Past returns are a poor guide to future outcomes when it comes to fixed income.
As we confront a world where central banks are pursuing pro-inflationary policies, global debt levels are surging and interest rates are rising, traditional approaches to fixed income are unlikely to deliver the results investors have enjoyed over recent years.
In our view, the case for taking an alternative approach focusing on absolute return outcomes has never been more compelling.
Global bond markets have changed substantially over the last ten years and bond indices are now structurally distorted and hampered in their ability to deliver compelling real returns.
Their core characteristics are now so altered that major bond indices are unlikely to be able to deliver outcomes in the future similar to those in the past.
Consider the Bloomberg AusBond Composite Index, the most widely used Australian benchmark. Figure one shows in 2007 the interest rate duration of the index (or sensitivity of the benchmark to changes in interest rates) was approximately 3.5 years.
If interest rates rose or declined one per cent, all else being equal, the benchmark would rise or fall by 3.5 per cent in value.
Figure 1: Interest rate duration of the Bloomberg AusBond Composite Index, 2007
[Source: Franklin Templeton Investments, Bloomberg]
Today the same benchmark has interest rate duration of approximately 5.25 years; a 50 per cent increase in the sensitivity of the benchmark to changes in interest rates.
Applying a similar shock of a one per cent rise in interest rates over the next year (which is not an unrealistic scenario in our view), means the potential loss from the traditional bond index would be in the order of five per cent! At the same time, the average yield in the benchmark has dropped from more than six per cent in 2007 to approximately 2.5 per cent today!
The outcome - bond benchmarks are delivering very little income but significant volatility compared with previous periods in history.
Absolute return can help tackle this by beginning with cash as a benchmark and then considering every investment position an active one regardless of traditional benchmark composition.
Are bonds sufficient diversifiers?
In many periods over the last 140 years bonds have failed to act as a diversifying asset class within broader portfolios. The notion that bonds always provide portfolio diversification and protection is not borne out by history.
During the past 30 years or so bonds have generally performed well, and the far right-hand side of Figure two suggests that bonds have in general delivered the much-desired negative correlation with equity markets.
However, compared with the preceding 100+ years, this recent history appears to be the exception. Over the period 1876 to 2018, bond and stock markets experienced a positive correlation 62 per cent of the time.
Contrary to popular asset allocation beliefs, there is no observable stable relationship over time between the two asset classes that can be relied on for future portfolio construction.
Figure 2: Bond v stock correlation since 1876
[Source: Franklin Templeton Investments, Yale University Department of Economics]
Underlying macro drivers are critical.
Disinflation (and at times deflation risks) defined the past 30 years and, at least until the global financial crisis (GFC), the period of global economic stability both combined to support a traditional approach to bonds in investor’s portfolios.
Looking forward, we believe it is difficult to project the same conditions for the global economy and financial markets.
Central banks are operating a pro-inflationary policy, and we should expect that after an extended period of inflation running below the official two per cent policy target, inflation should lift and then reside at a level above two per cent for the foreseeable future.
The problem is that the market is not prepared for an inflationary period.
Too many balanced/diversified portfolios that rely on the spurious assumption of negative correlation between bonds and stocks will be disappointed with poor returns as bond values tend to fall – in both nominal and real terms – closely followed by weak equity returns.
Navigating the choppy waters ahead in bond markets requires an alternative approach that still honours the role of fixed income as the ‘balancer’ in portfolios and the defensive asset class.
We believe this requires an absolute return approach to bond investing, but it is important to define what this means.
Investors still seek bond portfolios that operate with a relatively conservative stance. Average credit quality should be reasonably high, and the ability to delve into riskier sectors of fixed income such as high yield and emerging markets limited.
Furthermore, absolute return means still using the defensive characteristics of government bonds at appropriate times by flexibly altering portfolio duration within reasonable parameters.
Essentially absolute return bond funds look for the right opportunities for an investor’s portfolio rather than those that happen to make up the benchmark.
While timing changes in portfolio composition from traditional bonds to absolute return can be difficult, we highlight two key points:
- the traditional bond market has undergone a significant adverse shift in underlying risk/return characteristics; and
- the macro drivers and relationship between bonds and stocks over the next ten years is likely to be very different to the last 10 years.
We encourage investors to challenge the status quo.
Chris Siniakov is the managing director for Australian Fixed Income at Franklin Templeton Investments.