“Investors must recognise that bond markets are less liquid than they were a few years ago,” said Susan Buckley, managing director, global liquid strategies, QIC.

“In times of market stress, liquidity can be non-existent, and importantly the price of liquidity is not consistent,” she says.

“They key is being aware of liquidity risk premia so [you] need to be nimble even in times of stress. If investors don’t need liquidity, then they can benefit from a high premia for liquidity,” she said.

Around 42 per cent, or $10 trillion, of the Citi World Government Bond Index is negative yielding.

Arguably if the world has fallen into a global liquidity trap, then negative yields will be a feature for a long time, she said.

“The negative consequences of that include a squeeze on velocity or circulation of money; bank profitability comes into question and stymies credit creation, and negative interest rates have and will exacerbate liquidity, or illiquidity, in fixed income. This means you need a 3D framework which considers liquidity – so need to consider risk, return and liquidity.”

In terms of portfolio construction, Chris Baker, principal at Mercer, says a rigid liquidity budgeting approach, and a more objectives-based portfolio construction approach, is needed to work around this environment.

Mercer has adjusted down its assumption of returns in fixed income, and Baker was particularly adamant that benchmark investing is a mistake.

“One of the worst things you could do is to invest via benchmarks as a starting point,” he said.

“We advocate that investors shift their mindset from a beta to a more alpha based approach, based on the purpose of the fixed income allocation.”

Mercer is also now allocating fixed income allocations by their purpose, such as income generation or downside protection.


Mercer research initiative – two secure income universes

In terms of return seeking areas, the most recent research initiative at Mercer is the creation of two secure income universes.

Mary McLaughlin, chief investment officer of the MIESF, said there were three paths that investors were taking in response to the low yield and low return environment:

  1. Accept the low return environment and manage expectations, concentrate on portfolio efficiency and expand the opportunity set
  2. Increase risk in the portfolio. At an asset allocation level that is seen in tilts towards high returning asset classes, and in fixed income it’s been in a greater allocation to credit. McLaughlin said that all investors “were one asset class risker than they’d like to be, and in fixed income are one dimension riskier than they’d like to be”
  3. Chase alpha (or hope). Investors are achieving that through lifting constraints, and in fixed income, absolute return investing is the flavour of the month.

“I think it is appropriate to have some healthy scepticism that constraints weren’t what were limiting alpha possibilities,” she said. “Be realistic about what’s achievable.”

McLaughlin also said that cash relative to bonds should be reassessed and could provide some of the attributes that investors are looking for in fixed income.

“As a source of liquidity, the advantage of cash over bonds strengthened. The option value of cash should also be recognised,” she said.

“As a diversifier to equities, fixed income usually beats cash hands down. But [with] current low yields the scope for positive returns is limited, and I’d argue the diversification benefits of bonds over cash has been eroded. And in terms of defensiveness, cash is a clear winner as the cost of giving up the upside is much lower.”


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