Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 227

How fixed interest is undergoing profound change

For the past 30 years, global fixed income investors have enjoyed an almost unbroken run of positive absolute returns.

Diversified global fixed income has not only done its job of providing protection and diversification but has formed the basis of strong overall portfolio performance, particularly on a risk-adjusted basis. It has been a truly golden period where a relatively static strategy has been highly rewarding. Yet Australians remain significantly under allocated to bonds.

Are bond markets at a turning point?

Recently, more commentators have called an end to this secular bull market. Indeed, in the past few years we have experienced several periods of rising bond yields. In particular, since July 2016 when China unveiled a package of stimulus measures, it signalled a reflationary environment could bring an end to this virtuous bond environment.

Whether this transition is - ideally - slow and gradual, or swift and violent, is still to be seen, but in our view, we are likely to see a change of scenery from the near cyclical lows in yields.

With benchmark duration expanding, creating greater sensitivity to interest rates moves, future traditional fixed income returns appear mediocre at best. At worst, index-constrained investors may end up nursing capital losses as low coupons may not cushion potential price drops.

(Duration measures a bond's price sensitivity to changes in interest rates. For example, if a bond has a duration of five years, its price will fall about 5% if its yield rises by 1%).

The fallacy of benchmarks

The current construction of the high-profile Bloomberg Barclays Global Aggregate Index highlights the risks that investors may be exposing themselves to, leading to the potential for ‘rewardless risk’ over the near to medium term.

The rapid rise in the duration of this Index - as shown in the chart below - increases both the sensitivity of the index to future rises in rates and the likelihood of capital erosion.

In addition, the Index currently includes approximately 18,000 issues that span 70 countries and 24 currencies. It is a monster, making it difficult to efficiently replicate, incurring higher transaction costs and greater error in the tracking process. It doesn’t necessarily provide the diversification that investors expect. For example, it is heavily biased to countries that have been issuing the most debt; the US, Eurozone and Japan via sovereign bonds, which make up more than half of the Index.

What of return expectations? At 30 June 2017, this Index offered a yield of 1.63%, offering little protection against the shocks that could lie ahead. About 15% of the underlying securities are paying a negative yield, eating capital in the process. An additional 22% of bonds pay less than 1%. While some investors are tightly mandated to hold allocations close to the Index, those with the ability to make a choice are already on the move.

Figure 1: Bloomberg Barclays Global Aggregate Index Rate and Duration History

Source: Bloomberg Barclays Global Aggregate Index

Flexibility and innovation are critical

With this backdrop, it is not overly dramatic to say that fixed income investing is going through a sea change. From discussions with investors, there is a far broader agenda on the table with increased scrutiny and deeper thinking around how best to structure exposure in the next market phase. Asset management industry innovation has witnessed the development of niche strategies designed to exploit structural alpha sources through to broadly-based unconstrained approaches that ignore the benchmark in the search for the optimum balance between risk and return.

New approaches and new strategies are the order of the day. However, it is not straightforward as investors fret over how to construct portfolios if core fixed income offers less protection and, potentially, becomes more correlated to traditional growth assets. Indeed, the lines blur further due to the growth of alternative fixed income strategies that are aggressive in their approach, utilising shorting techniques alongside complex trading and derivative strategies.

Finding value in the interconnected bond markets

If the Index is the ‘rewardless risk’ trade, where is the value in bonds? The chart below shows global bond markets are dominated by a few countries, sectors and investors.

Figure 2: Big universe, limited selection

Source: Bloomberg Barclays Global Aggregate Index

Regardless of the direction of rates, the interconnectedness of global markets and the overpowering presence of central banks fuel dislocations and opportunity, created by:

  1. Fear and greed
  2. Supply and demand, including non-economic players such as central banks, and
  3. Lack of long-term investment horizons.

Due to any combination of these factors, prices can deviate significantly from fundamental fair value, but over time prices typically adjust to reflect inflation, credit fundamentals and liquidity conditions.

Alongside these dislocations sit the economic opportunities that arise as the outlook for growth, inflation and liquidity conditions change. These are impacted by longer term drivers such as indebtedness, demographics and technological change.

Let’s look at one of these dislocations, assuming the history of interest rates is the history of inflation, as seen in the Figure 3.

Figure 3: The history of US rates is the history of inflation

Source: Bloomberg. As of 31 March 2017. PCE = Personal Consumption Expenditures, is an inflation index excluding food and energy.

One could be forgiven for thinking that the fast-growing emerging markets have a higher inflation pace than the traditionally slower developed markets. But this is not the case, as emerging and developed market inflation rates are actually converging.

This is an example of where value can be found.

As the chart below shows, the real yields offered in emerging markets such as Brazil, South Africa, Indonesia and Mexico are attractive at current levels, given the drop in inflation in those countries. This contrasts dramatically with the European developed market stalwarts of the UK and Germany, whose real yields are negative.

Figure 4: Where is the value?

As of 31 May 2017.

The largest and most important market - US sovereigns - appears to be fairly valued on this analysis and here the debate is most pronounced around the value of the US dollar. A strong argument would be that the greenback is overvalued, measured on a purchasing price parity (PPP) basis, and President Trump would certainly like to see it lower. This trend of a weakening US dollar has been evident since his election in late 2016.

What’s next in the ‘normalisation’ of bonds?

Much is written about normalisation of markets, but - what is normal? Is the post Second World War period any guide at all, or is normal more similar to the nineteenth century when bonds offered low stable yields for multiple decades? How will the great QE experiment end and what tantrums and turmoil might we seeing going forward? And, how does the geo-political flux impact returns and expectations?

As ever in the investing world, asking questions is much easier than finding the answers. The bond market has evolved and developed a range of strategies, instruments and approaches that can be applied to navigate a more complex world. It is this complexity that should drive more investors away from poorly-constructed benchmarks, freeing them to embrace the flexibility and improved return and diversification potential of a more unconstrained or even absolute return approach.

 

Andy Sowerby is Managing Director at Legg Mason Australia. This article is general information and does not consider the circumstances of any investor.

RELATED ARTICLES

Hunting for value in fixed income

A closer look at defensive assets for turbulent times

Why allocating more to fixed income now makes sense

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Latest Updates

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Economy

Australia's economic report card heading into the polls

Our economy grew by a nominal rate of 7% per annum from 2017 to 2024, but it benefited from the largesse of fiscal and monetary policies, both of which are now fading. We need a new, credible economic growth agenda.

Preference votes matter

If the recent polls are anything to go by, we are headed for a hung parliament at the upcoming federal election. So more than ever, Australians need to give serious consideration to their preference votes.

SMSF strategies

Meg on SMSFs: Tips for the last member standing

It’s common for people as they age to seek more help in running their SMSF if their capacity declines. An alternate director may be a great solution for someone just planning for short-term help in the meantime.

Wilson Asset Management on markets and its new income fund

In this interview, Matthew Haupt from Wilson Asset Management discusses his outloook for the ASX, sectors such as REITs that he likes, and his firm's launch of a new income-oriented listed investment company.  

Planning

‘Life expectancy’ – and why I don’t like the expression

Life expectancy isn't just a number - it's a concept that changes with survival rates over time. This article breaks down how age, survival, and societal factors shape our understanding of life expectancy, especially post-Covid. 

The shine is back on gold, and gold miners

Gold mining stocks outperformed in 2024 and are expected to do well in 2025. At this point in the rally, it's worth considering what has driven gold prices higher and why miners could still have some catching up to do.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.