optimum exposure to fixed income in the face of inflation and interest rate uncertainty? raman...
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Optimum exposure to fixed income in the face of inflation and interest rate uncertainty?
Raman SrivastavaCo-Deputy Chief Investment OfficerStandish, a BNY Mellon Company.
September 2014
Any views and opinions expressed hereafter are those of the investment manager, unless otherwise stated.Prepared for professional clients only
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Global Investment Outlook 31/08/2014
Source: Barclays as at 31 August 2014
• Nearly 70% of the Barclays Global Aggregate Bond Index is comprised of Treasury and Government-Related securities
• More importantly, on a risk basis, the vast majority of risk is driven by duration
• Standish expects growth in the U.S. to improve but other countries may be affected by decelerating growth in China
Source: Barclays, Standish as at 31 August 2014
Treasury Government Related Corporate Securitised Term Structure Risk Other Risk
Looking Ahead to a Changing Fixed Income Landscape
• There are at least three large differences underpinning fixed income markets looking forward as compared to the environment post 2008 GFC1
Some central banks are beginning to withdraw liquidity Spreads are much tighter in many fixed income sectors Increased regulation has made the trading of certain fixed income sectors more difficult
• In Standish’s view, going forward, returns in the unconstrained space must be generated without the benefit of wide beta spreads
• Hence, Standish believes sector rotation and security selection will be more important return drivers
1 GFC = Global Financial CrisisSource: Bloomberg as at 31 August 2014
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JP Morgan High Yield Bond Index Spread
Divergent Central Bank Policy Provides Richer Relative Value Backdrop5 Year Forward 5 Year Swap Rate
Data from Bloomberg as at 26 August 2014
1/1/
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2/19
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4/9/
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5/28
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7/16
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12/1
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1/28
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3/18
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5/6/
2011
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8/12
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9/30
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11/1
8/20
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1/6/
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4/13
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6/1/
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9/7/
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10/2
6/20
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12/1
4/20
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2/1/
2013
3/22
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5/10
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6/28
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8/16
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10/4
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11/2
2/20
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1/10
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2/28
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4/18
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6/6/
2014
7/25
/201
41.00
1.50
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3.50
4.00
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5.00
5.50
-
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1.00
1.50
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USD EUR GBP SEK CAD JPY
%
For JPYIn % terms
%
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/199
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6/1/
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8/1/
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3/1/
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10/1
/201
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5/1/
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12/1
/201
3
7/1/
2014
0
50,000,000
100,000,000
150,000,000
200,000,000
-150,000,000
-100,000,000
-50,000,000
0
50,000,000
100,000,000
High Yield Bank Loans
For Bank Loans
June 2013 – Outflow of $15.6bn
JP Morgan Global High Yield Bond Index Spread +59bpJuly 2014 – Outflow of $10bn
JP Morgan Global High Yield Bond Index Spread +47bp
Potential Opportunities in Asset Classes That Are Sensitive to FlowsU.S. Mutual Fund Flows (Cumulative)
Data from Bloomberg as at 26 August 2014
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Temporary Shock Could Create Opportunities
Total Return Following a Shock (2 Standard Deviation Move in the S&P VIX Volatility Index)
Source : Barclays Point as at July 2014
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Examining Non-Traditional Fixed Income Strategies
• Non-traditional, opportunistic, unconstrained or absolute return strategies have been a growing segment of the fixed income universes.
• Typically, these strategies are characterised by the following attributes:
- Benchmark-agnostic
- Target an absolute positive return
- Can invest in any area of the fixed income universe
- Can use instruments such as derivatives to isolate specific risks and eliminate others
Dynamic Sector Allocation
Source: Standish as at 30 June 2014. Portfolio holdings are subject to change at any time without notice, are for information purposes only and should not be construed as investment recommendations.Representative account data is to be considered supplemental information to the attached GIPS compliant composite presentation found in the appendix. Standish Mellon Asset Management Company LLC claims compliance with the Global Investment Performance Standards (GIPS®).
