The US Federal Reserve’s decision in December 2013 to start tapering its quantitative easing programme marks the start of the journey towards a more normalised macroeconomic environment, where short-term interest rates and government bond yields will move closer to historic averages.
While a return to a more positive economic environment and an increase in interest rates will be welcomed by equity investors and savers, the outlook is much less positive for fixed income investors.
Chris Iggo, chief investment officer of fixed income at AXA Investment Management, says: “If tapering is the beginning of a return to a more normalised macroeconomic environment, that’s unambiguously negative for fixed income as bond values will come under pressure.” Fixed income investors are well aware of these challenges and have repositioned their portfolios to mitigate their interest-rate risk by allocating assets to shorter duration investments.
Anthony Christodoulou, ETF consultant, says: “That’s made short-duration a very crowded trade, making the yield from this type of investments paper thin.”
While fixed income investors face some very real challenges over the medium to longer term, over the shorter term there could be opportunities, as the tapering journey is likely to be choppy with plenty of frequently reversing market currents. “If QE caused downward pressure on the price of many assets, then the withdrawal of QE may cause volatility and asset re-pricing,” says Mr Iggo.
The turmoil in emerging market equities and debt markets is a good illustration. These markets benefited from QE capital inflows but once QE was reduced, they lost support, asset prices fell and capital flows reversed, adds Mr Iggo.
During increases in volatility and bouts of risk aversion, investors will shun riskier assets and search for defensive assets. That will cause longer duration bond yields to fall and prices to rise for short periods.
These market movements could be a boon for fixed income investors who will need to take advantage of any opportunity to create additional returns for their portfolios.
“In moments of high risk aversion, fixed income managers should take on long-term duration risk to increase the overall return of the portfolio, by buying a 20-year US Treasury ETF,” says Mr Christodoulou.
Fixed income ETFs are an ideal instrument for investors to implement such trades as they allows investors to pinpoint accurately the duration they want to access, he adds.
Aleem Siddiqui, investment director at Close Asset Management, agrees: “The great thing about having a diverse range of fixed income ETFs is that an investor can really target whichever part of the yield curve they want.”
Mr Christodoulou adds: “ETFs also have low frictional trading costs which help to protect against returns being eroded.”
There is another advantage to using fixed income ETFs: they make it much easier and faster to build a position in than the underlying fixed income instruments. That allows investors to move quickly in and out of particular fixed income exposures, ensuring they can react relatively quickly when markets move, adds Mr Siddiqui.
Siu Kee Chan, senior investment manager at ING Investment Management, concurs: “The cheapness and ease of use make ETFs a very appropriate tool for a multi-asset manager who wants to make money from a short-term tactical asset allocation.”
Bond ETFs can be used in more ways than simply going long government bonds in times of risk aversion. Mr Chan says: “Even though our mix funds currently do not have structural ETF allocations to high yield or emerging market bonds, we have used bond ETFs to take short-term positions in these markets when risk appetite in the market is high.”
And multi-asset managers such as Mr Chan are not confined to switching between different fixed income categories but can switch allocations to fixed income from other asset classes.
Stephen Cohen, chief investment strategist for iShares Emea, says: “In January, we saw a significant number of investors who were long emerging market equities ETFs sell these positions and invest instead in US Treasury ETFs.”
In the past it would have been more difficult for investors to use ETFs to express different tactical views on the fixed income markets. But there have been significant advances in recent years.
Mr Cohen says: “Over the last three to five years there has been a lot of ETF fixed income product development giving investors a broad range of tools to build not only a multi-asset fixed income portfolio but also to help take tactical positions.”
The outlook is undoubtedly challenging for fixed income investors but at least the increased range and liquidity in fixed income ETFs makes it easier to exploit market opportunities and build a multi-asset credit portfolio.
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