Fixed income that is unexpectedly fascinating

What's been happening?

Fixed income markets appear to us to have undergone remarkable changes over the last three years. The underlying trends that support our deleveraging theme, such as high debt levels in particular, are, we believe, supportive of fixed income markets, as they should result in low interest rates, while also helping to keep a lid on inflation. We also believe that such an environment is, however, disruptive, as it may raise the possibility of default by both companies and governments.

The response from the authorities, who are struggling to cope with the negative effects of deleveraging, may have a significant influence upon markets, especially in the short to medium term. Whether these authorities resort to the maintenance of very low rates, money-printing or default, all such possible responses have, over the past year, appeared to us to have caused significant concerns among investors, and have, we believe, changed the fortunes of global bond investors. We have observed that many of the official responses to deleveraging have produced some unintended consequences, and to exploit these unintended consequences is one of the major challenges facing today's global bond managers.

On account of the widespread concern about a possible collapse in the euro or a sharp slowdown in the Chinese growth story, investors have been, we believe, reluctant to invest. We have observed that concerns have, more recently, been offset by the provision of funds through central bank operations, most recently in the form of the European Central Bank's 'LTRO' (Long Term Refinancing Operations). While disaster remains at bay, however, our research suggests that the liquidity these funds have provided seems to be flowing into financial assets instead of into the real economy. As we said in our last note, A strategy for all seasons, we expect this 'risk on' environment to continue at least until the effects of the most recent LTRO program have worked their way through the system. We believe a weakening economic environment could potentially return as a significant concern to investors once the effects of that program have waned.

Why has the impact of these events differed between countries and regions?

Our global realignment theme addresses the growth of emerging market economies versus the debt-encumbered nations of the western world. We trace some of the roots of this theme back to the Asian currency crisis of 1997. The former reliance of many emerging Asian economies upon foreign capital, combined with an inability to finance their obligations in their own domestic currencies has, according to our research, been gradually removed. From 1998, a group of emerging market central banks embarked on a different course of action, which built up domestic savings and led to gradual improvement in their creditworthiness.¹

Meanwhile, our research has shown that the eurozone effectively decided to go the other way. The creation of the euro single currency and the encouragement for European banks to treat all the member countries' government bonds as having the same level of risk led, we observe, to a gradual and damaging reliance upon external financing. As the benefits of eurozone membership dissipated, a significant decline in credit quality became, in our opinion, inevitable. In our view, this convergence between developed-market and emerging-market credit quality has the effect of broadening the opportunity set for the global bond investor.

What does this mean for fixed-income investing?

To take advantage of this broadening opportunity, we believe that investors should adopt a 'truly global' approach to fixed income investing, which is not dictated by indices.

Bond indices are built on market capitalisation (i.e. the amount of an issuer's debt outstanding), which has the effect of steering the index-tracking investor to the markets where, historically, there has been the greatest issuance. In our opinion, these are not, however, the markets that are likely to have the best returns. We believe some of the markets which offer better risk and reward benefits are actually to be found in the emerging markets space. Here, we are talking about countries that, we observe, have improving credit rating support and also flexibility over monetary policy. Since 2000, seven large emerging market countries have achieved investment-grade ratings (Brazil, Colombia, Peru, Panama, India, Mexico, and Russia).²

The recent rises in the price of oil have the potential to be more than transient fluctuations, and could result in higher inflation expectations. We believe that one of the key advantages of our flexible approach to fixed income investing is that it allows us to reflect our interpretations of such events in our portfolios, for example, in this case, by switching holdings of government bonds into inflation-linked securities, to protect against the risks we perceive on the horizon.

We are choosing currently to use asset allocation to reflect the more favourable attitude towards risk markets through greater emerging market exposure and a more diversified currency exposure, rather than through holding peripheral European debt. We continue to be concerned about the approach to the eurozone crisis, which piles fiscal austerity onto already weak economies. A prolonged period of recession in parts of southern Europe will, in our opinion, continue to shift the crisis from a liquidity issue into a solvency issue. While we believe, ultimately, that the authorities will come to their senses and that investors in Italian and Spanish government debt will not be forced to take a proverbial trip to the hairdressers (suffer a reduction, known as a "hair cut", in the capital due tothem), we think that we may be likely to suffer Greek default and Portuguese capital impairment (a reduction in the payments due to investors in the country's government bonds) first. We therefore continue to use our global, flexible and thematic approach to investing to minimise exposure to countries where we are uneasy about financial sustainability, and to seek instead investment opportunities in countries with stronger fundamentals and a positive long-term outlook.