A notable political adviser once said that given the option of being reincarnated as the President or the Pope, he would choose instead to come back as the bond markets, because then he could intimidate everyone. That might have been true throughout the past decades, when global fixed income investors known as bond vigilantes demanded higher Treasury bond yields whenever inflation fears popped up, essentially disciplining US policy makers as a result. That dynamic has undergone an interesting evolution in recent years. As the world’s central banks have flooded the world with liquidity to beat the recession, a new type of bond vigilante has emerged.
We’re talking about unconstrained global fixed income investing, which is propelled by a multi-year momentum driven by the increasingly widespread recognition that bond benchmarks are intellectually incoherent. Modern bond indices were created in the mid 1980s when it made a great deal of sense to organise the markets on the basis of debt issuance. At the time, outstanding debt globally was relatively low. Effectively since then we’ve seen an explosion in debt. What began as an enormous acceleration in private sector debt has shifted to public sector debt as governments have shouldered the burden post financial crisis. Throughout the cycle we’ve seen very little in the way of significant deleveraging. This has resulted in today’s bond benchmarks effectively concentrating rather than spreading risk. Governments issuing the most debt now account for the highest components of the benchmark. In turn, this has created three significant risks to traditional benchmark strategies. Duration (significant sensitivity to changes in interest rates), concentration (highest allocation to the most stressed and frequent borrowers), and constraints (limited flexibility to capture returns outside the confines of the index). All of these challenges might be more feasible if yields were higher, but in fact they are at nearly generational lows.
In our view, this migration towards unconstrained global fixed income investing may undergo a further acceleration in the near future. The reason is rising interest rates. We know without doubt that the next move in interest rates is going to be up. The timeline is fairly well choreographed by the world’s central banks and shouldn’t come as a surprise to investors, but the move will nevertheless exacerbate some of the structural issues with benchmark constrained investing that we’ve outlined above.
The new bond vigilantes of the unconstrained world are in a position to allocate capital to the sectors and areas of the global fixed income markets that present opportunities, regardless of region or type. If they don’t like something they just don’t buy it, irrespective of the weight it may or may not have in the index. Simply put, if the fundamentals and the valuations aren’t there, these managers are free to deploy capital elsewhere. A global unconstrained bond approach is also arguably better poised to handling liquidity challenges if/when they should arise in the markets because of their flexibility and lack of limitations.
For investors, the critical factor will remain manager selection. That means looking under the bonnet to see exactly what the manager is doing, how they are delivering returns and how they are managing risk.
In terms of how that translates to current investment positioning, some insights as we see the markets currently: