- Many believe a three-decade-long bull market on bonds is coming to an end.
- The search for yield, however, continues.
- To stay viable, perhaps it's time to try a new way of thinking about investments.
The only way is up. Or so it seems for global bond yields. A three-decade long bull market is coming to an end, and an era of significantly weaker returns could be upon us. Indeed, wherever fixed-income investors look, they’re confronted with profound change.
Disinflation has given way to rising prices in some places, once-ample monetary stimulus is being steadily withdrawn, globalization is in retreat due to moves to cap trade and migration, while mainstream politics is threatened by disruptive, populist parties.
This presents investors with a dilemma. While their search for yield remains undiminished, their reliance on the strategies that have delivered success in the past now threatens to introduce unintended risks into their portfolios. Traditional fixed-income funds — which are tied to a reference benchmark — are no longer a viable option.
Because most bond indices are capitalization — or, perhaps more accurately, liability-weighted, they skew investments towards governments and corporations that issue the most debt. This leaves investors exposed to potentially unfavorable shifts in borrower creditworthiness, and often shuts them out from more attractive fixed income investment opportunities.
Duration is on the rise
As evidenced by the Bloomberg Barclays Global
Aggregate Index, duration of investment grade debt
has been increasing sharply.
Making matters worse, investors’ vulnerability to increases in interest rates (as measured by the duration of their portfolios) has never been greater. For example, companies are taking advantage of low interest rates, in anticipation that they’ll rise in the future, by issuing new bonds with ever longer maturities. As shown in the chart on the left, the duration of the Bloomberg Barclays Global Aggregate Index — one of the most widely used bond indices — has crept up to 7.0 years, from 5.4 years a decade ago.
This is particularly worrying at a time when interest rates across much of the world have stopped falling and, in some cases, are staring to rise. Currency and credit exposure are thus set to become more important sources of return.
The solution to this conundrum is greater flexibility. Investors might be better equipped to tackle the difficulties that lie ahead by pursuing a strategy that ignores the constraints of a benchmark, targets absolute rather than relative returns and focuses on mitigating the threat of capital loss at all times. The Ivy Pictet Targeted Return Bond Fund strategy adopts such an approach.
In pursuing a flexible approach that targets absolute returns, investors may need to abandon some conventional ideas about bond investing. At the very least, they should be prepared to:
1. Look further afield. Bond investors have traditionally fallen into two camps: those that adopt a passive strategy because they believe markets are efficient, and those who believe that inefficiencies do exist and can be exploited to maximize returns.
Yet these approaches are not the polar opposites they appear to be. Both expose investors to the shortcomings of capitalization-weighted benchmarks — the first group by tracking the indices and the second by seeking to outperform them.
As a result, there is often surprisingly little to distinguish between long-only, actively managed portfolios from their passive counterparts. Both are susceptible to the shifts in the broader market environment and changes in their benchmarks.
To give an oft-cited example, Greece stung benchmark-tied investors in two ways. First investors were exposed to losses until Greek bonds eventually dropped out of the main euro zone indices. They then suffered again by missing out on those assets’ subsequent rally. We can also point to the continued inclusion of Venezuela in many benchmarks, despite that country’s rapid economic deterioration.
This highlights why it’s important to break free of the benchmark straitjacket. By doing so investors can also more effectively target specific sources of risk and return — interest rate, currency and credit premia. A portfolio which is well diversified across all three has the potential to gain in value across the various phases of an economic and financial cycle.
2. Look beyond the economic cycle. Many bond investors spend a lot of time and effort attempting to forecast future economic conditions. Yet, economic forecasts can be inaccurate. (Famously, in 2008, economists did not forecast any recessions in 2009; a year later 49 of the 77 countries studied were in recession.1)
What’s more, official data often send conflicting messages, leading to disagreement between experts as to the true state of the economy. Finally, each business cycle is invariably different from the one before. Radical shifts in the political landscape — such as Brexit or Donald Trump’s U.S. Presidency — can up-end economic models. And then there’s the knotty problem of distinguishing cause from effect in any statistical analysis.
