Fixed Income Is Necessary

1/14/22, 10:12 PM Why fixed income still matters?
- Financial Advisers - Schroders - Individuals - Schroders
Why fixed income still matters
Fixed income is still relevant in a low

interest environment
09/08/2017
Stephen Kwa
Head of Product, Fixed Income & Multi-Asset
Fixed income is important because the future is uncertain. Fixed income

is also important because it is a diverse asset class that can provide
opportunities for investors across the full market cycle.
While obvious, this is important to remember in considering the

importance of fixed income to investors in a world where yields are low.
Consider May 2017. The Bloomberg Composite Bond index returned
almost +1.2%, whereas Australian equities returned -2.75% for the same
period (a difference in performance terms of almost 4%). This isn’t
meant to say that we won’t see periods where bonds are a drag on
returns, but avoiding exposure because this might happen is a big risk.
What happens if deflationary fears resurface? Notwithstanding yields are

still relatively low (and we’d argue below levels consistent with the pace
of economic fundamentals) sovereign bonds will rally their “socks off”
(as they did at the start of 2016), and equities will fall. Bonds will
outperform equities in a deflationary scenario by a significant margin.
While this is not our central scenario, we build portfolios because we
don’t have perfect foresight and this is not a scenario that can be
discounted. Even if the opposite scenario unfolds and bond yields do
eventually normalise, the impact on portfolio returns from holding
bonds themselves is likely to be small (even if moderately negative in the
short run).
Recap of the role fixed income plays in a portfolio
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1/14/22, 10:12 PM Why fixed income still matters? - Financial Advisers - Schroders - Individuals - Schroders
Fixed income can play a number of roles in an accumulation based

portfolio:
– In a defensive capacity as a source of low risk return; for the

diversification of equity risk; as a source of liquidity; the generation of
income; and, to protect capital.
– In a more absolute return / return seeking role primarily utilising

the entire diversity of the asset class
The ability of fixed income to play different roles in part reflects the
diversity of the asset class (in contrast to equities). This diversity is
reflected in a range of factors including issuer (governments v
corporates), issuer quality (investment grade v sub-investment grade,
developed v emerging), degree of subordination (senior secured debt v
hybrid / subordinated debt), security type (fixed rate v floating rate),
maturity, coupon, individual covenants etc.
The ability of fixed income to act as a defensive portfolio stabiliser, akin

to portfolio insurance, paying off during periods when equities are
stressed is primarily the result of duration (ie the sensitivity of bonds to
interest rates which tend to correlate with the economic cycle).
Figure 1 - Bonds provide valuable portfolio insurance during times of

market stress
Quarterly bond returns versus quarterly equity returns from January

1990 to June 2017
Source: Datastream, data since 1990. 1Bloomberg AusBond Composite 0+Yr Index. ^ASX200,
prior to Q3 1992 the MSCI Australia TR Index is used as a proxy.
While in today’s market environment cash has some appeal as a low risk
source of income, its role is different to that of bonds in that cash
provides no ‘option pay off’ during periods of market stress (green
quadrant in Figure 1 above). Any potential short term under-
performance of bonds versus cash can be regarded as the insurance
premium paid for the prospect of benefiting from an offset to equity
volatility and ‘pay off’ during market stress.
With interest rates now at historic lows many advisers are questioning
the role of fixed income in investor portfolios. However, there is no
guarantee that interest rates are going to rise and if they do it’s unlikely
they will move significantly. While interest rates are low by the standards
of the last 30 years, within a longer context it is normal for 10 year yields
to be sub 5% and with structural pressures on growth and inflation
suggesting benign longer term outcomes low yields are likely to remain
the norm (even if not quite as low as they have been).
Figure 2 –Historical Australian 10 year government bond yields
1980’s and 90’s were the exception, interest rates are now not that low
by historical standards
Source: Global Financial Data
Putting rate rises into context – Addressing rate rise fears
The inverse relationship between bond prices and interest rates is an

