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Investment Insights

Fixed Income
Summer 2016

Fixed Income 3.0:
How to Approach
Bond Portfolios
in a Post-PostCrisis World

• Contemporary fixed income markets can be divided into three
periods: the crisis period from 2007–2009, the post-crisis period
ending in late 2014, and the present post-post-crisis period.
• Recent ineffectiveness of monetary stimulus paired with global
interconnectedness makes prolonged low interest rates and low
inflation globally more likely in this post-post-crisis period.
• The current period can be characterized by weaker economic growth
and lower asset price returns than markets have seen historically, but
with more volatility.
• Bond investors in this period should keep the following considerations
in mind: avoid bond strategies with “scope creep”; expect lower taxequivalent portfolio yields, likely in a range of 3% to 4%; and aim for
liquid investments.

1

The crisis period was marked by the culmination of the housing market excesses and the free fall in most financial assets. This piece.4% 2. which included a federal funds target rate of 0% and several quantitative easing programs.5% 1.S. The post-crisis period that followed was defined by extremely accommodative monetary policy in the United States. and in muted inflationary pressures.S. there have been three distinct periods in the financial markets. RIMES.2% –34. It has been eight years since the “Global Financial Crisis. in negative interest rates in several major economies. the Total Return Outlook Is More Benign Spreads (bps) 2000 Margaret Steinbach Investment Specialist S&P 500 Price Financial Crisis (risk-off) Post-crisis (risk-on) Post-post-crisis (mixed) 1600 2000 1200 1500 800 1000 400 500 0 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 Total Returns (Annualized) U. dollar. the post-crisis period of 2009–2014. and our view that conservative core taxable strategies that avoid scope creep can help dampen volatility in clients’ portfolios.5% 1. the structural changes in the global economy and financial markets that have resulted from the crisis. At the very least. and the current post-post-crisis period.7% 9.2% –5.0% –7. and the challenges ahead that still need to be addressed. The U.2% 19.9% 12. focuses on monetary policy experimentalism.4% Post-Crisis (Mar ‘09– Oct ‘14) Post-Post-Crisis (Nov ‘14–Jun ‘16) Sources: Barclays. defined by the nature and direction of market moves: the Global Financial Crisis period of 2007–2009. Treasury yields and the U. 2 2500 .S. In order to build sustainable bond portfolios in today’s environment. Three Distinct Periods in Fixed Income Evolution After Risk-Off and Risk-On Periods.S. 2016.Mike Gitlin Head of Fixed Income David Hoag Portfolio Manager Our theme of bond yields remaining lower for potentially a lot longer and our belief that we entered a “post-post-crisis” period in November 2014 predates the Brexit vote and market reaction. Britain’s vote to leave the European Union is a meaningful event with global implications. HY EM USD Aggregate Global Credit S&P 500 Global Financial Crisis (Jun ‘07–Feb ‘09) –16.2% 4. however.2% 16.” but in many ways. As of June 30. Three Distinct Periods in Fixed Income Evolution In the past decade. it is important to understand how we got here. the impact of low developed-market yields on U. Federal Reserve’s commitment to employ all available (including unconventional) policy tools helped asset prices to finally stop their descent in March 2009. global political and economic uncertainty will cause greater volatility. the impact is still being felt today — in lackluster economic growth around the world.