An alternative strategy is to look beyond the business cycle and instead try to identify the long-term structural changes occurring within the economic and financial systems.
A number of these secular investment themes underpin the positioning of the Ivy Pictet Targeted Return Bond Fund. By selecting investments that harness these trends, investors can more effectively diversify the sources of risk and return in their portfolios.
- Lower rates for longer. While interest rates are starting to rise from historic lows in some major markets, we believe it will be a slow process. Real economic growth remains subdued, and developed world governments face an uphill struggle to reduce public debt to levels that can support more fiscal spending. This should continue to put downward pressure on real interest rates.
- Stuttering, protracted reform of the euro zone. The financial crisis has highlighted the need for far-reaching yet complicated reform of the euro zone, not least to establish a common banking union and create a fiscal transfer mechanism under which the public debts of euro zone members are pooled and supported. Yet given the politically charged environment in which decisions are taken, it will take time for the region to overhaul its economic and fiscal structure. Europe’s increasingly vocal populist movements are likely to further delay progress, as could the fallout from the UK’s decision to leave the European Union. We believe this presents as many opportunities for investors as it does risks.
- A newly-assertive Japan. Thanks to the radical policies of Prime Minister Shinzo Abe and Bank of Japan governor Haruhiko Karudo, Japan appears to be slowly moving away from the problems that have plagued it for the past two decades — recession, deflation, debt and ineffective government.
- An economic transformation in China. China’s sweeping economic reforms are yielding early dividends, as its economic focus switches from exports to domestic consumption. Capital market liberalization, the expansion of the local bond markets and a potentially more mature, slower-growing economy will have big implications for investment returns in China, as well as far beyond its borders.
3. Diversify risk at every opportunity. The radical shifts in the global investment backdrop in general, and in the bond market in particular, make the mitigation of risk even more important than usual. In our view, an effective way to dampen the volatility of returns and keep risks to a minimum is to embrace diversification at every stage of the portfolio investment process. On one level, this involves taking great care to avoid over-exposing a portfolio to any one investment theme, idea or source of return. On another, it means ensuring investment strategies are expressed in a way that offers the most efficient trade-off between risk and return. Scenariobased portfolio construction is critical to meeting these goals.
- Diversification by investment theme and risk scenario. If one investment theme does not play out as anticipated, it is important that the portfolio is sufficiently diversified to be able to deliver on its investment objectives. With this in mind, we make sure that all our themes and risk scenarios are evenly represented in the portfolio. This distinguishes us from typical strategic bond funds or active benchmark-oriented portfolios. The former tend to concentrate investments in high conviction ideas, while the latter do not usually venture far beyond the boundaries of their reference index.
- Diversification by source of return. Investing across a broad range of developed and emerging fixed-income asset classes gives investors access to a number of potential sources of return. The Ivy Pictet Targeted Return Bond Fund strategy aims to secure returns from three main sources: interest rates (reflecting the yield curve and duration positioning in the major government bond markets); credit spread or premium (such as corporate debt and peripheral government bonds); and currencies. We also recognize that each of these is also a potential source of risk, and ensure the portfolio’s risk budget is equally distributed across all three sources.
Diversified volatility can help reduce portfolio risk
The chart below shows a breakdown of the Ivy Pictet Targeted Return Bond Fund strategy volatility by currency, credit and interest rate.
- Efficient implementation of investment themes. By embracing a broad investment universe, our investment managers are able to implement their ideas in the most efficient way. We screen securities based on their valuations, and use only those offering the most attractive long-term value to implement our investment ideas.
For instance, we have a number of ways to express our conviction that interest rates will remain low for a protracted period. These range from long positions in corporate bonds which are likely to benefit from low interest rates, like high yield issuers, to offsetting hedges in U.S. Treasuries.
