Salman Ahmed and Carolina Minio-Paluello are respectively chief global strategist and deputy CIO at Lombard Odier Investment Managers.
The world has changed.
The old map will no longer help navigate fixed income markets. The roads have changed, towns have changed and even the land itself has changed – with a quarter of the territory fenced off and no longer accessible.
What caused this? Put simply – the central banks have become dominant players in bonds in order to fulfill their economic incentives. For everyone else, that’s a problem. It means taking greater risk for uncertain returns.
A new approach to fixed income is needed.
The first step is a recognition that the old ways no longer work. The second is a fastidious attitude to portfolio construction. Adherence to market capitalisation is no longer the certainty it once was.
Such approaches will allow investors to navigate the new world order for fixed income investing.
Central banks are dominating the market
The influence of central banks is extraordinary. They now hold on average 25 per cent of sovereign bonds in advanced economies, with the European Central Bank (ECB) extending its buying to corporate bonds.
Indeed, by the end of 2017 it is estimated that the ECB will hold 34 per cent of total German public sector debt. They held almost nothing before 2008.
This is a massive shift. It is likely to continue, with widespread disinflation forcing the central banks to keep policy easy. Equally, negative interest rates are here to stay in a number of major economies.
It would, however, be naive to assume that widespread use of the printing press is entirely a benign process.
This dominant investor status means central banks can skew investment performance disproportionately, if often unintentionally, and make markets difficult to navigate. The results can be shocking.
Over the past two years, fixed income markets have suffered what can be called micro liquidity “accidents”. In these scenarios, the act of moving bonds into cash has had an outsized impact on pricing.
In mid-2015, German bund markets suddenly seized up. Yields shot up from five basis points to more than one per cent in days. Easy monetary policy, it seems, has serious unintended consequences.
In our view there are two reasons for these accidents – increased herding and tighter regulation.
Herding occurs when numerous large investors hold similar positions, and are therefore affecting outcomes.
Much of this can be explained by the extensive use of quantitative easing. Central banks encouraged investors to increase fixed income allocations – often using market capitalisation benchmarks.
As a result, many fixed income investors are taking on disproportionate risks without the commensurate rewards.
Tighter regulation of market makers has exacerbated matters further. A sharp fall in the inventory they hold restricts their ability to intervene when large numbers of investors suddenly decide to buy or sell.
In the current environment, fundamentally-driven fixed income allocations implemented through buy and maintain frameworks, where the need for trading is decreased to just default risk-mitigation-based interventions, can reduce sensitivity to not only liquidity accidents (which we think will continue to happen) but any potential rise in interest rate.
Exploring the solutions
There is little point looking to the past for answers. Instead of using a market capitalisation approach, investors should consider fundamentals, such as the level of indebtedness of the issuer.
Size and quality must be also evaluated. For government debt leverage ratios, GDP and the social dynamics are key issues; for corporate bonds, income and asset quality matter. Liquidity is another consideration in any conversation.