The global financial crisis (GFC) in 2008 resulted in major deficit funding by governments around the world as the public sector stepped in to counter the shrinkage of private balance sheets and credit demand. At the same time central banks, through conventional and unconventional policies, kept interest rates low across the curve. Naturally, debt issuers (both public and private) have taken advantage of these low interest rates by extending debt maturities and borrowing for longer terms, thereby reducing their refinancing risk.
Years of low interest rates and consistent long issuance by borrowers have caused the major fixed-income indexes around the world to have more long maturity bonds and as a result, more duration. This means that today's well-known broad market indexes have more interest rate risk and return potential. For example, as seen in the chart below, the duration of FTSE/TMX Canadian Universe Bond Index has grown since 2008. In the U.S., the duration of the Barclays U.S. Aggregate Bond Index has crept up even more in the same time period.
Chart 1 – The duration of major broad fixed-income indices has increased since the GFC
Higher duration of fixed-income indexes is good for traditional 60/40 portfolios...
Most traditional balanced portfolios that use a 60/40 equities/bonds asset mix and are benchmarked against broad fixed-income and equity market indexes (without leverage), suffer from excessive equity risk relative to fixed-income. A typical 60/40 portfolio has about three times more equity risk than fixed-income risk. This is the primary reason why the typical Canadian 60/40 portfolio is not an efficient portfolio – i.e. it does not have the best risk/return profile.
Having more duration in the fixed-income portion of a traditional balanced portfolio helps better balance the equity/bond risk and return. Still, the imbalances between equity and bond risks in traditional portfolios are large. This is particularly important as we approach the end of the first phase of monetary experimentation with elevated financial asset prices everywhere you look, with no obvious place to hide in the face of increased volatility.
Inside fixed-income, low yields and high duration is a bad combination...
Focusing on the fixed-income allocation, the duration extension of the indexes has wreaked havoc on the risk-adjusted returns of the asset class looking forward and on a standalone basis. As yields have fallen, the income portion of government bonds has diminished compared to the capital gains portion of the returns. In this environment, risk-free bonds trade more like commodities or stocks than income products. Since the income component has left the asset class, clients primarily hold bonds not because of income but for much needed insurance against a fall in the risky assets (e.g. stocks, commodities, high yield assets, etc.) that they are exposed to.
Chart 2 – More of the performance of the asset class is dominated by capital gains
Is there a solution?
Not without taking additional risk or different kinds of risk. The general narrative for investors in the last few years has been to chase higher yielding assets relative to risk-free government bonds. Although this strategy results in better yield for the portfolio, it does so by introducing new risks (e.g. equity risk, credit risk, etc.) into the portfolio. This strategy has generally worked in recent years as risk premia in the markets have fallen since their peak during the GFC. One clear example of this phenomenon is the fall in credit spreads since the GFC which allowed “yield seeking” strategies to outperform government bonds.
Chart 3 – The risk premium for holding risky assets has normalized since the GFC
The outlook for these “yield seeking” portfolio postures that are widespread today is less certain looking forward. The bulk of risk premia tightening is behind us as major asset classes have normalized relative to bonds and the popular yield seeking strategies no longer look like a sure one way bet.
Signature’s fixed income asset allocation
We still believe that higher yielding sections of fixed-income offer much needed value and income, especially in an environment where the income component of risk-free bonds has left the asset class. The solution is to tactically allocate to and away from them in an actively managed fixed-income portfolio since higher yield assets are not a one-way bet anymore. This is our philosophy behind the Signature fixed income products which differentiates them from others.
Sophisticated investors realize that higher yields come with added risks that require active management. The price of additional income in higher yielding assets and the price of the protection offered by the duration of the government bonds fluctuates in the market. Tactical asset allocation within a disciplined portfolio construction framework enables investors to take advantage of these fluctuations and to purchase additional yield when the price is right.
Chart 4 – The available income in different segments of the fixed-income market fluctuates
Signature’s fixed income products utilize our multi-asset class asset allocation expertise and track record within the fixed-income asset class. The flexibility of the mandates combined with the agility with which asset allocation decisions are implemented enable us to take advantage of opportunities in the fixed-income market as they present themselves.
To determine the asset allocation of the funds, we begin with a quantitative monitor of available return per unit of risk across all areas of global rates and credit. Afterwards, individual asset class experts in rates, investment grade credit, high yield credit and emerging markets discuss the developments in their respective markets. This qualitative assessment is further enhanced by the view on commodities, equities, currencies and the general macro environment assessment that come from Signature’s multi-asset allocation meeting.
Our collective appetite for risk based on quantitative and qualitative assessments determines the allocation to highest yielding bonds within the mandate. Our view on commodities and currencies determines the allocation to global bonds. Our monthly fixed income asset allocation process ensures that Signature’s fixed income products benefit from the full scope of Signature’s asset allocation expertise and capabilities.
In our view, tactical asset allocation within fixed income is going to be a major contributor to performance as the markets navigate the later stages of the current economic expansion.