A distinctive aspect of our investment approach is that we seek to identify a security, or combination of securities, to both capitalize on the investment idea and, at the same time, to protect the portfolio should the strategy not play out as anticipated. For example, our constructive medium-term view on China is reflected in an allocation to hard currency emerging market debt. However, our scenario analysis shows that this could be a volatile investment, and we have therefore combined it with short positions in emerging market (EM) currencies. Thanks to this risk-focused approach, we are prepared for any falls in EM hard currency debt, such as the one seen following Trump’s victory in the U.S. presidential election in late 2016.
Our role in a diversified portfolio
The Ivy Pictet Targeted Return Bond Fund offers investors the potential to secure attractive risk-adjusted returns over the course of the market cycle.
Because our investment managers seek to capitalize on longterm trends, and because they also have the freedom to invest in a broad range of fixed-income securities, they have greater scope to mitigate volatility and identify opportunities that offer value than strategies tethered to capitalization-weighted indices.
The strategy’s emphasis on risk management and diversification should not be underestimated. It is instrumental in ensuring the portfolio delivers an efficient trade-off between risk and return.
Thanks to its distinct characteristics, the returns generated by Ivy Pictet Targeted Return Bond Fund also exhibit a low correlation with those of most equity and fixed-income classes. This means an allocation to the strategy could improve the risk-return profile of a balanced portfolio.
Bonds have historically provided investors with steady capital returns, particularly following the financial crisis. Yet the profound changes under way in the fixed-income market indicate bond returns will be more volatile than they have been over the recent past. Investors looking for bonds to provide an anchor for their diversified portfolios should consequently modify their approach. We believe that flexible bond strategies such as Ivy Pictet Targeted Return Bond Fund that ignore the constraints of a benchmark, target absolute rather than relative returns and make risk mitigation an explicit part of their investment process are more likely to prosper than traditional benchmarked strategies in this changing investment environment.
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¹ International Monetary Fund
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 2017, are subject to change based on market conditions or other factors, and no forecasts can be guaranteed. The information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance, and time horizon.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise, especially securities with longer maturities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may seek to manage exposure to various foreign currencies, which may involve additional risks. The value of securities, as measured in U.S. dollars, may be unfavorably affected by changes in foreign currency exchange rates or exchange control regulations. Investing in foreign securities involves a number of risks that may not be associated with the U.S. markets and that could affect the Fund’s performance unfavorably, such as greater price volatility; comparatively weak supervision and regulation of securities exchanges, fluctuation in foreign currency exchange rates and related conversion costs, adverse foreign tax consequences, or different and/ or less stringent financial reporting standards.
Mortgage-backed and asset-backed securities in which the Fund may invest are subject to prepayment risk and extension risk.
The Fund employs investment management techniques that differ from those often used by traditional bond funds, including a targeted return strategy, and may not always perform in line with the performance of the bond markets. The Fund is also non-diversified and may hold fewer securities than other funds and a decline in the value of these holdings would cause the Fund’s overall value to decline to a greater degree than a more diversified fund. The Fund expects to use derivatives in pursuing its investment objective. The use of derivatives presents several risks including the risk that fluctuation in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Moreover, some derivatives are more sensitive to interest rate changes and market fluctuations than others, and the risk of loss may be greater than if the derivative technique(s) had not been used. These and other risks are more fully described in the Fund’s prospectus.
Diversification does not guarantee a profit or protect against loss in a declining market. It is a method to manage risk.
The Ivy Targeted Return Fund was renamed Ivy Pictet Targeted Return Bond Fund on April 3, 2017.
IVY INVESTMENTS® refers to the investment management and investment advisory services offered by Ivy Investment Management Company, the financial services offered by Ivy Distributors, Inc., a FINRA member broker dealer and the distributor of IVY FUNDS® mutual funds and IVY VARIABLE INSURANCE PORTFOLIOS℠, and the financial services offered by their affiliates.
Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which may be obtained at ivyinvestments.com or from a financial advisor. Read it carefully before investing.