Gabriel Altbach is Pioneer’s Head of Global Strategy and Marketing.
The third quarter brought fixed-income funds back into the spotlight, as net flows reached nearly €240 billion globally between July and September 2016. The year-to-date (YTD) figure is even more impressive: in the first nine months of 2016 bond funds (including active and passive) inflows exceeded €400 billion worldwide, within the record amount of bond fund flows in the last decade, €570 billion, reached in 2012.
The trend was manifest across all the main macro regions, with the US in pole position, recording YTD fixed-income fund flows of €180 billion. This was followed by Asia (mainly China) with €120 billion, Europe with almost €100 billion and Latin America with €17 billion.
Worldwide Fixed Income Net Flows (billion €)
Source: Strategic Insight Simfund database
After enjoying bumper sales from 2012-14, bond funds – particularly those that were actively-managed – were shunned by investors in 2015, especially in the second half of the year, as record-low interest rates and signs of imminent tapering by the US Federal Reserve Board (Fed) spooked investors. The mood changed again in 2016, following slower-than-forecasted worldwide economic growth, Brexit and further postponement of a rate hike by the Fed.
The dominant trend for the past few years is the advent of passive investments, not just for equities, but also in the fixed-income space. While passive ETFs and index funds accounted for 9% of worldwide bond assets in 2011, by September 2016 passives represented 15% of bond assets under management (AUM) globally. As in the case of equity, most passive bond fund sales occurred in the US, with 70% of the €970 billion worldwide passive bond AUM pertaining to that market in September 2016, and most of the rest sold in Europe. It’s striking that within passives, US dollar bond funds are already the third-largest category in terms of AUM, with €580 billion assets, after US equity (€2.5 trillion) and global equity (€610 billion).
In the current low/negative interest rate environment, the appeal of ultra-low-cost passive fixed-income strategies for many sectors of the bond market – especially government bonds – is easy to understand, as every basis point of income, and expense, becomes precious. But the paradox is this: the rate backdrop means — and this is bond math — that when interest rates rise in earnest, a static portfolio of duration-laden bonds loses more value than bonds with shorter durations. For example, if a bond has a duration of 5 years, its price falls by about 5% if its yield rises by 1%, and a bond with a 10-year duration would fall about 10% with a 1% rate rise. The longer a bond’s duration, the more prices fall as rates rise. Investors who hold bonds to term are not affected by price changes, but price movements are reflected in active and passive fixed income portfolios.
The risk of duration can be seen in the recent price movements of government bond markets around the world. Austria’s recently issued 70-year bonds, as an example, lost over 6% in the week ended November 11, 2016, while the world’s standard bearer – the US 10-year Treasury bond – dropped over 3.5% over five days ended November 15, 2016. This is the nature – and danger – of duration.
As yields have fallen progressively over three decades, with only occasional short-lived bouts of increases, many market participants have only experienced the constructive, portfolio-building side of duration. When the interest rate cycle turns on its head and investors have limited capacity to be nimble and allocate to bonds that are less sensitive to rising yields, or to zero- duration approaches, they could experience the destructive side of duration. And herein arises the concern I’d like to highlight: with hundreds of billions of euro flowing into passively-run, duration-laden bond strategies (short-duration bond index products are just 11% of passive bond fund AUM globally), investors in these strategies have increased risk. Here is an instance when investors may well “get what they pay for,” in that the lowest-cost options (the largest bond ETFs have expense ratios of 15 basis points or less) are the least capable of dealing with this new phase of rising rates in many parts of the bond market.
There are other issues with tracking bond indices. Credit risk is one. Many fixed-index indices are cap-weighted, meaning they allocate assets based on the capitalizations of the securities in the index. Many fixed income indices put the highest weightings in the most-indebted securities — the “biggest losers”. Tracking the most-indebted companies/governments in the world or in Europe is strikingly counter-intuitive.
Fixed-income active management comes with risks, can cost more than passive, and depends on portfolio manager skill. But in a rising rate environment, active management can potentially help avoid some of the challenges posed by passive strategies that have less flexibility to manage the risks associated with rising rates.