immutable fact and this simplistic see-saw view of the interest rate/bond
price relationship has resulted in some excessive concern about the
impact rising interest rates could have on investor portfolios.
Even if rates were to rise, this actually helps current bond holders over
the long term[1]
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[(20Stephen) was not found]20Kwa.docx#_ftn1). This is because coupons and
maturing principal can be reinvested at higher yields. While there is no
doubt that rising rates may result in short term mark to market losses,
no-one has a perfect crystal ball able to predict the future with 100%
accuracy and trying to over finesse timing can be damaging to longer
run outcomes.
The history
It is reassuring that the maths is reflected in history. If we look back at

10 year Australian government bond yields and returns over the past 70
years we see that in the late 1970’s when interest rates increased from
around 9% to 16% there was an initial pause in the total return index
before it continued to rise at an accelerated rate reflecting the higher
yields at which bond coupons and principal could be reinvested.
Figure 3 – 10 year Australian government bond total returns increase

faster after rate rises
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[(20Stephen) was not found]20Kwa.docx#_ftnref1) While cash is likely the better investment
during periods when markets are adjusting to rising rates it is difficult to know with perfect
foresight the direction of interest rates over a short time horizon.
Source: Schroders, eVestment
A structural bear market in bonds is near impossible over the long run
We believe talk of a ‘structural bear market’ in bonds is overblown.

What the maths and history show us is how difficult it is to resist the
inexorable rise in bond total return indices over time driven by the
coupon return (‘carry’). Rate rises are mere blips in the face of the
rising tide of total returns even during the rapid inflation and rising rates
of the late 1970’s or the sharp rise in rates in 1994. We would require
interest rate rises at an ever increasing rate in order to force the total
return index shown in Figure 3 (blue line) to flat-line. Yields would have
to rise at an exponential rate continuously for extended periods of time
to force the total return index into a downward trend – a most unlikely
event.
Markets are a discounting mechanism
It is also worth remembering that if markets anticipate an environment

of rising rates then these expectations will already be discounted in
forward rates. If future rates rise as expected then investor returns will
be no worse than cash.
Is active still relevant?
Fixed income still has an important role to play in investor portfolios in

an uncertain world and even in the event of rising rates investors should
have little to fear. However, the performance of active fixed income
managers over recent years has been disappointing.
The passive portfolio is akin to a momentum strategy and it has been

difficult to outperform a passive buy & hold index while the market has
continued to trend higher supported by the tailwind of declining rates.
Active managers (including Schroders) have become wary of the

increased risk associated with longer duration fixed income benchmarks
and as valuations have become expensive. Portfolio positioning across
many portfolios has become increasingly defensive however this has
been detrimental in an environment when fixed income just keeps
getting more expensive.
Figure 4 - Rolling 3 year returns of the Schroder Fixed Income Fund

versus the peer group and the Bloomberg Ausbond Composite index
Source: Morningstar Direct
Not surprisingly, index funds are capturing an increasing share of flows

into this sector.
What are the dangers of the passive index?
Deep pocketed central banks have not only driven interest rates to low
(even negative) yields but have also distorted the composition of bond
indices. Issuers have taken advantage of this environment by issuing
longer dated debt which has seen the duration of benchmarks across the
developed world lengthening over recent years. Belgium, Ireland and
Argentina are just some examples of countries issuing 100 year debt.
It is important to avoid the temptation to chase past performers when

