Finding Bond Opportunities Throughout The Business Cycle by Gene Tannuzzo, CFA, ColumbiaManagement
- Global bond markets respond in different ways throughout the business cycle.
- A flexible strategy can adapt its risk complexion to capture opportunities and mitigate downside.
- Bond investors should avoid duration risk in 2015, focusing instead on opportunities in credit and currencies.
Gene Tannuzzo, CFA, Senior Portfolio Manager | January 5, 2015
For our full 2015 outlook, please read our 2015 Annual Perspectives.
It is well documented that high-quality government bonds perform well when the economy is slowing and central banks are easing policy. Many investors aware of this historical performance are now positioning for the unfavorable side of this relationship; that is, better growth could start pushing bond prices down. Unfortunately, this analysis may be incomplete, as it overlooks the fact that risk factors can often create value and opportunity, particularly at turning points in the business cycle. Risk factors in fixed income are like levers that bond investors can pull at certain times to generate return and actually mitigate overall risk.
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Opportunity at business cycle turning points
Turning points in the cycle are characterized by changes in the velocity and composition of economic growth, combined with changes in the level of available capacity within the economy to provide labor, produce goods and perform services. (Exhibit 1) As these factors evolve, trends in the bond market can change as well.
Recessions may benefit investors who have taken on duration risk by investing in long-dated bonds. In the bond market, duration risk offers its best returns when the economy sours. When economic growth slows (a recession in Exhibit 1), inflation expectations typically decline as well. As a result, the central bank cuts rates and yields on long-dated bonds tend to fall, buoying prices. Volatility risk also increases as investors grow uncertain about the future of the economy and markets.
In troughs, those exposed to credit risk stand to gain the most. When the economy hits a trough, investors exposed to credit risk (the risk that a bond issuer will fail to pay interest or principal) may experience better outcomes. Wide yield spreads more than compensate for economic uncertainty. Credit market healing precedes a broader economic recovery. During this phase, risk premiums (i.e., spreads) contract, leading to more attractive borrowing conditions for companies and outperformance from credit-sensitive bonds.
During recoveries, credit risk remains low and currencies could benefit. As the cycle progresses into a recovery phase, improving labor markets and growing corporate profits lead to a broader base of economic growth that keeps default rates contained. Differentiation in economic leadership leads to a divergence of monetary policy among nations. These changes can lead to meaningful and persistent moves in currency performance.
When an economy overheats, inflation-linked debt takes center stage. As an economy reaches full capacity, wages tend to increase, driving up price levels for goods and services. As inflation pressures mount, bond investors may find opportunities to profit from inflation risk by purchasing inflation-linked debt.
Changes in these dynamics can create profitable opportunities not only in a single bond market over time, but also across different bond markets at a single point in time. A flexible strategy can adapt its risk exposure to capture opportunities and mitigate downside.
Where are we now?
Based on our characterization of the business cycle shown above, the economic cycle in the United States remains in recovery. While the growth outlook remains firm, the economy still has spare capacity to fill. This is supported by high corporate profit margins, a declining unemployment rate and low inflation pressures in the near term. We believe this should help keep credit risk in check. With the Federal Reserve (the Fed) nearing the point of raising short-term rates, history suggests that excess returns from bonds remain attractive (Exhibit 2), and credit risk remains preferable to other types of risk.
Lastly, we believe valuations remain appropriate, given today’s point in the cycle. Credit spreads are generally wider than they have been in previous periods when the Fed has raised rates.
Outside the United States, we can find economies in each of the business cycle stages. As global economies continue to diverge, central bank policies are diverging as well. The United States is expected to raise rates in 2015, and the United Kingdom may follow suit. Meanwhile, Japan has recently taken a more accommodative policy stance, while the European Central Bank may embark on full-blown sovereign quantitative easing. The major central banks are providing liquidity support that could be more helpful than many investors appreciate; the four largest central banks are likely to expand their balance sheets by nearly $1 trillion next year alone. Broadly speaking, this should help suppress volatility throughout the market and support global bond returns.
Recommended investment approach: Move duration risk to the back seat, and focus on opportunities in credit and currencies in 2015.
While domestic markets face interest rate risk, duration is more attractive in some other countries, such as core Europe (due to monetary policy) and Mexico (due to the valuation of real interest rates). We also believe there may be opportunities to profit from changes in the yield curve, both in the United States and in other G10 bond markets. Meanwhile, diverging monetary policies could be positive for currency markets, with the U.S. dollar poised to move another leg higher in 2015. With the recent decline in commodity prices, inflation risk has not been a major concern lately, but this may change toward the end of 2015.
Credit remains attractive as the Fed approaches rate hikes, and bond valuations are not stretched given the state of the U.S. economy. However, we are cautious about lower quality credit in sectors and regions with insufficient growth to support a high debt burden. In 2015, investors may begin to weed out some of the winners from the losers.
Yields are low, but investors need not shun the entire bond market as a result. Rather, investors could seek to exploit opportunities presented by bond market risk factors beyond duration. Today’s bond market offers profitable total return opportunities for investors who are able to prudently balance their risk budgets (Exhibit 4).