Investors should be looking past a “safe haven mentality” and be structuring their portfolios to deal with the possibility of a looming risk of inflation in the longer term, says Ed Britton, Towers Watson’s global head of fixed income manager research.
Britton (pictured) gives a pessimistic outlook for nominal bonds, saying that they are the most likely to be “eaten away” if, as he predicts, the world economy eventually moves beyond its current malaise and inflationary pressures take hold.
“The mentality is still very much about safe havens, and we are trying to talk with investors about facing the risk of the future, not the past,” Britton says.
While not forecasting a fixed-income bear market, Britton says the amount of liquidity sloshing around the world economy, driven by what he describes as “governments pumping monetary base into the world economy” will eventually seep out into asset prices.
“You don’t have to be a die-hard monetarist to think about what is going to happen to that liquidity once confidence comes back,” Britton says.
“It has got to be inflationary and it is seeping out already into commodity prices and into currencies that are seen as safe havens.”
Britton says the long-term bull market that fixed income investors have enjoyed is over and they need to start thinking creatively.
This involves looking at more diversity both in terms of managers and strategies.
“We are seeing people consider more return-type mandates; so you don’t want the duration, let’s kick that out and take on absolute returns, and there you have lots of levers, including the short side,” he says.
“If we are not in a long-term bull market you need to be able to make money on the short side, in rates and more so in credit, because credit is so asymmetric.
“For shorting credit, the upside is bigger than the downside, so you can turn it around, but you have got to have confidence in your manager that they can use derivatives and all that goes with that, such as the liquidity and the need for good risk control. But there are avenues there to exploit.”
While markets are currently focusing on sovereign debt concerns, particularly in Europe, Britton says investors who have done well on corporate credit should look at their fixed income portfolio and judiciously add sovereigns to increase diversity.
“Perversely, one of the things we are saying to people is think about adding some sovereign risk,” he says.
“Not necessarily adding risk in total to your portfolio; but if you have investment-grade corporate exposure that has done pretty well, don’t switch it all but diversify it, because that is the best way to deal with uncertainty.”
Britton says that adding sovereigns where there may not have been much exposure, could provide a different type of risk to a portfolio and a contrasting return distribution to corporate credit.
Towers Watson has been looking at simple, low-cost solutions to managing fixed-income portfolios.
One of the concerns it has been grappling with is the tendency for conventional, cap-weighted bond indexes to leave investors exposed to the biggest debt issuers and hence to the most indebted countries.
Britton says that popular market capitalisation indexes, such as Citigroup’s World Government Bond Index, leave investors overly exposed to countries like the US and Japan.
Towers Watson have looked at a number of solutions, including GDP-weighted indexes, but in the end came up with an index that caps exposure to any one country at 10 per cent and to all of Europe at 30 per cent.
“Moving to a constrained index, which is what high-yield investors did years ago, is just a very sensible move,” says Britton.
In keeping with the theme of diversity, Britton says investors can also benefit from a greater exposure to emerging market debt.
“In 10 years’ time you would expect the main major emerging markets to be better rated than the main developed markets, so we are in a cross-over time. You don’t want to lend to people who need it,” he says.
“A lot of the emerging market economies have pretty strong fiscal positions and don’t need your money, so they are ideal people to lend to.”
Britton says he expects concerns over liquidity in emerging market debt will ease as these countries deepen their debt markets.
Not only are the opportunities in the debt itself. Britton says Towers Watson sees as many or more benefits in emerging market currencies, which he predicts will appreciate on the back of strong balance sheets and competitive economies.
“We think there is a good chance that the benefits [will] come through the currency as least as much as through the debt,” he says.
“We like the idea of unhedged local currency debt funds, or even just pure local EMD currency funds, so that is a good way for clients in general to play it.”