looking at fixed income returns. As central banks look to unwind their
balance sheets and normalise rates, fixed income benchmarks with their
longer duration look increasingly vulnerable. We would argue that the
time for passive fixed income investing is coming to an end.
How is the Schroder Fixed Income Fund positioned?
Our view remains that duration is expensive. Our short duration position
(currently totalling 0.6 years) is concentrated in Europe, where valuations
– reflecting ECB intervention - are most extreme. While all developed
bond markets remain expensive on our measures, in general our
preference is to be short the low yielding / most expensive markets in
favour of owning the higher yielding / less expensive markets. The
underperformance of US rates over the last several years has put the US
back into the ‘higher yielding’ camp alongside Australia, and we view
opportunities between these two markets from here as being mostly
tactical (currently favouring Australia over the US). We’re still biased for
some yield curve steepening with term premia remaining depressed,
and added to this positioning recently. We also retain a small long
position in Inflation Linked Bonds mainly in Australia, as pricing for
future inflation protection remains cheap.
In credit we’ve made few changes to our broad positioning over recent
months, having steadily pared exposures over the prior year as spreads
compressed. We hold a very modest absolute exposure, about the
benchmark weight. Our preference remains for short duration high
quality Australian debt over longer and lower quality global exposures,
and
over subordinated domestic issues. We’ve also recently pared our

government-related spread exposure to semi-government and
supranational issuers to below benchmark weight. Cash remains
elevated as a result of our negative valuation view on both government
and corporate opportunities.
Conclusion
Fixed income performs an important function for investors. It provides

regular income, rising total returns over time and diversification to
equities. The diversity of the asset class also provides investors with
opportunities across the full market cycle. These attributes are not
diminished by the prospect of rising rates. While short term paper losses
may result from rapidly rising rates this is essentially portfolio insurance
where fixed income typically performs strongly when equities are
performing badly (as has generally occurred over recent decades). Low
yields do not void this benefit. Over the longer term the shorter term
‘paper losses’ disappear and rising rates are actually good for bond
investors in the long run.
Passive fixed income indices have outperformed active managers over

recent years as the asset class has become ever more expensive. Returns
to passive index funds have also been boosted by the lengthening of
duration that has occurred in this asset class. However, the active versus
passive debate always goes in cycles and more so within fixed income
where it should be increasingly clear that a long duration low yield
portfolio is unlikely to continue to outperform more actively managed
portfolios as rates normalise.
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1/14/22, 10:12 PM Why fixed income still matters?

- Financial Advisers - Schroders - Individuals - Schroders

Why fixed income still matters

Fixed income is still relevant in a low

Fixed income is important because the future is uncertain. Fixed income

While obvious, this is important to remember in considering the

What happens if deflationary fears resurface? Notwithstanding yields are

Recap of the role fixed income plays in a portfolio

Fixed income can play a number of roles in an accumulation based

– In a defensive capacity as a source of low risk return; for the

– In a more absolute return / return seeking role primarily utilising

The ability of fixed income to act as a defensive portfolio stabiliser, akin

Figure 1 - Bonds provide valuable portfolio insurance during times of

Quarterly bond returns versus quarterly equity returns from January

prior to Q3 1992 the MSCI Australia TR Index is used as a proxy.

Figure 2 –Historical Australian 10 year government bond yields

Source: Global Financial Data

Putting rate rises into context – Addressing rate rise fears

The inverse relationship between bond prices and interest rates is an

It is reassuring that the maths is reflected in history. If we look back at

Figure 3 – 10 year Australian government bond total returns increase

was not found]20Files/Content.Outlook/U5U2AZ8D/201708[(20Why) was not

foresight the direction of interest rates over a short time horizon.

Source: Schroders, eVestment

We believe talk of a ‘structural bear market’ in bonds is overblown.

Markets are a discounting mechanism

It is also worth remembering that if markets anticipate an environment

Is active still relevant?

Fixed income still has an important role to play in investor portfolios in

The passive portfolio is akin to a momentum strategy and it has been

Active managers (including Schroders) have become wary of the

Figure 4 - Rolling 3 year returns of the Schroder Fixed Income Fund

Source: Morningstar Direct

Not surprisingly, index funds are capturing an increasing share of flows

What are the dangers of the passive index?

It is important to avoid the temptation to chase past performers when

How is the Schroder Fixed Income Fund positioned?

over subordinated domestic issues. We’ve also recently pared our

Fixed income performs an important function for investors. It provides

Passive fixed income indices have outperformed active managers over

Schroders is a world-class asset manager

For any further questions, please contact us.

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