With extreme monetary policy and political uncertainty making it hard for investors to find returns, Neil Dwane highlights how short-duration bonds offer the potential for higher returns today and reduced volatility when rates rise.
At our recent Investment Forum, we reconfirmed AllianzGI’s long-standing view that in today’s environment of central-bank repression, investors must take risks to earn returns. Yet while some have indeed enjoyed decent performance from their risk investments in recent years, there is still uncertainty about the changing political landscape and the distorted world of zero and negative interest rates. Negative rates have so far caused many investors to lose money, while merely low rates have failed to help investors adequately protect the purchasing power of their savings.
The risk of navigating difficult terrain with longer durations
While no one knows for certain how long this environment will last, it is becoming increasingly clear that global economic growth could remain slow and interest rates low for a very long time. This has forced some investors to take more duration risk in the form of owning traditional bonds with maturities of 10, 20 or even 30 years or more. The danger here is that the prices of these long-duration bonds will fall when interest rates rise, thereby causing a loss of capital.
Investors who own traditional bonds with long-term maturities risk watching their prices fall when interest rates rise, causing a loss of capital
Other investors try to mitigate this risk by seeking higher returns from longer-term investments in traditional equities or in illiquid alternatives such as infrastructure equity and debt, which can have investment horizons that stretch out 30 years. While these investments can be attractive alternatives to long-dated traditional bonds, their time horizons may be too risky for those who need shorter-term returns and income potential. After all, this is a marketplace of heightened volatility, elevated asset correlations and low returns warped by monetary policy – an uncertain dynamic that our financial repression thesis suggests could last another decade or more.
Negative Yields Are Spreading Around the World
Central banks have pushed many government-bond yields into negative territory to drive investors into riskier assets
Chart shows percentage yields of government benchmark bonds. Past performance is not a reliable indicator of future results.
Sources: Bloomberg, AllianzGI Global Capital Markets & Thematic Research. Data as of 4 October 2016.
Three reasons to consider actively managed short-duration strategies
Regardless of whether investors believe interest rates will remain “lower for longer” or feel a rate hike is imminent – though in our view, rate hikes are still unjustified in most of the world – short-duration investing can offer investors an appealing combination of attractive return potential and reduced downside volatility. Short-duration strategies have a broad opportunity set to capitalize on, including corporate debt, floating-rate notes and government bonds. Active managers know how to navigate this opportunity set to help investors exploit credit and illiquidity opportunities that exist across the US, Europe and emerging markets – without forcing them to take excessive duration risk.
Short-duration investing offers attractive return potential and reduced downside volatility
1 Insightful research gives active managers an advantage
With bond markets distorted by extreme monetary policy, most government bonds offer little in the way of attractive yields, forcing investors to look to the corporate sector for income potential. A strong, active investment process can be a benefit in this sector, as can the addition of insightful research from equity and bond research analysts who work together. Their combined analysis can enable portfolio managers to consider the entire capital structure of a company – both debt and equity investments – to find the healthiest balance sheets and the most attractive combination of risk and reward.
2 Enhanced income potential and flexibility mitigates uncertainty about inflation
Short-duration strategies do more than help investors guard against interest-rate hikes. Inflation is another real threat: It can spike unexpectedly, and even low levels can erode the real value of investors’ portfolios over time. The flexibility afforded by short-duration strategies can be a helpful addition in times of uncertainty while still providing attractive return potential. Moreover, with new regulations encroaching upon traditional sources of shorter-term capital within banks and money market funds, short-duration strategies offer a useful means of disintermediating these regulatory risks to earn an attractive spread over similar short-duration cash assets.
The flexibility and return potential of short-duration strategies can be helpful for fighting inflation
3 Active managers can optimize the risk/return ratio in changing markets
With their ability to assess changes in interest-rate policies, economies and the health of corporate balance sheets, managers of short-duration portfolios can move up and down the yield curve to optimize return and risk, and to capitalize on credit opportunities that arise in volatile markets. These advantages are only available in actively managed portfolios, as passive indexes are simply static baskets of securities that cannot adapt to changing circumstances.
