When the Fed cautiously started to talk about tapering in the summer of 2013, there was what seemed to be an allergic reaction from the markets. Fixed income investors sold off their higher-risk debt and emerging market debt indices dropped by 6% in a matter of days.
This was not good: if that is how the markets reacted to the beginning of a discussion about slowing the rate of QE, how would they respond when talk turned into action? And, even more terrifying, what would happen when QE stopped completely? Well, not much, it turns out. The Fed started to taper its bond purchasing programme in December 2013 and in October 2014, QE came to an end. Markets barely noticed.
More printing than ever
“The market behaviour in the summer of 2013 was born out of fear and driven by the idea that liquidity would be cut back by the Fed,” says Tristan Delaunay, general director at Athymis Gestion in Paris. “But this time, I’m not as pessimistic as some of the commentators because the Bank of Japan and the ECB have replaced the liquidity that will be taken out of the system by the Fed in the year to come.”
In fact, global liquidity is now higher than at any point in history, stresses Claes Roepstorff, who heads Nordea’s balanced and alternative products department in Denmark. “Even with the Fed tapering, there is a lot of liquidity left in the market which needs to be placed somewhere. On a global scale, there is even more QE now than a couple of months ago,” he says.
According to data from the Bank of International Settlements (BIS), the combined balance sheets of 
central banks in Europe, the US and Japan amount to more than €11trn, more than double the figure at the end of 2008 (see chart on the right).
central banks in Europe, the US and Japan amount to more than €11trn, more than double the figure at the end of 2008 (see chart on the right).Staying loose
Notwithstanding the ongoing balance sheet growth of the ECB and the Bank of Japan, there are several compelling reasons to assume that the Fed will not raise interest rates until late next year.
Roepstorff says: “The Fed has a long way to go when it comes to bringing down unemployment, or
increasing employment, so they are taking it slow. I think a rate rise is most likely to happen in the summer of 2015 or even later.”
The Fed does not have an incentive anyway to increase interest rates, considering inflation is well below the 2% target rate now, according to Tim Peeters of Belgian wealth manager Portolani. “The Fed wants to create inflation in order to ease government debt and create growth,” he remarks. In its autumn monetary policy statement, the Fed said it considers it “appropriate to maintain the 0% to 0.25% target range for the federal funds rate for a considerable time (…) especially if projected inflation continues to run below the Committee’s 2% longer-run goal.”
Considering inflation is now running at 1.7% – and with the oil price down by about 20% compared to a year ago – it would not be a particularly risky bet to say inflation will stay below target for the foreseeable future, notwithstanding surprisingly strong real GDP growth of 3.9% in the third quarter of 2014.
Braced for the worst
So, if interest rate risk remains muted for some time to come, what are the implications for asset allocation? Although an aggressive rate hike seems pretty far off even in the US, European fund selectors already have taken refuge. As yields are expected to rise first in the US, some have withdrawn from dollar-based bonds altogether, while there is an overall concentration in short
duration debt.
“There are very few reasons to be enthusiastic about the current fixed income markets and, more specifically, traditional fixed income funds which have too much interest rate risk embedded. Even for US 10-year Treasuries, the current yield of 2.3% is not yet high enough to consider going long duration,” says Peeters, who is heavily underweight bonds. “In the fixed income part of my model portfolio, I mainly have allocation to short duration bonds and absolute return bond funds,” he continues. “An allocation of roughly 20% to traditional bond funds should be a maximum to avoid the biggest effects of rate rises.”
Tanja Wennonen-Kärnä, a portfolio manager for Evli Bank in Finland, also has a focus on European short-duration debt. “We have a considerable allocation to short duration European high yield, and within this asset class we have a large exposure to the Nordic countries,” she says.
While a Nordic debt bias is common for investors in Northern Europe, Delaunay also has some exposure to the region’s corporate debt markets. “The Norwegian market especially has no sensitivity to the yield curve, and is therefore a good diversifier.The current oil price fall has widened the spreads of Norwegian issuers, providing a great opportunity for brave investors.”
Hunting for yield
Reducing your duration is also a way to bring down interest rate risk, something which both Peeters and Wennonen-Kärnä have done. “The other side of the coin in doing that, though, is that expected
returns are very low,” the latter admits. With the 30-year bond bull market having brought down yields to record lows, fixed income investors increasingly find themselves split between avoiding too much risk and securing at least some yield.
While short-duration strategies serve to mitigate the risks somewhat, fund selectors are increasingly looking for unconstrained and absolute return bond strategies to find yield, while still trying to spread risk across asset classes. Wennonen-Kärnä is one of those. “We recently introduced an unconstrained debt strategy,” she says. “It complements our focus on short duration debt.”
Roepstorff has gone down the same path. “We have started to use more unconstrained strategies in our balanced products as a sort of alternative strategy,” he explains. “Within fixed income, we do use curve and carry strategies. However, we have no exposure to long/short debt.”
Long/short debt strategies are a way to buy protection against falling bond markets, but the use of the strategy varies widely across Europe. According to EIE data gathered in 2014, the share of fund selectors using these strategies varies from more than 90% in Italy to less than half in
The Netherlands, Norway and Denmark. However, even the most unconstrained and innovative fixed income strategies do not always offer a return attractive enough to compensate for the level of risk-taking. As a result, many fund selectors are considering moving outside the fixed income space.
Roepstorff, for instance, raises the possibility of replacing some corporate debt with dividend-paying equities. “Dividend yields are quite attractive, and often higher than fixed income yields,” he says.
He is not the only investor thinking about replacing part of his fixed income allocation with an alternative, be it equities or even just cash. Peeters replaced part of his allocation to bonds with cash, thinking a bet on the dollar will deliver him a better return than fixed income would do. With the dollar up 10% against the euro since July, this bet has indeed served him nicely so far. On top of his dollar cash position, he also has a “reverse dollar hedge” on his European equity holdings.