This was evident in the first quarter of this year. Compared to the previous two periods. Federal Reserve attempting to normalize policy on the other.5 U. compared to the returns experienced over the prior 30 years. there has been no clear direction for risk. In addition. we take a look at the macroeconomic crosswinds at play and ways to think about building bond portfolios given the uncertainty of the current environment.S. In its recent report. 2013 2014 2015 2016 3 . resulting in a strong “risk-on” period for the markets in the post-crisis stage. U. Return expectations are much lower today and a far cry from the post-crisis period. Given these new market dynamics. the post-post-crisis period has been less straightforward. we should be prepared to see further bouts of high volatility. Federal Reserve.0 Bank of Japan 2..5 European Central Bank 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: Datastream. Federal Reserve 5.1 Adding insult to injury. asset returns have been mediocre at best. “Diminishing Returns: Why Investors May Need to Lower Their Expectations.0 7. The current state of the world.5 10. As of June 30. it’s possible that these unimpressive returns may continue to be generated alongside increased volatility. as investment banks continue to step away from their traditional role of providing liquidity in periods of sharp market moves.S.As interest rates across the yield curve fell to all-time lows. when asset prices gapped to the downside on concerns about the slowdown in China’s growth rate. coincides with the end of quantitative easing in the U.S. a focus on the liquidity of investments will become increasingly important. respectively. which we refer to as the post-post-crisis period.S. Below. There is nothing to suggest the current environment will change anytime soon.5% and 4% and 3% to 5% lower. and then fully recovered by the end of the quarter as market sentiment reversed.S. and the U. 2016. Europe and Japan Have Expanded Balance Sheets 15000000 USD trillions Balance sheet levels $12.S. investors reached for greater yield and return potential.” the McKinsey Global Institute suggests that equity and bond total returns could be between 1. With the central banks of several major economies experimenting with highly unconventional monetary tools on the one hand. we suspect this sort of volatility will remain common. Although rates have remained low. Federal Reserve concluded its third quantitative easing program at the end of October 2014. as depicted in the table below. Since the U. Quantitative Easing on Turbocharge in Major Economies Central Banks in the U.

continued to fall as the size of the quantitative easing programs has increased — in May declining 0.7%. the world’s second largest economy. as the nation’s credit expansion continues to slow. Federal Reserve.Quantitative Easing on Turbocharge in Major Economies “Despite the extraordinary efforts by central banks. it seems the markets are experiencing fatigue. Japan’s and Europe’s Purchases Continue USD Trillions 2007 June 2016 Size of Monthly Purchases Type of Asset Purchases $0.4% year over year. our expectation of sub-7% growth may continue to be a headwind for global growth. Never before have the balance sheets of the central banks of these major economies been so inflated. 4 . as monetary policy alone has not accomplished its original goals. it’s usually not until economic downturns that impactful fiscal policies are adopted. Despite the extraordinary efforts by central banks. RIMES. ETFs and REITs European Central Bank 1. global growth remains sluggish and inflation is generally running below policy targets. global growth remains sluggish and inflation is generally running below policy targets. 2016. the combined balance sheets of the U. Program Has Ended.9% as of the most recent readings. developed-market policymakers will need to consider fiscal stimulus in order to generate more sustainable growth. Treasuries and mortgage-backed securities Bank of Japan 1. Federal Reserve Sources: U. Federal Reserve.1% and 0.” In response to the Global Financial Crisis and the muted growth that persists years later. while Japan’s economy is growing at a pace of 1.7 3.5 €80 billion (US$89 billion) Euro-denominated government and corporate bonds U.S. The euro zone is growing at an annualized rate of 1. Furthermore.1 4.S. Monetary policy is now experiencing diminishing returns and economic growth is weaker than it should be at this stage of a recovery.S.S. European Central Bank and Bank of Japan totaled over US$12.1 trillion — a 283% increase since June 2007. dollars at exchange rates as of June 30. Uneven Economic Recovery Although this unprecedented level of stimulus resulted in double-digit asset price returns in the post-crisis period. propositions like entitlement reform and infrastructure spending projects tend to be politically charged issues. With monetary policy experiments (quantitative easing and negative rates) largely exhausted. although we would argue negative deposit rates are ineffective in achieving their intended goal.7 trillion (US$65 billion) Yen-denominated government bonds. The table on the prior page summarizes the size and nature of their balance sheets and asset purchase programs. respectively.S. Inflation in Europe and Japan has.S. Foreign currency converted to U. as emerging markets growth totaled just 4% in 2015. asset prices have recovered much more quickly than global economic conditions. counterintuitively. Although expansionary programs and fiscal policy reform are necessary at this juncture. Contributing to the subdued growth profile is a loss of momentum in China. It’s for these reasons that Europe and Japan have followed their Nordic counterparts in experimenting with negative deposit rates. Unfortunately. Meaningful fiscal stimulus is likely the next stage in attempting to stimulate global growth.5 N/A (ended Oct 2014) U. As of the end of June. central banks across the globe have aggressively expanded their balance sheets using a range of both traditional and unconventional policy tools. Asset Purchase Programs Have Dramatically Increased Central Bank Balance Sheets Although the U.2 ¥6. While we don’t expect a hard landing in China.9 $4. Muted growth has not been limited to advanced economies either.

