Is Fixed Income still a safe investment?

Rethinking the Fix for Income Returns

Historically, bonds played a reasonably predictable role in portfolios. Fast forward to the current day, where the market environment faces several challenges caused by low and often negative interest rates, increased market risk and fractured liquidity, which is disrupting the ease with which bonds can be bought and sold.

Bonds are now cushioned by vast amounts of cash from supportive central banks, they are much more difficult to get away from and are no longer behaving in the same way. It takes a brave and much more careful investor to tread a path through the new bond markets of today.

We have entered a new paradigm in which the old ways no longer work. In no small part, the change is down to central banks, who are using bonds as a policy tool to keep interest rates low, generate economic growth and avoid deflation. The central banks therefore don’t care too much about the price of the bonds they are buying. They will continue to buy them regardless.
The result is a marked decline in the yields bonds pay out, often into negative territory. But investors still need to find returns to meet their own objectives, which means they are forced to look further afield than they did historically. With that comes greater risk, however, which should prompt a change in strategy for bond investors.

To use an analogy: an investor wants to buy a reliable, but cost-effective car. The most reliable premium-brand cars are all too expensive because a bank is buying them up irrespective of price. The buyer must therefore take a bigger risk with their purchase by considering older, cheaper cars and those made by non-premium brands. As soon as the investor starts down this path, however, the only way to ensure they will still get from A to B reliably is by selecting more carefully based on keener analysis of the actual state an individual car is in.

The same is true of bonds. The further down the quality or ‘credit’ spectrum an investor goes or the longer the period before a bond reaches maturity (‘duration’), the more important it is to understand the genuine quality of the bond in question based on its fundamental attributes.

With interest rates set to remain lower for longer, there is no end in sight for this trend and its impact on the market is profound. Because investors are taking on more risks, they have become more sensitive to changes in the market place, thus questioning the safety role of bonds in a portfolio. As a result, small changes in interest rate expectations, for example, are creating much bigger movements in price, but it has also changed the nature of their relationship with equities. Bonds increasingly trade up and down in unison with equities, rather than counter to them. Thus bonds traditional role in a portfolio is no longer valid in today’s new world.

Now consider that, because of factors like regulation, the availability of bonds to buy and sell has reduced dramatically. This means it is going to be harder to buy or sell bonds and the cost is likely to be higher. The liquidity that dictates how easy and cheap it is to buy and sell bonds is far smaller than it was pre-2008. This means the exit door for investors wanting to sell out of bonds has shrunk meaningfully. It will continue to shrink further as regulation limits the ability and willingness of banks to hold bonds in reserve to deal with any periods of particularly strong buying or selling. Accordingly, the ease of buying and selling bonds, and the costs of doing so, have all changed for the worse.

Despite this tighter exit scenario and heightened sensitivity, investors are increasingly being forced to crowd into the same assets. This has been exaggerated by the over-use of market-capitalization weighted indexes, partly because they are believed to be more liquid. Crowding in this manner has a detrimental effect not just on liquidity, but on market risk – a shock will send more investors rushing for the same, smaller door.

This paints a scary reality. Finding a reliable, cost-effective bond now means selecting from a range of more expensive, older, sub-premium bonds that are less reliable and are more prone to dramatic price changes because investors are only interested in trading on an ever-smaller number of bonds at a higher cost.

Faced with that reality the starting point for selecting a bond simply has to change. Buyers would need to trade less frequently and focus much more on the fundamental quality of the individual bond. The market paradigm is different, which necessitates a rethink when it comes to building bond portfolios.

For over 40 years, investors have relied heavily on market-capitalization weighted indexes as the starting point for their bond exposure, but these indexes are inherently flawed because they favor the most indebted, rather than the most creditworthy borrowers. While this may have ensured better liquidity in the past, with crowding on the increase and the exit doors narrowing, the same cannot be said today.

Investors using these indexes as their starting point could own a higher proportion of poorer quality debt that will be more difficult to sell during periods of particular market stress. Today’s market environment requires that investors rethink their starting point. Trading less and focusing on credit quality should sit at the very heart of bond selection.

IMPORTANT INFORMATION – GENERAL MARKETING
This is a marketing communication issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter "Lombard Odier"). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This marketing communication is provided for information purposes only. It does not constitute an offer or a recommendation to subscribe, to purchase, sell or hold any security or financial instrument. It contains the opinions of Lombard Odier, as at the date of issue. These opinions and the information herein contained do not take into account an individual’s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes a personal recommendation to any investor. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Lombard Odier does not provide tax advice. Therefore you must verify the above and all other information provided in the marketing communication or otherwise review it with your external tax advisors.
Some investment products and services, including custody may be subject to legal restrictions or may not be available worldwide on an unrestricted basis.
Investments are subject to a variety of risks. Before entering into any transaction, an investor should consult his/her investment advisor and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. The information and analysis contained herein are based on sources considered to be reliable. However, Lombard Odier does not guarantee the timeliness, accuracy, or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices, market valuations and calculations indicated herein may change without notice.
Past performance is no guarantee of current or future returns, and the investor may receive back less than he invested. The value of any investment in a currency other than the base currency of a portfolio is subject to foreign exchange rate risk. These rates may fluctuate and adversely affect the value of the investment when it is realized and converted back into the investor’s base currency. The liquidity of an investment is subject to supply and demand. Some products may not have a well-established secondary market or in extreme market conditions may be difficult to value, resulting in price volatility and making it difficult to obtain a price to dispose of the asset.
European Union Members: This marketing communication has been approved for issue by Lombard Odier (Europe) S.A., a credit institution authorised and regulated by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg and by each of its branches operating in the following territories: France: Lombard Odier (Europe) S.A.• Succursale en France, a credit institution and regulated in France by the Autorité de contrôle prudentiel et de résolution (ACPR) and by the Autorité des marchés financiers (AMF) in respect of its investment services activities. United Kingdom: Lombard Odier (Europe) S.A. • UK Branch, a credit institution regulated in the UK by the Prudential Regulation Authority (PRA) and subject to limited regulation by the Financial Conduct Authority (‘FCA’) and the Prudential Regulation Authority (‘PRA’). Details of the extent of our authorisation and regulation by the PRA and regulation by the FCA are available from us on request. UK regulation for the protection of retail clients in the UK and the compensation available under the UK Financial Services Compensation Scheme does not apply in respect of any investment or services provided by an overseas person.
Switzerland: This marketing communication has been approved for issue by Bank Lombard Odier & Co Ltd, a bank and securities dealer authorised and regulated by the Swiss Financial Market Supervisory Authority (FINMA).
United States: Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
This marketing communication may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Lombard Odier.
© 2016 Bank Lombard Odier & Co Ltd – all rights reserved