With an inflation-induced bond sell-off now in its third year, the issue for fixed income investors is where to from here. Picking the direction and speed of interest rate movements, and the asset class’s likely correlation with equities markets, is challenging and the Fiduciary Investor Symposium in Healesville heard that traditional relationships between asset classes can’t necessarily be trusted to hold in the short-term.
PGIM fixed income chief investment strategist and head of global bonds Robert Tipp said that whenever rates have risen a lot – as in 2013, 2018 and 2022 – “that has been a problem for risk markets”.
“We saw earlier this year in March with SVB, when rates plummeted, spreads widened and rates went down. So I think you have kind of a negatively convex situation there, where, under normal circumstances the correlation is not that important. But if things are really strong, or really weak you’re going to get a bad reaction from risk product.
“It’s going to be an unstable hedge. But the saving grace is that sometimes it will work. And that returns are very presentable for fixed income here. As Chris mentioned, you know, it looks like a very solid asset class.”
Alpha opportunity
Even so, Tipp said, investors should be expecting some unusual yield curve behaviour but that would present opportunities to generate alpha from smart positioning.
Tipp said that after central banks have raised rates so far so quickly “at this point there’s not much further to go on the upside”.
“Any further moves from the Fed are going to be extremely measured so that means in extremis, [you] could you have three hikes in the next couple of years, I suppose,” Tipp said.
“But obviously, if you have a crisis, or things are really bad, they’ll be cutting all the way back to zero, and doing QE again – you know, in extremis.
“I think most investors have long-term horizons and over that period it’s going to make sense to be in the market. Having said that, though, the yield curve is misshapen: it’s concave up, it’s normally concave down, and there are going to be opportunities for yield curve positioning and generating alpha as a result of that.
“I think the market, whether you’re looking at nominal yields or real yields, they’re really restored back up to very respectable levels. And you know, in the next five to 10 years, those are going to turn into returns.”
AMP fixed income portfolio manager Chris Baker said the long-term correlation between bonds and equities is not likely to vary much from historical averages.
“But we think over the shorter term, given these increases in inflation [and] volatility, that the correlation will move around, more likely to range-trade and be slightly positive, if anything,” Baker said.
Baker said that as AMP stress-tests different scenarios it has identified “continued stagflation” as a potential risk, “which obviously will see rising yields and an impact on equities which…would imply a positive correlation” between the asset classes.
“We think overall, that in this environment, correlations will be unstable and, if anything, biased over the short-term to be positive,” he said.
“I’d preface all that with just given the rise in yields and the starting level of yields in fixed income, we still think that at these levels they now serve a core role within the portfolio, just given that starting level of yield.
‘Next big move’
“But we’re looking at supplementing that allocation with tail-risk hedging call-option strategies, just in light of this likelihood of variability around that correlation and unstableness of the correlation over the short to medium-term.”
AustralianSuper head of fixed income, currency and cash Katie Dean said she shared Tipp’s view on the “misshapen yield curve”.
“If we just think about the broader economy, the unemployment rate is rising across most parts of the world now, which usually does mean that the next move, or the next big move in interest rates is more likely to be down than up,” Dean said.
“I’ve got a lot of sympathy, though, for what Robert is saying in terms of the unusual behaviour of the yield curve now, relative to the last 20 years, and I think what we’ve seen is that a lot of investors have been waiting for that next big move, or anticipating that next big move, and they’ve really been anticipating it since bond yields got to about 3 per cent. So we’ve got another 300 basis points of downside here.
“I think the difference this time around is, first of all, the market has been conditioned to price for the Fed to move in and other central banks to move in and cut rates very quickly. And the surprise that we’ve had over the last 18 months is that actually, when you’ve got inflation so high and growth so actually strong because of balance sheets, then yields are going to be stickier than you think.
“Then there’s potentially more a little bit more surprise, in terms of the stickiness [of yields] rather than the ability for really strong capital appreciation in bonds, at least in the short term.”