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Representative Opportunistic Fixed Income PortfolioQuarterly (Q1 2009 - Q2 2014) Sector Allocation (in % terms)
Roles of Traditional versus Non-Traditional Fixed Income
Traditional (Aggregate Bond Index)
• Expensive allocation in today’s environment
• Still valid allocation for those willing to sacrifice some yield and return potential for benefit of owning duration, particularly in “flight to quality” events
• Manager selection is key in looking for ability to outperform without over-reliance on outright spread overweight
Non Traditional (Unconstrained Fixed Income):
• Valid for those funds which have both “Defensive FI” and “Growth FI” buckets
• Trading some duration risk for better return potential
• Could be best risk-return option for funds with an absolute return focus
• Must recognise that drivers of return over next five years could be different than past five years (i.e. cannot simply replace credit risk for duration risk)
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Global Investment Outlook – 31/08/2014
• Investors may be complacent about the risk of rising U.S. interest rates due partly to a weather-related slowdown in the economy.
• Despite Standish’s forecast for higher U.S. Treasury yields, they still believe credit spreads can hold in relatively well based on their expectation for a sustained U.S. economic recovery.
• Standish expects growth in the US to improve but other countries may be affected by decelerating growth in China.
• Some of the volatility in the emerging market bonds and currencies has subsided as a few countries have tightened macroeconomic policies. Countries whose economies are linked to the US fundamentals are improving.
• Although geopolitical risks are clouding the near term outlook, valuations in the emerging market debt space are more attractive than they were a year ago.
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Standish Predicts Resynchronisation of Global Growth as Emerging Markets Recover
August 2014
Survey 2013A 2014F 2015F 2013A 2014F 2015F 2013A 2014F 2015F 2013A 2014F 2015F
United States 1.9 1.9 2.5 1.2 2.0 2.2 1.9 1.7 3.0 1.2 1.5 1.7
Japan 1.5 1.3 0.9 1.4 2.1 1.4 1.5 1.6 1.1 1.4 2.9 1.9
United Kingdom 1.8 2.9 2.5 2.1 2.0 2.2 2.7 3.2 2.7 2.1 1.9 1.9
Euro-zone -0.5 1.0 1.3 0.8 0.7 0.8 -0.4 1.1 1.5 0.8 1.0 1.1
Developing Asia 6.5 6.5 6.6 4.3 4.4 4.1 6.5 6.4 6.7 4.3 4.4 4.3
CIS 2.1 0.3 1.6 6.2 6.5 6.0 2.1 0.9 2.1 6.2 6.3 6.1
Latin America 2.7 1.8 2.7 6.9 6.4 5.7 2.7 2.0 2.6 6.9 6.4 5.7
Global 3.0 3.3 3.6 3.3 3.7 3.5 3.0 3.4 4.0 3.3 3.6 3.4
Source: Standish and the International Monetary Fund as at August 2014A=Actual; F=Forecast1 CIS = Commonwealth of Independent States
Standish IMF
Real GDP CPI Real GDP CPI
1
G-3 Real GDP Growth
Source: Thomson Reuters Datastream as at July 2014
United States: Economic Outlook
• U.S. economic activity is rebounding from the weather-related slowdown in Q1 2014. Q2 growth surprised to the upside at 4% growth and Q1 was revised up to -2.1% from -2.9%
• At the same time, Standish are beginning to see signs of a bottom in US inflation. The core consumer price index (CPI) excluding food and energy has begun to tick-up with broad support from most of the major expenditure categories
• Standish believes an acceleration in wage growth driven by an improving labor market will add to price pressures later this year. Measures of short-term unemployment (<27 weeks) indicate that the U.S. economy may be operating closer to full employment than the official U-3 unemployment rate suggests
• Consequently, Standish worries that market expectations for Fed policy may change resulting in higher interest rate volatility going forward. Thus, they remain underweight U.S. duration
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1 Core PCE = Core Personal Consumption Expenditures price index (PCE)Data for all charts as at 30 April 2014.
