Cash rates around the world are at zero or near record lows, and many that remain in positive territory have been lowered in recent months, including in Australia.
In many markets bond rates have also dipped further into negative territory, while bond rates here have reached record lows. This is highly unusual.
While growth in Europe is unambiguously weak, the US economy continues to expand at a reasonable rate, and the strong pace of growth in much of Asia has slowed only slightly.
In Australia, our economy is not in recession. In fact, it is not even contracting – growth is merely below trend and is therefore deemed unsatisfactory.
Yet our cash rates are at generational lows.
There is no easy explanation to this complex global phenomenon to explain why this is happening, or for how long it may last.
One observation is that growth at a global level is still constrained by the excesses that led many countries into recession.
In this sense, many of the world’s economies are still rebuilding.
Closer to home, Australia has its own challenges in seeking new sources of growth, following declines in commodity prices and the tailing off of mining investment.
This new low-yield environment poses significant challenges for investment returns and a marked dilemma for investors who still regard fixed income as a traditional defensive asset added to a portfolio as an afterthought.
For starters, the entry point for bond rates is currently very low.
Ten-year government bonds in Australia are currently yielding 2.54 per cent, less than one per cent above the most recent inflation outcome (1.7 per cent), and as one-quarter of one per cent above the market’s forward estimates of inflation.
To make matters worse, at some point in the future, yields will be higher.
While a higher-yield environment helps to reverse some of the challenges raised earlier, it carries with it the possibility of capital losses for investors in fixed income.
What investors of fixed income should be considering are the big picture risks and concerns:
1. Whether you get your money back.
2. Whether the value of money you get back is lost in inflation.
3. Whether you are paid a reasonable return after the first two criteria have been satisfied.
What factors drive these risks?
A downgrade in Australia’s credit rating or significant capital losses from rising global yields could both have a detrimental effect on whether you get your money back.
Whether the value of the money you get back is lost in inflation is mostly influenced by whether the global QE experiment is effective in generating inflation.
And lastly, the current low-yield environment leaves very little left over to satisfy whether an investor has a return deemed ‘reasonable’.
Inevitably, these objectives also represent a bit of a trade-off, and many of the developments we are seeing in the market represent very different approaches to weighing up the relative importance of each of these concerns.
In grappling with this problem, investors are at the most basic level pursuing one or the other of two very divergent approaches.
Diverging strategies: chasing yield or a different view?
A common strategy is to simply seek yield. This involves seeking out investments that offer a higher yield.
This strategy can be very effective in the short term as in recent years, as there have been no big surprises to offset the small additional yield received.
However, greater yield goes hand in hand with more risk. And when yields are already low, the compensation received for extra risk becomes increasingly marginal.
The time when investors are most inclined to chase yield can therefore be the least rewarding time to do so.
The high degree of uncertainty in markets at present also means such a strategy is not likely to pay off over a longer time frame.
So what’s the solution? Is there an alternative?
An alternate approach would aim to restore the importance of absolute return – the value you get back against inflation – while still delivering a reasonable return compared with other strategies.
Recent trends towards customised benchmarks, after-inflation returns and objective-based investing are all examples of this.
Similarly, strategies that incorporate volatility management also provide a genuine point of difference from conventional market benchmark-driven strategies.
Forward-thinking consultants and investors have driven the significant growth in these alternative approaches to thinking about returns in recent years, yet a large part of the market remains focused on short-term, yield-seeking strategies.
The latter remains significantly exposed to many downsides, particularly if markets become more volatile.
It’s encouraging to know that there’s greater interest and a shift towards outcome-driven investment approaches as they represent a longer-term investment view.
Given the challenging market conditions, it’s crucial fixed income investments remain true to their purpose for their investors, and remain defensive against big picture risks.
Fixed income is traditionally valued by investors for its defensive and stable properties, and it is important the best qualities are retained.
Tamar Hamlyn is the principal and co-founder of boutique investment manager Ardea Investment Management.
