bank of England and the Federal Reserve on the other.
Ian Winship, manager of the Blackrock Global Absolute Return Bond Fund, says this dispersion of central bank policy is unusual, but is likely to offer opportunity to fixed income managers, especially as the Fed and the BoE move toward a rate increase.
“There is a relative value opportunity that results from it”, he says, adding that currently yield levels in the ten year space in Europe are around 1.1 and quite a lot of the European curve now trades inside Japan because the ECB is still actively engaged in trying to alleviate the disinflationary pressures facing the region.
This can be compared to the US and the UK markets, where a significant inflection point was seen when Ben Bernanke first floated the idea of tapering in 2013 and yields spiked. Yields have subsequently come down, but the view is definitely toward raising rates going forward and there is a concern that when they do begin to rise, yields will spike again.
But, while acknowledging these concerns, Winship says a sharp spike in yields is unlikely to happen.
“The US is doing fine, but they don’t want to repeat what happened last year where there was a surprise and yields rose quite rapidly and economic growth suffered as a result. Likewise, UK recovery story is fairly well balanced at the moment, but I don’t think the BoE wants to rock the boat either,” he says.
Nick Gartside CIO of JP Morgan's global fixed Income, currency & commodities (GFICC) group, agrees adding that while, typically, rising interest rates are the enemy of a bond manager as it leads to higher yields and consequently falling bond prices, it is worth asking whether or not some of that pain has already been suffered.
According to Gartside, central bankers this year have made it abundantly clear that in this cycle, interest rate rises will occur slower than normal with a lower terminal rate set to be reached
“Even as expectations of interest rate hikes draw nearer we have witnessed the opposite effect to last year. two year yields have risen by 0.30%, while ten year yields have fallen by 0.40%. This has lead to a curve flattening effect which we expect to continue, therefore again avoiding that dangerous parallel yield curve shift higher,” he says.
But, while yields may not spike when interest rates do actually begin to turn in the US and the UK, the direction of travel has changed, which raises further questions about the longevity of the bond bull market and the role of fixed income going forward.
Staying relevant
The last 30 years have seen the bond markets do phenomenally well and fixed income more generally grow. But, Winship says, because of this there has been little need to really innovate on the product side.
“We have had a heck of a run, but because it has gone on for such a long time the challenge now is to figure out exactly what active management in the space really is.”
He points out that while people have been talking about an end to the bond bull market is not new, nor is the talk about new products in the space that can perform when markets do turn. But, he says, while, there have been a lot of people talking the talk about new products, “if you look at the returns generated when Bernanke started to talk tapering, I would question whether much has actually been done,” he says.
Winship says the key is trying to be relevant in the space. “The other thing we are doing, which is unusual for fixed income people, is we are trying to listen to what our clients need”.
He points out that, while typically one shouldn’t be buying a fixed income product in order to generate a high return, in the past few years some investors have come to expect ‘hedge fund-type’ returns because they have been achievable.
“Fixed income should be boring, this is the part of the portfolio that people shouldn’t lose sleep over,” he says.
While most people think of fixed income in that manner, they have also come to expect higher returns and the problem is that as the direction of travel for yields has changed, as the multi-decade bull market in bonds tapers off, the challenge is to build products that can perform in both rising and falling markets.
“We have to always be trying to improve the product, because the way we have done it for the past 30 years is going to be challenged,” Winship says.
“I think we are going to find out over the next few years, because the old product just can’t work.
For Gartside, this new world of fixed income and especially the current dispersion within central bank policy means that investors need to start thinking more globally about fixed income.
“It is also important to remember that fixed income is a collection of different sectors and that they do not all move in line with core government yields. In an improving global economic environment, for example, allocating to areas like high yield, credit and emerging markets could well benefit portfolios.”
Increasingly, words like unconstrained, diversified, flexible are being bandied about; whole suits of new products have sprung up. But, whether or not many of these really are different will only be known in time. But, for investors the key is going to be actually understanding what it is one is buying, and how realistic the returns one expects from it are.
After all, as Winship points out, People often don’t understand fixed income because it has never not worked and you don’t ask questions when things are working.
