A $120 trillion market that’s more diverse than equities

Misguided assumptions about fixed income – perhaps most notably in oversimplifying what is an incredibly diverse asset class – see many investors miss out on the benefits of investing in debt markets, says T. Rowe Price's Joran Laird.

During a recent interview, the fixed income portfolio specialist debunked some of the most common misconceptions. Laird also outlined a few ways that fixed-income investors can minimise risk and boost returns, even as inflation ticks up and interest rates look set to rise in the not-too-distant future.

In a nutshell, he said investors should:

• Be unconstrained by benchmarks
• Maintain a highly active approach
• Invest in a diverse range of markets and bond durations.

“You just need to take a look at 2020. In the first quarter, long-dated US Treasuries returned more than 20% at a time when the S&P 500 fell by roughly 20%,” Laird said.

And beyond historical asset class performance comparisons, he gives four reasons why now is certainly not the time to abandon an allocation to government bonds. These include the looming tapering of stimulus by central banks and a slower China growth outlook.

In the following interview, Laird explains the differences in T. Rowe Price’s approach to fixed income versus traditional allocations and why he believes it’s now more important than ever to understand and review your exposure to global bond markets.

Some investors avoid fixed income based on assumptions the asset class either won’t deliver sufficient returns; or that it’s too risky. Why is this, and why do you believe debt assets belong in portfolios?

You just need to take a look at 2020 where in the first quarter long-dated (10+ years) US Treasuries returned more than 20% at a time when the S&P 500 fell by roughly 20%.

At the other end of the fixed income spectrum, US High Yield corporate bonds returned around 23% in the final three quarters of 2020.

The size of the global fixed income market is estimated at more than US$120 trillion – the breadth and depth is huge and there is something for everyone depending on their needs.

We still believe a fixed income allocation makes sense, especially as we enter a period of potential heightened volatility in financial markets. This could be driven by any number of factors including:

• China slowing,
• inflation concerns,
• developed market central banks starting the tapering process, and
• the potential for fiscal stimulus tailwinds to turn into headwinds in key markets, such as the US.

Against this backdrop, we believe flexibility will be key.

What are the biggest advantages of the asset class? Conversely, what are the biggest risks?

Fixed income is a huge market that offers investors a great plethora of opportunities with varying levels of risk, return potential, and correlation characteristics. There is essentially something for everyone as bonds may provide income or be used by investors as risk mitigation to keep portfolios balanced. A key advantage over equities lies in portfolio construction as fixed income managers can either be "risk-on" or "risk-off," while equity markets can only really have varying degrees of risk-on.

It's more important than ever that investors understand and review their existing fixed income allocation. That’s because there’s often an assumption that it always works as a diversifier but that depends on the environment and approach. For example, investors seeking higher income may be allocated to credit sectors such as investment grade and high yield – however, these are still positively correlated to equity markets and will likely suffer when there’s a selloff in risk assets.

Another key risk, as highlighted earlier, is the level of duration risk investors could potentially be exposed to either through index-based fixed income strategies or investing in credit (credit contains a duration component that exposes it to changes in the underlying risk-free rate).

With elevated inflation and central banks starting to withdraw liquidity, there’s potential we move into a rising interest rate environment, which could result in losses for bonds. That’s why active duration management and an approach like the Dynamic Global Bond, which is index-agnostic, is important because it helps give necessary flexibility to navigate the different types of interest rate environments.

Can you explain the focus of the portfolio and more specifically the roles of sovereign bonds?

We have three clear goals:

1. To generate regular income,
2. To minimise any losses, and
3. To provide clients with genuine diversification away from equity markets.

This means that during periods of volatility, when risky assets such as equities sell-off, we strive to be a performance anchor. To achieve this, we focus mostly on government bond allocation as opposed to credit risk because credit has a higher correlation to equities. We invest a large portion of our fund in high-quality and less volatile government bond markets that typically outperform during times of equity market stress and volatility.

Liquidity is also typically better in sovereign bond markets, which helps us to adapt quickly to changes in market conditions. But it’s not just a case of being long sovereign bond duration at all times because, for example, that simply won’t work when interest rates are rising. That’s why we tactically manage the fund’s duration so that we are able to adapt to the market conditions.

In the current environment, where there’s potential the interest rate cycle is turning this approach is likely to be more important than ever.

How do you address the challenges of covering such a global portfolio?

Stay true to the objectives you are trying to achieve. Our investment and portfolio construction processes benefit from a large global research platform that is the engine powering our investment ideas. Covering more than 80 countries, 40 currencies, and 15 sectors, our deep research capabilities enable us to uncover inefficiencies and exploit opportunities across the full fixed income investable base. But we do so in a disciplined way— managing risk is very important to us. We devote significant efforts to the analysis and monitoring of risk of each individual investment position, as well as the overall level of risk borne by the portfolio.

How do you manage duration, liquidity and returns in the portfolio– what are the key points that investors need to be aware of?

The fund’s return objective is to beat the Bloomberg AusBond Bank Bill Index by 250 basis points per annum (gross of fees). We aim to do that with a total return volatility range of between 2% and 4%. It’s important to note that our target spans a full market cycle, as performance will not always be in a straight line. During some periods we may do very well, such as in times of equity market stress like March 2020. But our performance may be more in line with cash-like returns during other periods – such as when there’s a slow and steady rally in risk assets – due to the fund’s strategy of delivering diversification. A typical example here was 2017, when credit spreads tightened progressively in the absence of significant volatility, meaning that the premium spent on the fund’s defensive hedges ended up being lost.

The management of country allocations, duration and the risk curve is an integral part of our portfolio construction process and the majority of performance is expected to be generated from these positions. We pick the best ideas from our global research platform and have wide latitude in tactically managing the fund’s overall duration. This gives us the flexibility to adapt to different market environments and cycles, meaning that when interest rates are rising, such as during the first quarter of 2021, we can quickly cut duration to as low as zero in order to minimise potential losses. By contrast, when rates are falling, we can increase the duration to as high as six years to potentially maximise gains.

How do we manage returns? Nobody can do this, as market conditions can’t be controlled. What we can do is manage the amount and types of risks that we take, and the returns will be a product of this. Ultimately this links back to the quality and accuracy of our research and portfolio management skill.

What’s one aspect of fixed income you think retail investors simply don’t pay enough attention to or properly understand?

A fresh approach to fixed income is required. Why? Let’s remind ourselves that while duration is a powerful diversification tool when there’s risk asset volatility, it may also be a powerful loss multiplier when yields are rising. That’s where traditional approaches to fixed income are particularly vulnerable as they are often constrained by benchmarks that might hold a lot of interest rate risk. Take the Bloomberg Global Treasury Index, for example, where total duration has risen from around five-and-a-half years 20 years ago to eight-and-a-half years today. Essentially, investors are now potentially much more exposed to interest rate risks than they have been in the past two decades and often they are not aware. This comes at a time when yields could start to rise as central banks look set to shift toward tightening in response to inflation pressures.

The current environment doesn’t mean you should just give up on fixed income, because it will still continue to play an important role in your asset allocation.

In fact, we believe there’s never been a more compelling time for active management, especially tactical duration management. That’s why we favour an unconstrained approach that has the ability to look beyond a predefined opportunity set to source both long and short investment ideas.

Invest with confidence

The global fixed income universe has expanded rapidly in recent years. With dedicated teams of sovereign, credit and currency experts located across the US, Europe and Asia, T. Rowe Price is ideally positioned to capture this growth and the market opportunities it offers by seeking to cut through the noise to generate consistent, long term returns. To learn more, please visit the fund manager's website.

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