Pure Relative Value: The Third Lever of Fixed Income

“In a world that is constantly changing, there is no one subject or set of subjects that will serve you for the foreseeable future, let alone for the rest of your life.” 

So said the American author, John Naisbitt, whose analysis of social trends led to predictions regarding automation in the workplace, globalisation and even the rise of artificial intelligence. While it is fair to say that some of his predictions were a little wide of the mark, his quote about change can certainly be applied to the world of investing.

Investors have faced tremendous change over the past decade and perhaps an even more radical shift in recent years as ultra-low inflation and negative interest rates gave way to sky-high pricing and aggressive tightening by central banks in both the developed and emerging world. Rapidly rising interest rates have been particularly painful for fixed income investors but have also contributed to equity market uncertainty and created dislocations in the relationship between asset classes.

Central banks have suffered a great deal of criticism for their response to the challenge of rising inflation and dwindling economic growth and while some of this may be unfair, central banks have undeniably shifted from suppressors of market volatility to volatility amplifiers in fixed income markets.

Until recently, central banks were quick to intervene whenever there was some form of market stress, either in the shape of interest rate cuts or quantitative easing, and that intervention was easy to justify given their objectives of price stability and economic growth were perfectly aligned. Inflation was running well below target, so whatever policy makers did to facilitate stable prices was consistent with supporting growth. These objectives are now misaligned, with the options available to tame inflation undesirable from the perspective of economic prosperity.

Why is this relevant?

These conflicting objectives, the associated policy uncertainty and central banks aggressively running down pandemic-era bond portfolios are why we consider the worlds’ reserve banks to be amplifiers of volatility. This also means that interest rates and bond yields are in a structurally higher volatility regime than they have been for most of the post GFC1 era. The escalated volatility presents a crucial consideration for multi-asset portfolio managers. Historically, their reliance on duration, predominantly achieved through government bonds, aimed to temper equity risk given the traditionally lower volatility of bonds compared to equities.

Nevertheless, this reliance is not infallible, as historical instances demonstrate periods where government bond volatility exceeded that of equities, as depicted in the accompanying drawdown chart. Furthermore, uncertainty about inflation and the path of interest rates introduces a more variable correlation between bonds and equities. We do however note that, while better outcomes can be achieved under negative correlation, this is secondary to the impact of relative volatility



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