The hunt for income is growing more urgent
Interest rates are at historically low or even negative levels, and today’s already-extreme monetary policies are continuously evolving – including “yield curve control” in Japan and a likely extension of quantitative easing in Europe. That makes hunting for income an urgent priority for many investors, and they will need to look beyond conventional bonds to find it – particularly when inflation can quickly turn low yields into negative returns.
Even if investors do not need to access their investment income today, adding income-generating securities to a portfolio can smooth volatility and supplement capital appreciation over time. We believe investors would be wise to look to active short-duration strategies to earn incremental returns and add diversification while guarding against serious drawdowns on their capital.
Duration is a measure of a bond’s interest-rate sensitivity expressed in years. If rates were to rise 1 per cent, a bond portfolio with a duration of 10 years would be expected to lose 10 per cent of its value as it adjusts to the new interest-rate environment. By contrast, a 1 per cent rate hike would cause a portfolio with a duration of 1.5 years to lose 1.5 per cent of its value. Duration risk is on the minds of many bond investors because interest rates and yields are so low; eventually, central banks will raise rates, which will cause a loss of capital as the bond’s value declines. In times like these, many investors look to shorten the duration of their portfolios to make them less sensitive to interest-rate hikes.
Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan. | AGI-2016-10-05-16515
Japan’s imposition of yield-curve controls marks the moment that monetary policy finally became subservient to government policy. Neil Dwane says “fiscal dominance” is a dangerous successor to financial repression – not just for investors, but for entire economies.
With its new policy of yield-curve control, the Bank of Japan (BOJ) has begun supplanting financial repression with “fiscal dominance”. Japanese monetary policy will now be subservient to government policy, which will use domestic fiscal measures such as wage controls to create the necessary levels of inflation that have up to now been hard to manufacture.
By choosing yield-curve control instead of what the market expected – helicopter money and infrastructure stimulus – Japan has all but ended the pretence of central-bank independence. If the practice of financing fiscal policy with monetary policy is successful, it will create inflation that erodes capital savings in many bond markets, it will endanger the purchasing power of retirement savings, and it will threaten global trade by raising international tensions as currencies become more volatile again.
If Japan’s new initiative is successful, it will create inflation that erodes capital savings, endangers the purchasing power of retirement savings and threatens global trade
Will the world follow Japan’s lead?
At our recent Investment Forum, AllianzGI’s investment experts extensively discussed whether Europe was confronting the same demographic and economic challenges as Japan did in the 1990s – and making some of the same mistakes. We also discussed the folly of negative interest-rate policies (NIRP) and the confusion they caused; NIRP has not only crushed banking profitability in Japan and Europe and undermined consumer confidence, but it has ironically caused savings levels to rise.
With central banks now dominating many bond markets – the BOJ, for instance, owns approximately 40 per cent of all Japanese government bonds – investors have been corralled into higher-risk and longer-duration bonds, and into bond-like equities with lower volatility. This situation may persist for some time, as there is no sign that any major central banks will be raising rates anytime soon – with the only prospect of monetary policy divergence coming in the form of a rate hike by the US Federal Reserve.
However, the BOJ’s recent changes to monetary policy are worthy of serious reflection: They are a tacit admission that NIRP is not working, and they are proof of Japan’s acceptance that a new policy response is required to avoid a crushing classic recession. Japan’s actions come after six years of central banks justifying their actions as a means of generating the economic growth and inflation needed to resolve the global economy’s excessive levels of debt – which happens to be the essence of our financial repression thesis.
The BOJ’s changes are a tacit admission that NIRP is not working, and proof that Japan knows it needs a new policy response to avoid a crushing recession
Yet yield-curve control moves central-bank policy in a momentous new direction. The BOJ is promising to keep bond yields at their currently low levels – 10-year Japanese government bonds yield zero per cent – while increasing the supply of yen into Japan’s economy until inflation meets or beats the BOJ’s 2 per cent target. This sounds like continued financial repression but in reality it is much, much more. It will allow the Japanese government to fight the labour constraints of its ageing and shrinking population by implementing a "wages policy" that will mandate income and pay increases until inflation rises sufficiently. (Of course, it is notable that even when the yen was much weaker, Japan’s policies failed to create inflation – so pressing are the forces of demographic deflation in Japan.)
