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September 2017

Value in Fixed Income? It's all Relative

  • Finding value in fixed income can be a challenge in the current market environment. Fixed income returns come from two main sources: 1) income, which is based on bond yields, and 2) changes in yields, which produce capital gains or losses. In the current environment, yields are low relative to history across all major sectors of the global bond market. We think this limits the upside return potential in most fixed income sectors, while the downside risk could be substantial.
  • Central bank policy has played a key role in the decline in fixed income yields. Central bank policies—including asset purchases and long-term commitments to maintain policy rates near zero—have suppressed volatility in short-term interest rates and contributed to lower yields by reducing risk premiums across global fixed income markets.
  • Central bank policy is now evolving, with profound implications for risks and opportunities in global fixed income markets. Central banks are beginning the gradual process of exiting from extremely accommodative policies. We expect this to drive increased volatility, greater differentiation and more dislocations within and across fixed income markets.
  • In this environment, we think relative value strategies offer compelling opportunities to find value in fixed income. Relative value strategies can be used to express views on economic and policy outlooks across countries, or dislocations within a single market, while limiting exposure to conventional fixed income risks. In this paper, we discuss three current examples of relative value strategies, but we believe the relative value opportunity set will be constantly evolving along with the overall market environment.
  • Relative value strategies may offer several potential benefits in a fixed income allocation. We think relative value strategies can 1) enhance the diversification of return drivers in a conventional fixed income allocation; 2) expand the opportunities to find value by looking across multiple fixed income markets when conventional portfolios tend to focus on a single market; and 3) improve the portfolio’s ability to position for an evolving central bank policy environment by focusing on broader financial conditions rather than interest rates alone.
  • Implementing relative value strategies in a conventional, long-only fixed income portfolio is possible, but opportunities may be limited by the portfolio’s benchmark. In our view, effective implementation of relative value strategies requires a broad, global opportunity set. One way to achieve this is by dedicating a portion of the fixed income allocation to a portfolio with broad discretion to implement relative value strategies.

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