(ATF) Traditionally, fixed income has been a diversifying asset class that typically performs well when risk markets such as equities sell off. However, many are questioning whether this approach is still as effective with bond yields so low — and with good reason.
In the first quarter of 2020, the Xetra DAX, the main German stock index, fell 25%, but German bunds, according to the Bloomberg Barclays Euro‑Aggregate Treasury Germany Index, rose only 2%, indicating that the diversification power of bonds may be much less potent in the current low interest rate environment.
If this is the case, it follows that government bonds should no longer be the sole risk mitigation tool for investors and that finding new sources of diversification should be a priority in 2021. This will require portfolio construction that is more agile and uses relative value positioning, volatility trading‑based instruments, and in‑depth research to benefit from potential de-correlated opportunities.
Where next for bond yields?
Given ongoing uncertainties surrounding the pandemic, lower bond yields should not be ruled out. However, the biggest shifts are likely to be behind us now. The yield on the two‑year US Treasury bond, for example, ended 2020 at 0.12% — which is already within the Fed fund’s target rate range of between zero and 0.25%. It was a similar story in other core markets, such as Japan and Germany, at the end of 2020.
While central banks are unlikely to raise interest rates in the near future, the prospect of some sort of tapering should not be completely disregarded, especially if a rebound in economic conditions leads to inflation picking up. The pressure on yields could be exacerbated further should governments start to signal plans to tighten fiscal policy.
Against this backdrop, there is the potential for greater volatility in government bond prices, particularly at the long end of curves. Active yield curve management could, therefore, be important in 2021, as will the ability to make dramatic shifts in duration posture. Inflation‑linked bonds may also prove beneficial this year.
What is liquid in your portfolio?
In March 2020, we witnessed the first real collapse in liquidity conditions since the global financial crisis. It started with credit markets, and eventually, every segment of the bond market was affected, with price dislocation even occurring in some parts of the US Treasury market at the height of the crunch.
This episode provided a stark reminder that liquidity is rarely present when it is needed and that it is always important to undertake a forensic analysis of the liquidity profile of fixed income under different market environments.
Furthermore, the March experience raises the question of which securities and sectors will be considered liquid in the future. Liquidity therefore needs to be found elsewhere — for example, from currency markets and derivative instruments such as synthetic credit indices, which both provided liquidity while other assets struggled during 2020.
Increasing the use of option positions could thus offer an opportunity to exploit sudden moves in volatility in 2021.
How to navigate this environment
To navigate some of the challenges highlighted by the three questions listed above, a flexible approach following three clear objectives is required:
1. Achieving regular returns – The aim here should be to generate consistent and sustainable performance from coupon income and capital gains. This makes diversification across geography and markets important, backed by trusted global research to uncover inefficiencies and potentially exploit opportunities across the full fixed income investable base.
2. Preserving capital and managing downside risk – Here, emphasis should be placed on minimising losses and preserving capital through managing downside risks, such as a potential rise in interest rates. This means aiming to manage overall duration with the view of flexibly and rapidly adapting to different market environments and cycles. So, when interest rates are rising, for example, duration could be cut to as low as minus one year to minimise potential losses, using instruments such as fixed income futures and interest rate swaps. By contrast, when rates are falling, duration could be increased to as high as six years to maximise potential gains.
3. Diversifying away from risky markets – Having a performance anchor during times of equity and risk market corrections is important. To help do this, defensive hedging positions, such as short positions on emerging market currencies, allocation to markets displaying defensive characteristics, or going long amid volatility through options, are needed so that during periods of market turbulence, one can benefit from price falls of risky assets. High‑quality and less volatile government bond markets also typically offer better liquidity, which helps when there is a need to adapt quickly to changes in market conditions and to take advantage of possible pricing anomalies and dislocations.
Positive tone for 2021
Looking ahead to this year, there are four themes that currently underpin the bullish tone in financial markets: ultra‑accommodative monetary policy, expansionary fiscal policy, significant pent‑up demand for services, and expectations that vaccines introduce a return to a more normal life.
As long as these themes continue, the positive tone underpinning markets is likely to remain in place.
Portfolios that strike a balance between country, duration, and yield curve positioning to take advantage of relative value opportunities globally, while also managing downside risks, are likely to perform the best in this environment. Flexibility will be key in 2021, given the need to be nimble in changing market conditions.
# Arif Husain is Head of International Fixed Income and Lead Portfolio Manager of the Dynamic Global Bond Strategy at T Rowe Price.