The asymmetry of bond markets was often used to differentiate the performance potential of fixed income and equity investments. Bonds, we were told, had significant downside potential, while their upside was limited by a purported zero yield bound.
However, in a world of negative interest rates this has proven untrue, with bond yields following interest rates below zero throughout Europe and in Japan. In fact, according to data compiled by Fitch, the volume of negative yielding bonds rose 5% in May and now exceeds USD 10 trillion, a number that is expected to rise should global economic growth remain lacklustre and central banks continue with their programmes of quantitative easing.
In this new world, the zero yield level is no longer a boundary. Bonds in Switzerland, Germany and Japan have all continued to appreciate since their yields fell below zero, and this is not just a comment on short-term performance. The Swiss five-year government bond yield fell below zero in January 2012 and has returned in excess of 4% since then, for example. This unfamiliar environment requires investors to adapt the way they think about fixed income markets and how they manage the associated risks. This has certainly proven a challenge for some, and as ‘value’ investors, buying assets that guarantee a loss in nominal terms if held all the way to maturity is something we undertake with extreme caution.
Since we expect this negative yield environment to persist for some time, we have re-examined the way we take interest rate risk and reassessed our investment tactics. We still believe that fixed income and currency markets are ultimately driven by economic fundamentals, but the periods and extent to which markets can diverge from these fundamentals appear to be increasing.
As such, we have added a number of systematic models to our investment process. We have used such models in our portfolios before, but the later ones have new drivers that are more appropriate for this interest rate environment. The new models have been back-tested to show that they would have added value over the last dozen years, as well as adding value in current quarters. To be perfectly clear, fundamental research remains the cornerstone of our ‘value’ investment process. But by adding quantitative arrows to our quiver, we feel better placed to capture the short-term changes in sentiment that have dictated bond and currency market performance in recent years. The models have proven an effective hedge for our fundamentally based approach and have added significant value since they were added to our armoury in early 2014.
Currently, bond yields in both the UK and the US remain at extremely low levels, despite sustained signs of modest economic improvement, and the potential for US interest rates to rise on more than one occasion since December 2015. We feel that the 30-year bull market for bonds is nearing its end, but we are not there as yet. Reassurances from central banks that they are ready to act should the economic environment deteriorate have been supportive of fixed income assets. This reassurance has created potentially dangerous bond market bubbles, exemplified by the growing stockpile of bonds with yields below zero.
Tactical gains can be captured in the short term – while the eventual long-term reversion of bond yields, with attendant drop in bond prices, remains our most prolific environment. It is one for which absolute return on unconstrained investing is so ideally suited.