Average Hourly Earnings Point to a Pick-UP in Core Inflation
Source : The Bureau of Labor Statistics (BLS) as at 12 August 2014
Source: Thomson Reuters Datastream
Short Term Unemployment Leads Wage Growth
Investors May Be Complacent About Rising U.S. Interest Rates
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1 MOVE Index – Merrill Option Volatility Estimate Index
Fixed Income Volatility Has Fallen Back Near Pre-Taper Lows 10 Year US Treasury Yield
Source: Bank of America Merrill Lynch as at 12 August, 2014 Source: THE US Federal Reserve as at 12 August, 2014
1
Euro Area: Economic Outlook
• Confidence has worsened and the data surprised to the downside amid heightened geopolitical risk and lagged effects from the US contraction in Q1 – in 1H 2014, the EA1 grew just 0.25%
• Survey-based measures of inflation expectations are stabilising, signaling a stabilisation in realised inflation, currently 0.4% in August
• The ECB’s new TLTRO2 program will start this month but recently Draghi hinted at further easing this year
• However, Standish expects positive surprises next year with the conclusion of the AQR3 and new ECB measures
• Already credit demand is improving and now is net positive
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Data for all charts as at 1 September 2014. 1 Euro Area 2 Targeted Long-term refinancing operations 3 Asset Quality Review
Correlation between growth and periphery spreads as risen
A simple regression of inflation expectations on realised inflation
Credit Demands – Firms
Source: Thomson Reuters Datastream
Source: Bloomberg: Markit; Standish
Source: Thomson Reuters Datastream; ECB; AFTE
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Emerging Markets: Appear Still Attractive
• Emerging Markets bonds have recovered some ground since the 2013 sell-off but remain attractively valued.
• After several years of strong inflows, outflows from EM debt were substantial in the second half of 2013 and the first quarter of 2014. Outflows were primarily from retail investors while institutional investors were more stable. The trend turned positive in April of this year and as of the end of July cumulative flows were again in positive territory.
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Source: JP Morgan, as at 9 July 2014.
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1/14
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5/10
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6/19
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7/29
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9/5/
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10/1
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1/1/
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2/10
/201
4
3/20
/201
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/201
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6/6/
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07/1
7/14
200
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EMBI Global Spread over U.S. Treasuries (LHS) EMBI Global Yield (RHS)
Sp
rea
d (
in b
as
is p
oin
ts)
Pe
rce
nt Y
ield
Source: JP Morgan as at 31 July 2014
Emerging Market Spreads and Yield
Annual Cumulative Bond Flows
Sector Model Summary
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Source: Standish as at 30 June 2014. For illustrative purposes only. Forecast information is not intended to predict future events, but rather to demonstrate the investment process of the firm in utilising its models and market views in constructing its client portfolios. Sector models are run monthly and are subject to change. Model portfolio data is to be considered supplemental information to the attached GIPS compliant composite presentation found in the Appendix. Refer to Disclosure in Appendix.
Model R-squared Sector Actual Fair Value
Attractiveness Score (Stand. Dev.)
Forecast Value
Attractiveness Score (Stand. Dev.)
Total Relative Value Score
75% Implied Rate Volatility (bps) 82 bps 93 bps 1.8 95 bps 2.1 3.883% EM Local Bond Yield (%) 6.54% 6.20% 1.2 6.27% 1.0 2.295% 2s-10s Treasury Yield Slope (%) 2.07% 2.65% -1.6 2.62% -1.5 -3.287% Municipal Bonds (bps) 3 bps 8 bps -0.3 11 bps -0.5 -0.887% Emerging Markets (bps) 285 bps 219 bps 0.5 258 bps 0.2 0.782% Investment Grade Credit (bps) 99 bps 101 bps -0.1 2 bps -0.5 -0.794% 10y TIPS break-even CPI (%) 2.28% 2.24% 0.0 2.14% -0.5 -0.794% Asian Credit Spread (bps) 240 bps 237 bps 0.1 270 bps -1.0 -0.984% Long Corporate OAS (bps) 146 bps 150 bps -0.2 168 bps -0.9 -1.087% European Corp. Bonds (bps) 101 bps 111 bps -0.3 119 bps -0.6 -0.981% High Yield (bps) 379 bps 399 bps -0.2 470 bps -0.9 -1.190% High Yield Bank Loan Spread (bps) 436 bps 410 bps 0.4 503 bps -1.1 -0.792% European High Yield Bonds (bps) 327 bps 380 bps -0.3 423 bps -0.5 -0.887% 10y Gilt Rate (%) 2.70% 3.03% -0.6 2.89% -0.4 -1.084% 10y Bund Rate (%) 1.35% 1.95% -1.2 2.01% -1.4 -2.696% Mortgage Pass Throughs (bps) 110 bps 108 bps 0.1 160 bps -3.9 -3.794% 10y Treasury Interest Rates (%) 2.53% 3.69% -1.9 3.86% -2.2 -4.183% UST/Bund Rate Differential (bps) 1.29% 0.78% -1.7 0.49% -2.6 -4.383% 5y Swap Spreads (bps) 7 bps 37 bps -2.5 50 bps -3.6 -6.1
Six Month ForecastCurrent Fair Value
Portfolio Characteristics
Standish as at 30 June 2014. Representative portfolio chosen is the largest portfolio in the Composite and is not chosen to show performance. Portfolio holdings are subject to change at any time without notice, are for information purposes only and should not be construed as investment recommendations.Representative account data is to be considered supplemental information to the attached GIPS compliant composite presentation found in the appendix. Standish Mellon Asset Management Company LLC claims compliance with the Global Investment Performance Standards (GIPS®).
