Fixed income investments are witnessing equity like attributes in recent times, with double-digit returns in the past seven-months alone.
With negative yields across one third of the fixed income market, and two thirds of the fixed income market with yields under 1%, there is little reason to get excited about the long-term potential from fixed income although it is still useful in portfolio construction because there are limited other choices to diversify risk.
One alternative is to push up the yield curve and obtain exposure to emerging markets and high yield debt. As a general rule, this higher risk tolerance has paid handsomely, with emerging market high yield debt the highest performing fixed income segment thus far in 2016.
However, it is also important to understand the country break-down of any exposure. For example, China tends to be well-represented in corporate bond market indices. As Chinese debt levels generally continue to rise at a rapid rate, active selection is required to navigate the mine-field of high corporate debt and potential default risks.
Our current valuation-implied returns heavily favour the economies with positive real interest rates such as Brazil, Colombia and South Africa. To the contrary, the most liquid fixed income markets of the United Kingdom, Japan, Europe and United States all continue with gross overvaluations and negative return expectations.
3 Big Central Banks on a Spending Drive
As generally expected, the central banks continue to move with three of the big four - Bank of Japan, Bank of England and the European Central Bank - all stimulating at the current time. In fact, you will be hard pressed finding any country other than the United States with a tightening bias.
Japan has been the most active in this space, and the size of the central bank balance sheet in Japan is something investors will need to keep a close eye on. One interesting side-effect to this liquidity splash is that the Japanese high yield bond market is now a bigger market than in Europe.
Given most central banks are mandated to facilitate full employment and stable inflation, one of the most surprising elements to the “lower for longer” story is the incredibly low inflationary environment. We have touched on this theme already, however it is remarkable because it is in direct opposition to the 18 leading economists that pleaded the Federal Reserve to stop quantitative easing round two in 2011 for fear of an inflation outburst and potential hyper-inflation. These economists included many notably gifted participants including Niall Ferguson, a professor of financial history at Harvard University.
The net result, and one of the most distorting themes in fixed income, is the drastic tightening in credit spreads.