paints a less rosy picture and inflation statistics are still running below the U. Real wages have increased. is on a path to decouple from its developed-market peers.S. Federal Reserve’s target.U. continuing to experience tepid growth and inflation. and feared. monetary policy remains extremely accommodative by historical standards.S. Federal Reserve.S.32% 4 The Great Depression (1929–1939) 31 years of low rates 8 years of low rates 32 years of low rates Global Financial Crisis (2007–2009) 1. 5 . the U.2 Although the U. Yet. interest rates will quickly rise once the U. is the expectation that the U. With major economies outside the U. and perhaps most importantly.95% 0 1870 1885 1900 1915 1930 1945 1960 1975 1990 1.5% over the past five years compared to a 20-year average of 2%.S. fundamentals and technicals both suggest this will not be the case. illustrated by a substantial decline in the unemployment rate and increase in labour force participation.S. U.S. decoupling is not something we anticipate — even assuming improvements in U. resulting in declines in the prices of fixed income securities.S. Federal Reserve raised the federal funds target rate for the first time in nearly 10 years in December. On the positive side. It’s been said. U. Since the infamous “Taper Tantrum” in mid-2013. economy grew at an annualized pace of just 1.S. and a mixed recovery taking place in the U. economic backdrop in isolation. Since consumption accounts for about 70% of U. Federal Reserve has attempted to move in the direction of normalizing Interest Rates Can Stay Low for a Long Time U. growth. for years that U. 2016 data as of June 30. the U. gross domestic product today.S.S.S.S. Productivity. Federal Reserve starts to reverse course. Compared to the rest of the world. economic data.. but Another fallacy.S. these are hardly conditions warranting aggressive monetary policy by the U. Finally.49% 2005 2016 Sources: Datastream. we believe.98% 12 The Long Depression (1873–1879) 8 5.S. had averaged 0. consumer spending remains muted even in spite of the effective rebate from lower gasoline prices.S. Federal Reserve.1% during the first quarter of 2016. the labour market has improved significantly in recent years. Looking at the U. Economy: Not an Environment for Aggressive Monetary Policy Tightening gains have not been as strong as in past cycles when unemployment was this low. Federal Reserve has been carefully trying to step away from the unprecedented easy money policy it has employed since the financial crisis.S. Despite higher wages and a recovery in single family housing.S. productivity has yet to improve in the period after the Global Financial Crisis. however.S. Given the interconnectivity of global economies and corporations today. as measured by annual output per hour. 10-year Treasury yields 16% 13. the power of the U. to act in isolation has diminished over the past decade. it’s hard to envision a scenario where GDP can rise meaningfully without stronger wage growth. According to the latest data release. the United States appears to be on better footing — but not by much. As the U.S.

