As yields spike and volatility rises, 2018 could prove to be the worst-performing year for fixed income across all asset classes in more than a decade.
All major asset classes have posted negative returns year-to-date, and with the US Federal Reserve set to continue raising rates and the European Central Bank (ECB) about to halt its bond-buying programme, the situation is unlikely to improve for fixed income investors anytime soon.
“Fixed income in general is a mess,” says David Karni, head of fund selection at Italian group BCC Risparmio & Previdenza. “It’s been very tough for global fixed income managers this year – all big players are down at least 2%.”
Many investors have responded by slashing fixed income allocations. In September, net outflows from bond funds totalled €8.9bn, according to Lipper.
Karni says he recently asked a leading bond manager where he saw opportunities in fixed income in the present environment. “Take two aspirins and call me in 2020,” was the manager’s caustic reply.
Most European fund selectors, however, will not want to disinvest completely. But in the face of bruising market conditions, where are the most attractive fixed income opportunities to be found?
Ride the volatility
The macro-economic background is not accommodating as central banks roll back huge quantitative easing programmes, pushing up volatility and squeezing overall return prospects.
If there’s one thing fixed income investors hate apart from poor yields, it’s volatility. In the absence of beta returns, however, one way to make money from fixed income is to profit from the opportunities that arise when markets are choppy.
Few assets have been as volatile as Italian government bonds over the last few months as the country’s newly-elected coalition government looks to ramp up spending setting it on a collision course with European Union.
The yield on 10-year Italian government bonds, for example, has risen more than 90% over the last six months and Moody’s has downgraded the country’s credit rating.
While Karni says that he remained underweight on fixed income overall, he had started to build up his sovereign bond portfolio on the back of the Italian BTP volatility spikes.
“We add to our portfolio every time we see a spike in volatility,” he explains. “We had reduced our overweight to neutral before the Italian elections [in March this year] and now are putting this cash back to work again.”
“For example, there is an opportunity in the short end; 2-year Italian bonds now yield 1.27%, while the Spanish equivalent has a negative yield. And the 10-year spread with Bunds also fluctuates a lot,” he adds.
Opportunistic bets on Italian sovereign debt notwithstanding, Karni adds that most investors should remain cautious on fixed income as the ECB sets about unwinding its bond-buying programme. “It’s better to stay in short-duration, and the end of QE in Europe can cause spread widening too. It’s dangerous to have a high-risk portfolio [over the next year].”
Duration-neutral
Not all fund selectors, however, are relying solely on short-duration opportunities.
Rico Bosma, a fund selector at Wealth Management Partners in the Netherlands, has a fixed-income portfolio that’s almost duration-neutral.
“The majority of our fixed-income allocation is invested in a duration-neutral index tracker, the iShares € Corp Bond Interest Rate Hedged Ucits ETF. This ETF has an effective duration of zero because all duration risk is hedged out,” Bosma explains.
However, since European short-term interest rates remain stuck at zero, the interest rate hedge hasn’t yet delivered the outperformance relative to long-duration bonds that Bosma had hoped for. Over the past three years, the ETF has delivered an annualised return of just 0.61%. Comparable ETFs without an interest rate hedge have performed significantly better.
But this performance may improve as markets begin to price in rate hikes after the ECB’s planned exit from its bond-buying programme next year. As a result, Bosma is sticking with his hedge.
Convertible bond appeal
Hedging out all interest rate risk makes sense if your goal is to limit drawdown potential, but such a conservative tactic is unlikely to provide clients with meaningful yield.
And opportunistic allocation, such as Karni’s bet on Italian government bonds, boosts your short-term chances. But in the present climate, mixed-debt investments may yield the best results.
Convertible bonds – that offer the opportunity to transform into equity over a set period – should also come under consideration, says Karni.
“Convertibles can help us manage risk on both the equity and bond sides over the next six to nine months,” he says.
BCC Risparmio & Previdenza, for example, hold NN Global Convertible Opportunities, a bottom-up fund with a concentrated portfolio of 40 names; and the JP Morgan Global Convertibles Fund, which Karni describes as a “classic portfolio that covers the whole market”.
Karni adds that another diversification opportunity can be found in emerging market debt local currency which he says was trading at a discount “despite good fundamentals” and remained attractive despite the hit some EMD funds have taken from the US-China trade war and the currency crises in Argentina and Turkey.
