In this video, Dagmara Fijalkowski, Head of Global Fixed Income and Currencies at RBC Global Asset Management, discusses the continuing relevance of fixed-income in today’s low-rate environment. She also explains how active management and global diversification can add value in fixed income portfolios.
How is monetary policy shaping the fixed income environment right now?
We are at an interesting point in the monetary policy cycle. Between December 2015 when the Fed delivered its first interest rate hike and December last year, monetary policy had been fairly straight forward. The Fed was increasing the Fed Funds rate, and also shrinking its balance sheet. Over the course of three plus years, or three years, interest rates were increased by 225 basis points, so, quite significantly. However, by the turn of the year, the communication from the Fed started shifting, they indicated more flexibility and patience, they were looking at weakening economic data and adjusting to it.
That was interpreted by the market as indicating that the next move from the Fed will be cuts. And here is a big discrepancy between what the Fed is telling us, future hikes… although they seem to be slowly backing out of those, but they’re still suggesting future hikes. And the market, which is pricing increasingly more and more interest rates cuts. We have been siding more with the market, but there is plenty of uncertainty. What we feel quite comfortable with is that when the yield curve flattens, what it often indicates is that the monetary policy tightening cycle is behind us, that the Fed has delivered the last hike. And from that perspective, it’s natural to look after a shorter or longer pause, towards interest rate cuts. That’s not a negative environment for fixed income.
As yields remain near 40-year lows, is fixed income still relevant for investors?
I hear that concern from investors and question quite often. Interest rates have been on a steady decline for the past 40 years, and often investors expect that since they are now near these 40-year lows when they imagine a future scenario they think about a mirror image. We assign a quite low probability to such development. We think that since rates bottomed in 2012. 10-year yields in U.S. have actually been trading in the 1.5% to 3% range 95% of the time. So that’s quite a well contained range at the bottom.
It’s good to remember that there are historic reasons why interest rates have come to these lower levels and they may stay at lower levels for extended periods of time. Two of these reasons, to give you an example, would be that central banks have been pursuing that inflation targeting policy and have actually tamed inflations quite well. And the second reason would be demographics, especially in developed market countries, aging population mean also that growth and inflation potential is lower. But that’s historic perspective. But when we think about interest rates we also think about the geographic perspective.
So, when we look at Barclays Global Aggregate Bond universe, 20% of bonds in that universe trade with negative yields mostly Japanese and European bonds. But when you are a North American investor, and you invest into these securities on a currency-hedged basis, your yield actually is higher than Canadian or U.S. yield in many cases. And that’s going to be the case as long as short-term rates in Canada and in U.S. stay higher than Japanese or European rates. We expect that to continue for a while.
There’s also another example that combines these historic and geographic perspectives, and that’s an example of Japan, where 10-year yields have been below 2% for 20 years, and only once during these 20 years Japanese investors in bonds had negative total return during that year. So, while questions about the role of fixed income in portfolios, and the future path of interest rates keep popping up, we believe that as long as inflation remains under control, fixed income is going to play an important role in investors’ portfolios.
Is there an opportunity to generate alpha through active management of fixed income?
Interestingly, I think actually there is more opportunity to generate alpha in fixed income now than at any time during the past 20 years. Even if you look at just the decade since the financial crisis, the fixed income market has increased both in breadth and depth. If you look at the outstanding stock of global government and corporate bonds, it increased by 60 trillion dollars. That’s three times the size of the U.S. economy. That’s a lot of choice. In addition to that, the number of issuers in the global fixed income markets doubled over the decade to over 22,000 issuers. More currencies are floating and freely tradable and cost of trading, both in fixed income and in currencies has declined. So we have the right amount of resources, with a deep analytic team, we believe that active investors can make important decisions that are going to contribute to value-added and alpha in fixed income portfolios.