Finding Alternatives in Fixed Income

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Éric Morin, M.sc

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Éric Morin, CIBC Asset Management, senior analyst.

Investors should expect low returns for government bonds in developed markets over the long run. To answer the question where else should investors look in the fixed-income space, we have to first understand why government bonds will deliver low returns in developed markets, and there are four reasons for this.

The first one is that obviously interest rates are extremely low, and they’re zero in most cases. The second reason is that interest rates will increase over the long run as the economy recovers, and the negative impact on prices will be larger than usual because interest rates will increase from low levels. And just keep in mind the convexity of the relationship between the bond and the rate.

The third factor is, despite increasing, interest rates will converge to levels that will remain low by historical standards over the long run and not materially above inflation. This is because over the long run, central banks will target extremely low policy rates because of low trend inflation and because of elevated leverage in the system. Keep in mind that leveraging in the system has increased materially since the full, complete renormalization cycle that took place in the mid-2000s.

The last factor — last but not least — central banks will continue to conduct asset purchases over an extended period of time, which will continue to put the lid on the longer head of the yield curve. This kind of financial repression means that investors will continue to be not rewarded for taking duration exposure in government bonds.

So, this means that investors should look at fixed-income product that offers: first, higher interest rates; second, limited prospects for interest rates to move up materially over the long run; and third, they should look for product that provides a reward for risk that is other than duration. One example is looking for a product that offers credit risk.

And emerging government bonds or an index of emerging government bonds is a product or an asset class that meets the three criteria.

So, the main risk for investors to lower asset allocation in government bonds in advanced economies is — the main risk depends on where they decide to increase the asset allocation. If investors decide to increase asset allocation into equity, such as increasing exposure to a global equity portfolio, they will have a larger exposure to the global macro factors.

If instead, investors decide to invest, let’s say, in emerging government bonds, then they will have more exposure to country-specific risks.

So, the main risks of lowering the weights into government bonds is a function of where investors decide to increase asset allocation.

In all cases, lowering the weights — the portfolio weights of government bonds — it means that you lower weights from a risk-free asset and increase weights into an asset that is riskier. So, it means that at the end, the portfolio has more risks, including country-specific risk, which could be diversified with a proper good portfolio.