risk-on market dynamics of the post-crisis era.S. Investment Implications The investment environment of the post-post-crisis era — namely one of low growth. the 10-year U. In the 31 years following the Great Depression.” Cross-market valuations between U.S. 6 Immediately following both the Long Depression of the 1870s and the Great Depression that began in 1929.78%. While rates have been expected to rise for years. the eight-year span of low rates since the Global Financial Crisis seems short by comparison (see chart on preceding page). the 10-year U. While this behaviour was rewarded in the low-volatility. For the reasons described above.S. low inflation. Treasuries and the sovereign debt of other developed-market nations are also keeping U. Seven years at the lower bound of interest rates has incentivized managers to reach further out on the risk spectrum in order to find higher yields and better return potential. Morgan’s developed-market sovereign debt index currently yields less than the 10-year U. it’s exceedingly important to invest in bond funds that behave like bond funds.S. however. Investing in core fixed income as part of a balanced portfolio is a crucial need in today’s unprecedented. Specifically. The United States’ relatively healthier trajectory compared to other major economies does not necessarily mean rates will rise meaningfully in the coming years. Longer tenured investors in today’s markets remember when U.S.S. In fact. respectively. fixed income portfolios invested in this way will be too highly correlated to the equity market to be considered “core fixed income. dollar. Furthermore. interest rates exceeded 10% in the early 1980s and have seen yields steadily decline over the ensuing decades. When taking this longer-term perspective. and abroad. It’s for this reason that many core fixed income funds hold significant amounts of high yield bonds today.S. North American companies lost $33.policy. Government bonds in Germany have negative yields out to nine years in maturity. recency bias leads to the bearish view that rates must “normalize” soon. Looking further back.4 This statistic was below 50% as recently as late 2013 and has steadily climbed since that time. we expect rates to remain low for a lot longer. over 37% of the index’s constituents have negative yields. uncertain environment.9 billion in revenues due to currency translation. Treasury. In addition to the fundamental and technical factors outlined above. Don’t be afraid to own duration. Treasury note yielded an average of 2. and it’s not until the 20-year point of the Japanese government curve that yields are positive. a whopping 84% of J. the largest impact in almost five years. core fixed income investments should lower overall portfolio return volatility. “In times of volatility like earlier this year. Treasuries suggests funds will continue to flow to dollar-denominated assets and keep a lid on U. In 2015. the strengthening of the U.” in our opinion.S.S.S. The persistent low-interest-rate environment post-crisis has dramatically changed investment manager behavior. Federal Reserve’s path to normalization will remain very gradual and will continue to respond to the strength of the U. low interest rates and low potential returns from risk assets alongside higher volatility — has important implications for fixed income investors. dollar as well as unforeseen developments in the U.49% (see chart on preceding page) doesn’t seem so bad. U. one constraint has been an increase in the value of the U.S. history tells us that there is a recency bias where too much emphasis is placed on the recent past in terms of expectations for the future level of interest rates. Treasury at 1.P. rates anchored. By comparison. history tells a different story as to what “normal” is and provides helpful context for today’s low-interest rate environment. It’s not just negative policy rates that have become more common — negative yields extend out to longer-dated sovereign debt as well. Watch for scope creep.S. rates.S. In the fourth quarter of 2015 alone. The U.5 The relative attractiveness of U. dollar hurt corporate revenues as more than 40% 3 of S&P 500 companies’ total revenues are derived from abroad. This is because high-yield bonds .S. interest rates remained low by historical standards for 31 and 32 years.

