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Preparing for Normalisation

Tuesday, March 21, 2017

US stock indices are trading at, or near record highs, US household wealth is booming and US inflation is edging ever closer to the Federal Reserve’s (Fed) 2% target. Anthony Smouha and Gregoire Mivelaz, who co-manage a number of GAM’s credit strategies, ponder the implications of a potential ‘normalisation’ of monetary policy for fixed-income investors.

The ramifications of rising inflation and normalising monetary policy are potentially numerous and far reaching. However, to a very large degree, the impact is dependent on the way investors approach bond investment. The fixed income spectrum extends from government bonds, at the lower end of the risk/reward range, to emerging market and high-yield securities at the other extreme.

As specialists in junior and hybrid debt, we can choose from not only fixed rate bonds, but a wide range of securities with variable coupons which are reset at pre-determined intervals. The advantage of variable coupons is that, when interest rates rise in response to a pick-up in inflation, it can mean that the bondholder receives a higher income without a commensurate increase in underlying risk – since coupons adjust in response to rising interest rates, much of the so-called duration risk is mitigated. As such, the erosion in capital value that is typically associated with fixed coupon bonds in a rising-rate environment can also be avoided.

In addition, it is important to bear in mind that a return of inflation is often an indicator of a strengthening economy, which can cause corporate-bond credit spreads to narrow. This reflects a reduction in risk premia since default rates tend to be subdued during periods of economic strength. Consequently, as Michael Lewis’s new book, ‘The Undoing Project’ (which reflects on the Nobel prizewinning work of Daniel Kahneman and Amos Tversky in behavioural economics) teaches us, the seemingly obvious is not always so – higher inflation and rising interest rates are not necessarily the nemesis of all bond investors.

Behind the curve

Although the widely anticipated Fed hike materialised in March, we nevertheless expect Fed policy to remain behind the curve in 2017 as long as European growth remains low. We are conscious that the latter has surprised to the upside in recent weeks, but continue to feel that uncertainty over the outcome of a series of important and impending European elections has the potential to derail current incipient economic progress. Similarly, while the Chinese economy has thus far managed to defy the doom-mongers, we still believe that there is sufficient uncertainty for the Fed to remain cautious.

Nevertheless, we ultimately expect a return to more normal rates of interest, by which we mean a normalisation of the nominal return above inflation. These adjustments never come gradually so we prepare ourselves for sharp moves in rates by diversifying our portfolio across both fixed and variable coupon or floating rate bonds, in order to reduce interest-rate sensitivity.

Given that the Fed cycle is unlikely to proceed uniformly, and that the accompanying rhetoric will shift one way and then the other along the path to normalisation, we envisage that the rate on the benchmark US Treasury note could potentially trade in a range of 2.2% to 3.2%. Consequently, we will endeavour to position our portfolios for a wide spectrum of eventualities. However, we are also cognisant of the need to maintain vigilance and stand ready to change our view should circumstances dictate.

The one overriding concept that we always bear in mind, and one that strongly influences our strategy, is that the return bond investors achieve is a combination of price movement and coupon accrual. Most of the daily news is focused on the former, meaning that the latter is a grossly underappreciated contributor to returns over time. A bond investor who can earn 6% coupon income will receive an 18% accrual over the course of a three-year period.

With inflation remaining low that seems to us to be a very attractive premium over expected inflation rates even should bond prices fall 4-5% over the same period. For a high-coupon earning bond investor, the outlook for the next few years remains promising. Conversely, the opposite is the case for those with low coupon income, who are vulnerable to seeing several years of coupon accrual wiped out by an equivalent fall in bond prices. Consequently, we believe that the choice of both manager and strategy will play a critical role in determining how successful fixed-income allocations prove in the years ahead.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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