It is news to no one that central bank action has broken the interest rate market. Rates do not respond to traditional factors like economic growth or inflation fundamentals. They instead react to statements from the U.S. Federal Reserve and the European Central Bank. And with central banks showing no sign of easing off the accelerator, the race to zero rates continues. Under such a scenario, it has become almost mathematically impossible to make money in traditional fixed income.
Europe, which has become the global epicenter of the hunt for yield, is pushing the forefront of the zero bound, testing fundamental tenets of investing. Six weeks into an 18-month program of ECB stimulus, the effects are already profound. Ten-year German Bunds are yielding just 7.5 basis points. It’s conceivable — even likely — that soon investors will effectively be paying for the privilege of borrowing money from core European governments. There is no reason to think that we can’t go farther down the rabbit hole in Europe.
In the U.S. the Federal Reserve continues to find reasons to delay the process of returning to rate normalization, even after seven years of no rate increases. While they are slowly edging closer, realistically, rates we think will continue to be range-bound for the rest of the year. Our concern is that the longer the Fed puts off its initial liftoff, the worse the potential impact will be on bond investors.
As a global illustration of the disruptive consequences of a potential rate move for investors, consider a common global sovereign bond index in which the current average yield is at an all-time historical low of 1 percent, with a duration or interest rate sensitivity of roughly seven years. If interest rates were simply to normalize from here, even just edging back toward where they were during the heart of the financial crisis, investors long on this index would stand to lose 10 to 20 percent of their principal, depending on the duration.
Investors cannot afford to be complacent in this environment. They have to grasp that traditional fixed income no longer can do what it originally was supposed to do.
Fixed income was created for three things: provide income, preserve capital and offer diversification benefits compared with other commonly held asset classes, such as equities. When rates scrape zero, it takes the income out of fixed income. Correspondingly, capital preservation is no longer ensured when bonds carry such high interest rate and duration sensitivity. Even the diversification benefit has faded as asset classes move in lockstep, thanks to central bank stimulus.
With the case for traditional fixed income foundering, an absolute-return strategy makes sense for investors. Taking a flexible approach to move between sectors, depending on the market, can help to preserve capital and outperform cash. The ability to capitalize on relative value between various instruments as well as market exposures means that investors can be well positioned in a rising interest rate environment. Absolute-return strategies can exploit price anomalies across traditional and alternative asset classes to beat the market in a variety of economic conditions.
So where are the opportunities to generate uncorrelated returns, irrespective of prevailing conditions? The rewards granted for risk taken look unfavorable in most areas of the market for an absolute-return-oriented investor. Capital should be deployed only when investors are well compensated for the risk. Holding cash is a sensible hedge and preserves liquidity to be activated when the right opportunity comes up, and when one can act on a contrarian basis.
That said, there are reasonable pockets of opportunity, such as U.S. high-yield, which seems selectively mispriced. Default rates are low, for one thing. Also, the asset class continues to benefit from extremely accommodative monetary policy and offers a coupon of 7 to 8 percent. More esoteric areas of the market, such as select nonagency mortgage securities that don’t have direct interest rate sensitivity, look interesting as well.
In today’s highly distorted bond environment, no one has a map to safely navigate the path back to normalization. We are truly in unprecedented territory. Investors would be wise to focus on stability, reducing the likelihood of capital losses and preserving capital. Above all, recognize the mathematical realities facing traditional fixed income and increase your diversification.
William Eigen III is head of absolute return and opportunistic fixed income at J.P. Morgan Asset Management in Boston.
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