Rethinking Core Fixed Income in a Rising-Rate Environment
Michael Hasenstab, chief investment officer, Global Bonds, Franklin Templeton Fixed Income Group®, says it is time for fixed income investors to think outside traditional boxes. He believes that with today’s market environment and the prospect of rising US interest rates on the horizon, investors need to rethink their core fixed income portfolio. He makes the case for an actively managed, global, unconstrained fixed income strategy.
Three key requirements exist. First, the strategy needs active management to be able to adeptly invest in the relative strength of select countries and currencies while avoiding the weakness of others—something an index cannot do. Second, it should be well poised to deliver a negative correlation1 to US Treasuries2 given the seemingly inevitable eventual rise in interest rates. Notably, while some strategies claim to have a negative duration,3 that is not synonymous with the more important goal of having an overall negative correlation to US Treasuries. Third, the strategy needs a long-term track-record that investors can thoroughly analyze over market cycles and unexpected events. These are some of the tenets of Dr. Hasenstab’s approach.
Interest rates on government bonds still hover near historically low levels in many parts of the world, near 0% for some core developed economies such as Japan and in the eurozone. However, we believe yields will eventually rise in many markets in the face of stronger economic growth, albeit at various speeds given the disparate stages of recovery. We believe it is imperative that clients prepare well for that by investing in strategies that demonstrate a negative correlation to US Treasuries. We believe that doing so will help provide investors with downside protection when rates rise.
The United States continues to gain ground in its economic recovery, with the International Monetary Fund forecasting a growth rate for the US economy of 1.7% for 2014 and 3% for 2015.4 We believe improving US growth should have a broad-based positive aggregate demand effect on the rest of the world and help support the economic health of the global economy.
Dim Prospects for Traditional Core US Fixed Income Portfolios
The US Federal Reserve (Fed) has been winding down its asset purchase program and signaling higher rates are ahead. In this environment, we believe core US fixed income portfolios traditionally managed to a conventional benchmark could face dim, likely negative, return prospects due to their benchmark limitations and inherent duration risk. In a rising-rate environment, we believe that unconstrained, global fixed income portfolios that have the flexibility to manage duration should be better positioned to outperform.
The duration of traditional fixed income indexes has largely remained steady while yields in developed markets across the globe have been declining since late 2008, largely as a result of central bank intervention aimed at pushing down borrowing costs in a bid to stimulate economic activity and revive growth.
As a result, longer-maturity government bond valuations have become relatively unattractive, in our view, and the income earned would be insufficient to compensate against the risk of rising interest rates. As such, we seek negative correlation with US Treasuries in our strategy. While many other managers are focused on negative duration, we feel it’s more important to design a portfolio that delivers an overall negative correlation to US Treasuries while reducing interest rate risk. We strive to achieve this in part by being short duration. In addition, we overlay currency and credit strategies. For example, we remain long the US dollar and short the Japanese yen and euro as we believe the US economy’s growth will likely increase the value of the US dollar while the quantitative easing in Japan and the eurozone is likely to persist, putting pressure on those currencies relative to the US dollar.
Looking Beyond an Index
Being global and unconstrained runs deep in our DNA; these fundamental elements have been refined over decades of experience within the Templeton Global Bond Group which was founded in 1986. Both require a completely different mindset from passive and traditional core market investing and involve more in-depth local research and trading capabilities, risk management, and operational infrastructure to operate at the scale required to put money to work fluidly and responsibly.
Global fixed income investing does not yet lend itself to passive strategies. Strong risk-adjusted return potential, not the size of a country’s index weighting, drives our investment choices. In our view, taking an active management approach to fixed income investing is essential in volatile market environments and/or during shifts in interest rates. We and many others are expecting such a rise in US interest rates in 2015.
We use a truly unconstrained approach to global investing that helps us to discern potential opportunities when others worry or even panic, and it equips us to react quickly when others may not. Our combination of in-house, bottom-up country research and fundamental analysis as well as macroeconomic modeling assists us in identifying high-conviction investment opportunities. This process gives us the tools to enable us to take contrarian views to the market.
We believe our investment time horizon of two to five years enables us to take advantage of inefficiencies that generally require a longer holding period to generate alpha (measure of performance on a risk-adjusted basis).
Duration and Risk
My team and I strive to position our portfolios with built-in liquidity, giving us additional flexibility during periods of extreme volatility. This enables us to maintain our convictions and patiently wait for prices to move toward what we think is their long-term fair value. Moreover, unlike some managers, we do not use stop-loss systems—an order to sell a security when it reaches a certain price—as we have often seen these moments of apparent panic as opportunities to buy.
As the Fed continues to wind down its asset-purchase program, we expect US rates to continue to normalize toward historic norms over the medium term. In Europe, we believe rate normalization is likely to be slower than in the United States due to Europe’s more tepid economic recovery. Under this scenario of rising rates, we believe traditional core US fixed income strategies have greater vulnerability to capital losses as many target duration to be within a range—within two years, for example—relative to the duration of their respective benchmarks, generally exposing these portfolios to interest-rate risk regardless of the health of the economy. The strategy of just using negative duration could leave investors vulnerable to price depreciation in the short term should interest rates decline and, depending on the implementation, could leave investors with more interest rate exposure than they intended.
In our view, the United States has likely passed the inflection point in interest rates and may be in the early stages of the normalization period in monetary policy. By contrast, we believe interest rates are likely to stay anchored in Europe amid further stimulus from the European Central Bank (ECB); however, we also believe yields are likely to rise eventually as the region’s recovery gains more ground. We believe the limitations of traditional bond benchmarks diminish the performance potential in terms of income generation and duration gains given the extremely low levels in interest rates. The limitations may also increase the beta (market) risk—or risk of general market movement—for core US fixed income portfolios, particularly in a rising-rate environment.
We believe traditional core strategies with concentrated duration exposure appear ill-suited for this type of environment, and those that have relied on falling interest rates to generate returns are likely to face challenging times ahead if rates trend higher. Thus, we believe an allocation to an opportunistic and truly unconstrained strategy that can invest flexibly across global fixed income markets can help to reduce bond volatility and generate additional alpha potential.
In our view, increased Fed tapering, the asymmetric risk/return in bonds based on today’s low rates, and the inevitable bouts of volatility make a strong case for shifting assets towards more actively managed, unconstrained fixed income.
Michael Hasenstab’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
This information is intended for US residents only.
What Are the Risks?
Templeton Global Total Return Fund
All investments involve risks, including possible loss of principal. Currency rates may fluctuate significantly over short periods of time, and can reduce returns. Derivatives, including currency management strategies, involve costs and can create economic leverage in the portfolio which may result in significant volatility and cause the fund to participate in losses (as well as enable gains) on an amount that exceeds the fund’s initial investment. The fund may not achieve the anticipated benefits, and may realize losses when a counterparty fails to perform as promised. Foreign securities involve special risks, including currency fluctuations and economic and political uncertainties. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in interest rates will affect the value of the fund’s portfolio and its share price and yield. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. The fund is non-diversified, which involves the risk of greater price fluctuation than a more diversified portfolio. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. These and other risk considerations are discussed in the fund’s prospectus.
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