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Investing in Fixed Interest – From QE to QT

What does the prospect of rising interest rates mean for bond exposure within diversified investment portfolios? Ryan Hughes, Head of Active Portfolios at AJ Bell, discusses some of the issues involved and some of the ways that they are approaching the challenge.

For many of you reading this article and for me writing it, we have known nothing else in our investment careers other than a fixed interest bull market. With interest rates in the UK and US peaking in the 1980s, it has been, pretty much, a one way street ever since with falling bond yields and a fantastic environment for make money from government and corporate bonds alike. This has been great news for investors. It’s really just been a case of taking credit and duration risk to generate decent returns from bonds as you’ve been adequately compensated for taking risk as interest rates have fallen across the developed world.

A sea-change for fixed interest

However, looking forwards, it seems entirely conceivable that we have entered, or are about to enter, a very different environment that could represent a sea-change in how we have to think about fixed interest investing.

In the period since the financial crisis in 2008, central banks took the collective decision that the best way to navigate through the economic challenges was to employ a period of ultra-low interest rates. The idea was to try and stimulate the economies out of their slump through a process known as quantitative easing (QE). This of course meant an amazing time for fixed interest securities as rates moved lower and lower as central banks hoovered up vast quantities of bonds, helping bond yields turn negative in some instances. However, since the Federal Reserve began the end of its bond buying programme and started to finally raise interest rates in 2016, we have entered a new phase for fixed interest markets. In this quantitative tightening (QT) regime, duration management and credit selection are becoming much more important.

Looking forwards, it seems entirely conceivable that we have entered, or are about to enter, a very different environment that could represent a seachange in how we have to think about fixed interest investing.

Looking forwards, given the enormous debt pile that now hangs like a millstone around the necks of the major developed economies and markets, it appears that central banks will now have to look to somehow inflate their way out of the problem over the next few decades. As a result, this almost inevitably means a period of higher interest rates is ahead of us. This is a pretty obvious statement to make given where interest rates currently sit but with so many investors still piling into bonds regardless, it is not entirely clear that everyone has understood the implications of this.

Duration risk

At the same time, we have seen a significant structural shift in the duration of the benchmark over the last decade as governments have looked to take advantage of low rates and issue longer-dated debt. As a result, the duration of the gilt index has increased from 7 years before the financial crisis to 12 years today. This has significantly increased the duration risk for investors, particularly those who are investing passively and may not even be aware of the change. But what does it all mean for investing in bonds?

Our approach – going for shorter duration

To try and explain this, I’ll highlight how are we navigating these challenges in the AJ Bell MPS range? Well, firstly, we believe that over the next few years, interest rates have to rise in developed markets. As a result of this, we have opted to keep our duration significantly lower than the benchmark. This means where we have exposure to UK government gilts, we are fully invested in short duration bonds; these are gilts with a duration of up to 5 years, although the weighted average is just over 2 years. This should bring significant downside protection to the portfolio should interest rates start to move up later this year and into 2020, particularly if a satisfactory resolution to Brexit is found. Given the very low fees available from passive ETFs investing in UK gilts, we have gained exposure through the Lyxor FTSE Actuaries UK Gilts 0-5yr ETF.

We believe that over the next few years, interest rates have to rise in developed markets

Away from UK government bonds, we have also recently instigated a position in US government bonds in our lower risk portfolios. Once again, this is focused on short duration bonds, this time with a duration of up to 3 years, albeit the average maturity is less than 2 years. The attractiveness of looking to the US is the yield pick-up available given the significantly higher interest rate in the US at present where the Federal Reserve have rates at 2.5% as opposed to just 0.75% from the Bank of England. In addition, we have indication from the Federal Reserve that interest rates are likely to move higher with the Fed ‘dot plot’ estimation of future rates pointing to at least one if not two rate rises this year and more in 2020. Once again, we have gained exposure passively at very low cost through the recently launched Invesco US Treasury Bond 1-3yr ETF.

Clearly there is risk that growth in the economy slows and rates do not go up in the manner that we expect, but the use of short duration strategies is much more about protecting capital if rates do go up rather than making money if they don’t. We are very comfortable with the risk / reward trade off of this and expect on the balance of probabilities that over time interest rates will be structurally higher from here.

Emerging market debt

Another area of focus for us is emerging market debt. When we look at the portfolios that advisers operate, we rarely see an allocation to this asset class, possibly due to the perception that significant risk comes with it. However, as we look to build diversified portfolios that are efficient on a risk-adjusted basis, we see the benefits that an allocation to this asset class can bring. Importantly, these emerging economies are in a different phase of the economic cycle but also are structurally far better placed given that they don’t have the same level of indebtedness as developed markets. Gaining exposure to fast growing economies such as Brazil, Mexico and Indonesia amongst many others brings real diversification to our portfolios. It also brings a higher level of income with a distribution yield of circa 6% per annum from our preferred holding, the M&G Emerging Markets Bond fund.

A different phase – a different approach

Overall, as we enter a different phase of the economic cycle and central banks in developed markets shift to a quantitative tightening approach, the challenge of navigating fixed interest markets has become more difficult. Duration management will become critical, particularly for lower risk investors who, for so many years, have not had to worry about capital losses from the fixed interest element of their portfolio. Our focus at AJ Bell has been on short duration strategies designed to protect capital in rising rate environments while we have also started to look further afield to the US for yield enhancements without materially shifting the risk exposure of the portfolios. Importantly, our expectations have shifted towards a capital preservation approach to our core fixed interest exposure as the cycle shifts and central banks look to finally deal with the debt mountain that has built up through decades of loose monetary policy.

Overall, as we enter a different phase of the economic cycle and central banks in developed markets shift to a quantitative tightening approach, the challenge of navigating fixed interest markets has become more difficult.

About Ryan Hughes

Ryan started his career in 1999 working for an independent financial adviser, progressing to become Head of Portfolio Management at an award-winning advisory firm. Ryan then joined a global asset management firm as a Fund Manager, where he oversaw more than £10bn of multi-asset portfolios and also sat on the investment and global asset allocation committees. After seven years, Ryan joined a small multi-asset boutique managing portfolios for clients all around the world, before joining AJ Bell three years later to help establish our investment capability. As Head of Active Portfolios, Ryan now oversees all actively managed investment solutions and fund research.




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