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Representative Opportunistic Fixed Income Portfolio
Sector Distribution Summary
% Market Value CTD1 CTSD2
Developed Sovereign 28.57 -1.78 0.00US Nominal 0.00 -3.32 0.00US Inflation Linked 12.63 0.62 0.00Non US Nominal 15.94 0.92 0.00Non US Inflation Linked 0.00 0.00 0.00
Municipal 1.29 0.08 0.14Emerging Markets 18.85 0.74 0.41
Local Currency 11.43 0.32 0.00Hard Currency 7.42 0.42 0.41
Corporates IG 10.43 0.43 0.42Corporates HY 13.99 0.48 0.53Securitized 25.32 0.45 0.70
Agency 0.87 0.02 0.02ABS/RMBS 13.08 0.16 0.40CMBS 11.36 0.27 0.28
Other 1.55 0.58 0.00Total 100.00 0.98 2.20
1 Contribution to Duration2 Contribution to Spread Duration
PortfolioAverage quality BB+Average duration 0.98 yrsYield to maturity 4.07% Spread Duration 2.20 yrs
Portfolio Characteristics
1 Germany (0.77), Luxembourg (0.68), Singapore (0.51), South Korea (0.47, Kenya (0.79), Bermuda (0.39), Supranational (0.36), Argentina (0.34), Australia (0.24), Kazakhstan (0.14), Japan (-0.06), EMU (0.01), N/A (-0.27) Standish as at 30 June 2014. Representative portfolio chosen is the largest portfolio in the Composite and is not chosen to show performance. Portfolio holdings are subject to change at any time without notice, are for information purposes only and should not be construed as investment recommendations. Representative account data is to be considered supplemental information to the attached GIPS compliant composite presentation found in the appendix. Standish Mellon Asset Management Company LLC claims compliance with the Global Investment Performance Standards (GIPS®).
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Representative Opportunistic Fixed Income Portfolio
Country Distribution (%)
PortfolioUnited States 50.9United Kingdom 9.0Brazil 7.1Spain 5.6Italy 4.8Mexico 4.0Portugal 3.0Nigeria 2.1France 1.9Venezuela 1.6New Zealand 1.5Ireland 1.3Switzerland 1.3Russia 1.1Colombia 0.8
Other 1 4.1Total 100.0
Currency Distribution (%)
Portfolio
Brazilian Real 1.6Swiss Franc -1.0South African Rand -1.5New Turkish Lira -2.0Swedish Krona -3.9New Zealand Dollar -4.1Total 100.0
US Dollar 92.6Norwegian Krone 4.9Indian Rupee 4.0Australian Dollar 3.1Russian Ruble 2.1Mexican Peso 2.1Nigerian Naira 2.1
Duration/Yield curve Exposure (CTD) Quality Distribution (%)
Investment Implications 31/08/2014
• Standish expects U.S. Treasury yields to underperform German Bunds and Japanese Government Bonds in 2014 as the U.S. economy leads the global recovery.
• Investment grade and high yield bonds should post positive excess returns in 2014, but there may be a limit to how far spreads can tighten. High yield bonds have the potential to produce positive total returns.
• While Standish expects a modest recovery in EM growth, idiosyncratic risks have increased the importance of country and security selection for the asset class.
• Standish believes Australian and New Zealand government rates have room to rally
• In Standish’s view those EM countries whose economies are related to the US represent good value
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