Statements attributed to an individual represent the opinions as of the date published.Summary • In the post-post-crisis period. Canada. and do not necessarily reflect the opinions of Capital Group or its affiliates. Richard. The GGBI is composed of the sovereign debt of the following developed-market countries: United States. as well as the correlation of bond portfolios to equities exhibit a strong positive correlation to the equity market. we suggest including a filter for equity correlation as well. Susan Lund. global. and actual events and results could differ materially from those expressed or implied in any forward-looking statements made herein.P. 5 08/2016 © 2016 The Capital Group Companies. McKinsey Global Institute. Netherlands. nor for any actions taken in reliance thereon. References to particular companies or securities are included for informational or illustrative purposes only and should not be considered as an endorsement by Capital Group. May 2016. Rather than reaching for yield and utilizing lower-rated or exotic instruments. a global investment management firm originating in Los Angeles. their values change frequently and past performance may not be repeated. Fixed-income investment professionals provide fixed-income research and investment management across the Capital organization. management fees and expenses all may be associated with mutual fund investments. In times of volatility like earlier this year. where some managers are reaching for yield.com/~/media/McKinsey/Industries/Private Equity and Principal Investors/Our Insights/Why investors may need to lower their sights/MGI-Diminishing-returns-Full-report-May-2016.P. While many financial advisors tend to focus on historical returns and fees in selecting managers. legal or financial advice. is part of Capital Group. California in 1931. Secondary goals could be generating steady income and total returns consistent with prudent management. and emerging markets bonds. Germany. Please read the prospectus before investing. cannot decouple from the rest of the world • Interest rates are likely to stay lower for longer • Investors need to be mindful of liquidity • Investors also should be wary of scope creep. Australia. speak only to the stated period. Data as of each issue’s 2014 and 2013 fiscal year-end. 4  As of June 30. Jon Harris.ashx. Italy. Morgan Global Government Bond Index (GGBI) yielding less than the 10-year U. delayed or incomplete information. including domestic. Diminishing Returns: Why Investors May Need to Lower Their Expectations. Capital Group funds are available in Canada through registered dealers.S. Belgium. for securities with equity characteristics. The information provided is intended to highlight issues and not to be comprehensive or to provide advice. and are subject to change at any time based on market or other conditions.S. Additionally. it’s exceedingly important to invest in bond funds that behave like bond funds.S. however. Inc. and the opinions expressed by an individual do not necessarily reflect the views of other investment professionals. Maturities should also be diversified. 1  U. Mutual funds are not guaranteed. we may see lower asset returns with greater volatility • T  he U. Mekala Krishnan. they act solely on behalf of one of the three equity investment groups. We assume no liability for any inaccurate. In the calculation of this statistic. Spain. Unless otherwise indicated. Data represents the percentage of debt in the J. These groups make investment and proxy voting decisions independently. investment advice nor a recommendation to buy or sell. Inc. Morgan Global Government Bond Index that has a negative yield. The information contained herein has been supplied without verification and may be subject to change. Consider adding a conservative fixed income mandate whose primary focus is stability of principal. 2016. Not intended to provide tax. differences of opinion are common. Treasury. it should be composed of a broad range of high-quality fixed income securities. The Capital Group companies manage equity assets through three investment groups. Denmark and Sweden. The statements expressed herein are informed opinions. Tim Koller. Japan. Sree Ramaswamy. 7 . For your individual situation. http://www. Capital International Asset Management (Canada). and Duncan Kauffman. Views expressed regarding a particular company. as it raises the risks that investors take. Dobbs. Specifically. Given today’s uncertain environment. industry or market sector should not be considered an indication of trading intent of any investment funds. Allocate to capital preservation.S. please consult your financial and tax advisors. Bureau of Labor Statistics as of 12/31/15 2 Source: Compiled by S&P Dow Jones Indices LLC from data provided by S&P Capital IQ. For informational purposes only. The primary purpose of fixed income in a portfolio should be to serve as the ballast to the equity sleeve. from short to long term. we believe a diversified portfolio should include a capital preservation component.mckinsey. Forward-looking statements are not guarantees of future performance. trailing commissions. security. France. Commissions. We encourage you to consider these and other factors carefully before making any investment decisions and we urge you to avoid placing undue reliance on forward-looking statements. Data represents the percentage of debt in the J. Protecting your portfolio against potential equity market volatility is especially important when considering equities are in their eighth year of a bull market despite a more recent struggle in corporate earnings growth. based on publicly available filings or press releases. 2016. Treasuries have been excluded from both the numerator and denominator. core fixed income investments should lower overall portfolio return volatility and serve as the anchor to a balanced portfolio in times of equity market stress. all U. in the Capital SystemSM. United Kingdom. 3 As of June 30. the investment professionals featured do not manage Capital Group’s Canadian mutual funds.