The BOJ has raised the stakes in a dangerous game
Far beyond being merely a successor to financial repression, fiscal dominance is in fact more dangerous than its predecessor policy because the BOJ has not actually promised to cap Japanese bond yields; instead, it may in fact allow yields to rise as inflation returns, imposing potential capital losses on bond holders as well. If that happens, fiscal dominance would not only lessen the purchasing power of bonds through inflation but also create drawdowns of capital for an ageing and cautious population of savers.
Far beyond being merely a successor to financial repression, fiscal dominance is in fact more dangerous
Moreover, a weaker yen could reward Japanese exporters just at a time when the political cycle is moving against globalization, possibly toward protectionism. This could sow the seeds of trade wars and retaliation, all of which would further lessen global economic growth and confidence.
With much debate at the Fed’s recent Jackson Hole meeting about the policy responses needed to soften the inevitable US recession, the BOJ has substantially raised the stakes: It will be monetizing its government's financial needs at the expense of the yen. The Fed has admitted that it normally eases interest rates by approximately 5 per cent during a recession, which it cannot do now. As such, it may resort to another significant bout of quantitative easing (QE). For its part, the European Central Bank (ECB) has already begun to reach the limits of its own monetary programs, and it may be forced to taper regardless of its willingness to lessen its support for the economy. Indeed, central banks globally now recognize that the longer QE lasts, the more it distorts markets and economies, and the harder it is to cease.
Ironically, it is still possible for the Fed to implement fiscal dominance as it has in the past, but it will be impossible for the ECB to do so, since that would require even bigger Target 2 balances; at their current level, the ECB is already transferring enormous quantities of funds from strong European members to weaker ones.
Why fiscal dominance matters
Clearly, we are migrating from a world of financial repression – where interest rates are held below stubbornly low inflation rates – to fiscal dominance, where the monetary policy of central banks becomes subservient to the solvency and fiscal requirements of their governments. This is a significant shift for many reasons:
- If more governments adopt this stance, they will be able to influence inflation with fiscal policy. This would complete the re-politicization of central banks and draw them back into the arms of the governments from whence they were created.
- Fiscal dominance also pushes central banks further down the road they had been travelling down for years, after their failure to exercise oversight and economic control resulted in two equity market crashes and one enormous financial crisis in 20 years.
- Fiscal dominance means that Japan’s government will generate enough inflation to ease the distress that has been affecting Japan for the last 25 years. However, as the yen devalues (importing inflation), the BOJ will find itself unable to control interest rates, bond yields and the level of its currency at the same time.
- As Japan heads down this path, the yen and Japanese government bonds will likely come under pressure. A weaker yen would likely help Japanese exporters, but the overall trend against globalization and free trade may ultimately work against them.
- Although fiscal dominance is so far limited to Japan, it could have profound implications for investors elsewhere if other governments follow Japan’s lead and ensure that their bonds no longer protect the purchasing power of savers.
- Whether economies stick with financial repression or tilt toward fiscal dominance, this negative environment may persist for decades. As such, global economic growth will remain slow and low, and investors’ returns will be driven by their appetite for accepting volatility and risk.
- It continues to be important for investors to pursue alpha with active management, since beta returns are set to be low and volatile, which could undermine cheap index investments. And given the ongoing environment of volatility, investors should continue taking a close look at the risk-mitigation and diversification benefits that alternatives provide.
Although fiscal dominance is so far limited to Japan, it could have profound implications for investors elsewhere if other governments follow Japan’s lead
About fiscal dominance: A central bank’s blank check for its government
When a government forces its central bank to buy its debt, which the bank does by “printing” more currency, it creates a rare situation known as “fiscal dominance”. A government usually takes this extreme step to finance higher spending levels – perhaps with the express goal of manufacturing inflation. The biggest downside of fiscal dominance is that central banks lose their independence and meet their governments’ spending needs rather than their countries’ economic needs, and their currencies generally suffer greatly. Japan has experimented with fiscal dominance before, in the 1930s, as have Argentina, Brazil, Italy and Zimbabwe. All have found it difficult to escape.
Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan. | AGI-2016-10-18-16631