Seeking Alternatives To Traditional Fixed Income Strategies
2018 Investment Themes series: Late-cycle theme #1
Opportunities in the bond universe are increasingly rare. Risk premiums, already weak in 2016 and 2017, are shrinking further due to cash injected by central banks. Investors have been forced to take on more risk to obtain decent yields. We explore here several ways of finding value in the bond universe and alternative funds with similar volatility levels.
Variable-rate bonds in the US
The US economy continues to grow at a moderate pace and the labour market is increasingly tight. The US is nearing the end of the economic cycle. President Trump’s strategy is to extend the cycle with a fiscal stimulus programme. This will have the effect of increasing debt and accelerating inflation. The Federal Reserve, which will try not to fall behind the curve, has already started to tighten credit conditions, something which is set to continue gradually. We forecast three rate hikes of 25bps each in 2018 in addition to the increase in December 2017. The rate at the end of the cycle may increase to 2.25%. Indeed, 2-year rates should continue to rise.
In this context, we favour variable-rate bonds, synthetic bonds indexed to short rates (credit-linked notes or CLN). However, we do not include any inflation-linked bonds because they usually have longer-dated maturities and a greater sensitivity to real rates. Credit-linked notes have a higher risk-return profile and are only suited to investors with an appropriate risk tolerance.
Unconstrained bond funds
We expect yields to rise gradually, both in the US and the eurozone, particularly due to the gradual normalisation of monetary policy in the world’s major economies (except Japan). This rise should make existing bonds less attractive. An active management of interest rate risk is thus crucial, above all in the fixed income universe where yields to maturity (YTM) are extremely low. Therefore, so-called “unconstrained” funds, which have no benchmark constraints and can be invested in all sub-asset classes, should generate higher returns than traditional funds.
Emerging Market bonds in local currency
Emerging Markets continue to benefit from world economic growth. Inflation has fallen in a large number of these countries, leading central banks to lower key rates. Several central banks (in Brazil, Mexico, South Africa and Colombia) should continue to relax monetary policy in 2018. Logically this will favour the attraction of existing bonds. Yields to maturity are attractive (around 6.3%), offering a buffer in the event of a variation in risk premiums and currencies. We forecast the euro to strengthen somewhat against the basket of Emerging Market currencies over the coming year, which will have a partial impact on expected returns. On the other hand, we think that the dollar should depreciate slightly versus Emerging Market currencies, generating additional returns for USD investors. Emerging Market bonds in local currency have a higher risk-return profile and are only suited to investors with an appropriate risk tolerance.
Alternative funds (alternative UCITS)
Interest rates and government bond yields remain very low, a trend set to continue especially in the eurozone. It is trying times for bond investors because government bond yields and Investment Grade corporate bonds are likely to be very low.
Consequently, we have studied several potential sources of performance in this asset class while seeking a similar level of risk (volatility or price fluctuations). Alternative funds, particularly “Long/Short Equity” strategies (benefiting from price anomalies between shares) and Macro strategies (benefiting from market trends such as interest rates, commodities and currencies) are likely to offer attractive returns while limiting the portfolio’s sensitivity to rising interest rates.
Opportunities in the bond universe are increasingly rare. We have explored several ways of finding value in bonds and alternative funds with similar volatility. In the US fixed income market, we favour variable-rate bonds and synthetic bonds indexed to short rates (credit-linked notes or CLN). We also like Emerging Market local currency bonds and unconstrained funds. Alternative funds also offer opportunities and we have a preference for “Long/Short Equity” and “Macro” strategies.
This strategy is based on the scenario of an improvement in world economic growth and a rise in short-term rates in the US. Failing this, investors in floating rate notes are exposed to a shortfall compared with fixed rates. Investors in Emerging Market bonds in local currency may suffer losses given that the currency risk could be high. A rise in interest rates and risk premiums in Emerging Markets would also be disastrous.
Find more articles on market strategies and investments on our Voice of Wealth app available from the App Store and Google Play.