With low or negative yields now a reality, European bond investors may conclude that there are no opportunities in European fixed income. Interest rates on the continent are, after all, at historic lows.
Yet, the value proposition of the fixed income asset class hasn’t gone away – even when set against the 10-year U.S. Treasury note’s nearly 130 basis point decline over the past year to about 1.7%.1
Opinion is divided on whether the yield curve inversion is a clear-cut sign of an imminent recession, but it does make the case for a more nimble and innovative approach to fixed income; an approach that not only looks to limit interest rate risk but also seeks to capture the total return characteristics that fixed income provides.
Agile and active
The dilemma for fixed income investors remains: move up the risk scale and achieve more return potential, or reassess their expectations?
At PGIM Fixed Income, Michael Collins points out that investors can take advantage of market dislocations via an absolute return fixed income strategy. Absolute return fixed income strategies are not constrained by a benchmark, can usually take short and long positions using derivatives depending on the manager’s view of the market, and can focus on delivering positive returns with moderate volatility. Low correlation to traditional equity and bond markets can also be a useful diversifier.
Collins says: “The main thing about the absolute return fixed income style is that you can dial up and down your expected return by taking more or less risk across the different levers that you can pull in this type of fixed income portfolio.”
PGIM Fixed Income’s absolute return fixed income portfolio managers are supported by teams of sector specialists—comprised of portfolio managers and research analysts—who conduct in-depth fundamental and relative value analysis to recommend bonds for the strategy.
PGIM Fixed Income’s portfolio managers use a proprietary risk management system and risk budgeting process to assess both interest rate risk and credit risk and construct optimal portfolios.
“A lot of absolute return fixed income strategies were designed to minimize interest rate risk,” Collins notes. “But in today’s low rate environment, which could last for some time, investors have become less concerned about interest rate risk.”
Is there still scope for the ECB and the other central banks to raise rates?
“That's off the table,” adds Collins. “The Fed is obviously on a rate cutting path and the Bank of Japan will likely keep rates low for many years. People are now resigned to lower rates. The risk is on the credit side.
“Being as late in the cycle as we are, and as the recession risks start to bubble up, you really want to protect your investors’ capital by controlling the total level of credit risk; and importantly, being in the right bonds.”
“Protecting investors’ capital through security selection and avoiding the losers is paramount. Many more bonds will likely experience credit problems over the next several years.”
Tariffs casting a shadow
While bonds have always played an important role as part of a portfolio’s defensive component, the white noise of uncertainty around Brexit, the growing gulf between political visions for Britain, and the viability of the eurozone underscores the priority of avoiding losses.
Speaking on political risk, Collins says their approach is to understand the likely outcomes and turn that into a scenario analysis.
“For example, on the trade war between the US and China, our base case has been that if there’s enough economic pain or market pain, Trump and Xi will get together, resume talks and at least try to make some progress to limit the downside risk in the economy and in the markets. And Trump, to be sure, has shown that he's very sensitive to economic data and market behaviour.
“However, it seems that even with the weakness in global manufacturing and some volatility in the market, the two sides appear to be more and more determined in their stances. Our view is that we’ll be looking at uncertainty around global trade for some time.”
From an industry risk standpoint, this will continue to inform bottom-up investment decisions at PGIM Fixed Income.
“We might not want to have a lot of auto exposure, for example, because that sector is caught in the crosshairs of the global trade war.”
A ‘sanguine’ view
The various layers of uncertainty – from geo-political risk to credit risk – means that Collins and the team are measured when it comes to the broader outlook for bonds. “When economic growth goes from 3% to 2% to 1% and there are a lot of highly leveraged companies in competitive industries facing margin pressure, you're going to have credit problems.
“We’re seeing this manifest itself in the leveraged loan market, the investment grade corporate market to some extent, and in the private debt markets. Companies have taken on a lot of debt and their balance sheets require earnings growth in order to be sustainable.
“Slowing global growth and the resultant idiosyncratic credit problems have already been priced into the market in many cases with credit spreads, on average, still trading well above their historic lows. So, given our view that recession risk is fairly low, and spreads remain relatively attractive, we hold a pretty sanguine outlook for bonds over the longer term.”
We are in a tough environment. Does this mean the end of traditional fixed income investing? Not quite. But as the bond bull market fades, flexible approaches are increasingly in demand.
In many instances, absolute return fixed income investments are providing some very acceptable answers.
1 As of 26 September 2019.
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