Bond markets have become increasingly volatile
Increasing volatility in fixed income markets mean bonds are no longer a safe haven, with pension funds facing particular risks, Pictet Asset Management says.
The investment manager's research note said the recent surge in bond yields had "rocked" fixed income investors, noting that losses on one benchmark bond index from its 2021 highs have already exceeded their near 11% drawdown during the global financial crisis in 2008.
Pictet warned it was unlikely this sort of volatility was going to disappear - adding that investors would have to learn a different, more active, approach to fixed income investing.
Senior investment manager Jon Mawby explained: "An era of unconventional monetary policy - which drove yields to exceptionally low levels - is coming to an end amid a broadly global inflationary surge.
"This suggests bonds are no longer the safe haven for investors they once were, with particularly significant risks for those holding longer-dated securities, an investment staple for institutional investors with long-term liabilities, such as pension funds."
Mawby said the roots of this predicament were "30 years in the making" and were formed during a period of ever-intensifying financial repression, with central banks deliberately holding interest rates below the rate of inflation. This, he said, not only artificially compressed yields but also meant the ups and downs of credit and economic cycles were far less pronounced.
He said another side-effect financial repression is that traditional credit markets have become more highly correlated with equities, shrinking investors' margin for error - something Mawby said means the future return characteristics of fixed income assets will not be the benign ones of the past four decades.
Mawby said investors who can avoid making mistakes, such as chasing returns, and exploit opportunities that present themselves will tend to succeed in this environment - something he said was especially true today, given the large number of credit investors in the market, particularly those accessing it passively.
He said: "This has increased volatility as an ever-larger number of investors move in and out of the market simultaneously, particularly through exchange traded funds. Meanwhile, there has been a huge accompanying deterioration in the credit quality of company issuing bonds. As a result, investors' risks have grown significantly."
Mawby said the idea of not chasing returns will inevitably feel alien to investors, noting that reducing risk when valuations are stretched and taking opportunities to add risk when other investors are fearful is indeed contrarian.
But he said it is this contrarian, value-focused mindset and objective assessment of the state of credit markets that offers the strongest basis on which to navigate these volatility cycles.
He added: "The Covid pandemic and the events of March 2020 are salient examples. Many high yield bond investors suffered significant losses during the worst of the crisis. But for those who had previously taken steps to minimise risk and were therefore well placed to take advantage of the value that was on offer, there were many good quality credit securities available at multiple percentage points below their par values."
Today, Mawby said, it is investment grade credit that appears particularly risky.
"That's because in this part of the market, asset allocation decisions come with very little margin of error and much of the generational high risk previously outlined. In contrast, rising stars within the high yield bond market - sub-investment grade companies whose financial prospects have been improving - offer much better risk-adjusted prospects," he said.
Given how markets have behaved in recent times, Mawby added it is "inevitable" that there will be many more bouts of intense bond market volatility, accompanied by severe peak-to-trough declines.
He concluded: "Though we can produce a list of potential risks in store, we can't predict the specific catalyst. What we can do, however, is position ourselves to take advantage of these events when they happen. This means understanding what reflects fair value in asset allocation decisions and then trying to realise as much of the total return available as possible - but without becoming greedy and chasing returns unnecessarily."
