Fixed income – new dynamics demand fresh thinking
/How changing markets require investors to think and act differently.
KEY INSIGHTS
Changing dynamics mean that the past decade is probably a poor guide as to how bond markets might perform going forward.
With central banks removing stimulus support and hiking interest rates, we expect tighter global liquidity, higher interest rates, and bouts of volatility to continue.
While the environment is challenging, we see potential for great buying opportunities, so a flexible approach to bond investing is vital.
Bond market volatility is set to continue as markets prepare for life without central bank support. After more than a decade of stimulus measures, central banks are withdrawing liquidity and hiking interest rates in response to multi decade high inflation. Given that aggressive actions of central banks drove yields down so low in the first place, their withdrawal is likely to be highly disruptive – and will ultimately have a much bigger impact on markets than economic growth forecasts.
Faced with rising rates and volatile markets, we believe that bond investors will need to think differently and adopt a broader, more flexible approach that emphasizes active duration management and volatility management. Below, we explore three key risks – and ideas to help mitigate them.
KEY RISK: RISING BOND YIELDS
Portfolio approach – Active duration management will be critical
We believe that managing duration actively will be critical to navigating this environment because it enables investors to tactically respond to different market environments and regime changes. It also gives investors the flexibility to take advantage of any pricing anomalies and dislocations that might occur in a volatile environment.
A broad approach with the scope to invest in different bond markets across the globe may also be beneficial as it offers opportunities to take advantage of scenarios where policy is diverging.
KEY RISK: VOLATILITY IN CREDIT MARKETS TO CONTINUE
Portfolio approach – Defensive positioning and active duration management
A defensive approach may work well in this environment as deploying hedging strategies can help to navigate volatility. Managing duration actively is also important, given the duration risks to which credit portfolios may be exposed.
KEY RISK: STOCK/BOND CORRELATIONS ARE CHANGING
Portfolio Approach – Go Broad Using Full Toolkit Of Instruments
A broad approach that deploys the full toolkit, including currency and derivatives markets, may help to balance and mitigate risks in a portfolio.
How the Dynamic Global Bond Strategy may help in this environment
The changing market environment means that investors can no longer rely on the post Global Financial Crisis investment playbook and will need to think and act differently going forward. We believe that the environment will suit our Dynamic Global Bond Strategy, which is flexible, has a strong emphasis on active duration management, and employs defensive hedges to provide diversification against risk assets.
General fixed income risks
Capital risk – The value of your investment will vary and is not guaranteed. It will be affected by changes in the exchange rate between the base currency of the portfolio and the currency in which you subscribed, if different.
ESG and sustainability risk – May result in a material negative impact on the value of an investment and performance of the portfolio.
Counterparty risk – An entity with which the portfolio transacts may not meet its obligations to the portfolio.
Geographic concentration risk – To the extent that a portfolio invests a large portion of its assets in a particular geographic area, its performance will be more strongly affected by events within that area.
Hedging risk – A portfolio’s attempts to reduce or eliminate certain risks through hedging may not work as intended.
Investment portfolio risk – Investing in portfolios involves certain risks an investor would not face if investing in markets directly.
Management risk – The investment manager or its designees may at times find their obligations to a portfolio to be in conflict with their obligations to other investment portfolios they manage (although in such cases, all portfolios will be dealt with equitably).
Operational risk – Operational failures could lead to disruptions of portfolio operations or financial losses.
Source: T. Rowe Price. Arif Husain, CFA, CIO, Head of International Fixed Income, Lead Portfolio Manager, Dynamic Global Bond Strategy
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