1. Art and Diseño

IN FOCUS
A
s the US Federal Reserve closes
its Quantitative Easing (QE)
program, investors in fixedincome markets are being
warned to expect some volatility.
A natural response to expectations of
volatility is to seek the proven benefits of
diversification – reducing risk by investing
in a broader range of securities that have
a low correlation of returns.
Earlier this year Rick Rieder, BlackRock
managing director, chief investment
officer of fixed income, fundamental
portfolios, and co-head of Americas fixed
income, issued a paper suggesting that it
was “a good time for a fresh look at a
wide range of fixed-income strategies”.
BlackRock said that even as the Fed
tapered its QE program, the European
Central Bank (ECB) and Bank of Japan
(BoJ) were stepping up theirs.
This represents a significant shift in
the balance of policy stimulus – and for
the first time since the global financial
crisis (GFC), it means a rise in US interest
rates is being contemplated.
Understanding what the shift in global
dynamics means for currencies, interest
rates and for potential economic growth –
and getting it right – will be the focus for
all investors in the next three to five years.
“None of these developments threatens
the foundational role of bonds in
institutional and individual portfolios,”
the BlackRock paper said.
“But they do portend continued
change in fixed-income markets – and,
we believe, make a more diversified
approach to fixed-income strategy
worth considering.”
Hayden Briscoe, AllianceBernstein’s
director of Asia Pacific fixed income,
says the end of the Fed’s QE “may have
a greater impact on global markets than
is currently expected”.
“At this stage, our view is that investors
may want to brace for some volatility
ahead,” Briscoe said, in a note issued
in October.
Briscoe said the withdrawal of the
Fed’s QE program was likely to have a
bigger impact on global markets than
“anything the BoJ or ECB are likely to do”.
“That calls for investors to be cautious,
in our view,” he said.
“Looking back at how QE affected all
asset markets, the same could apply in
reverse, as well. Investors, in our view,
should be thinking about risk reduction.”
Investors in fixed-income
markets need to be ready for
potentially lower returns,
and should be cautious about
chasing superficially attractive
alternative sources of higher
yields. Simon Hoyle reports.
LOWER FOR LONGER
Robert Mead, a managing director and
head of portfolio management in Australia
for PIMCO, says that the likely direction
of interest rates in the coming three to
five years can’t necessarily be accurately
gauged by looking at what’s happened
before.
“The ‘new neutral’ means interest rates
are going to stay lower for much longer,”
Mead says.
“Trying to look at historical rate cycles
or listening to the fearmongers [saying]
rates are too low and they’ll have to go up
significantly, I think is the last thing that
planners or anyone else should be listening
to…because it’s completely invalid.
“The reason rates have to stay lower
for much longer is because the global
system is still highly levered. Since the
financial crisis, there’s essentially been no
delevering of the global financial system.
All that’s happened is leverage has moved
from one pocket to another.”
Low-riding fashion
here to stay
30 PROFESSIONAL PLANNER Dec 2014 – Jan 2015
www.professionalplanner.com.au
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rising rates?
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ALTERNATIVES.
BONDS.
EQUITIES.
INCOME.
Past performance is no guarantee of future results. The services and products provided by PIMCO Australia Pty Ltd (ABN: 54 084 280 508, AFSL: 246862) are only
available in Australia to persons who come within the category of wholesale clients as defined in the Corporations Act 2001. They are not available to persons who are retail
clients, who should not rely on this communication. Before making an investment decision investors should consider, with or without the assistance of a securities adviser,
whether the information contained herein is appropriate in light of their particular investment needs, objectives and financial circumstances. Information contained herein has
been obtained from sources believed to be reliable, but not guaranteed. No part of this publication may be reproduced in any form, or referred to in any other publication,
without express written permission. © PIMCO, 2014.
IN FOCUS
THE ‘NEW NEUTRAL’ MEANS INTEREST RATES
ARE GOING TO STAY LOWER FOR MUCH LONGER
Mead says the corporate sector has
been effective at delevering, and that’s
why corporate bonds have been attractive
investments, but virtually all consumers
outside the US have done very little.
Australian consumers are actually more
highly levered that before, he says, and
governments around the world have
“levered up considerably”.
“The reallocation of that leverage has
been significant, but at the absolute level
there’s really been no delevering,” he says.
“So given that backdrop, the key
message is: first of all, bonds can still play
a very important role in the portfolio, not
only as an income generator, and they
continue to tick that box; but also as an
anchor to all the other risk assets that are
being held by investors.”
Mead says investors should not look
to the past as a guide to likely bond yields
over the next three to five years.
“They will be much, much lower,”
he says.
Mead says the Australian economy is
currently relatively weak, which is why
interest rates are currently low, but even
when the economy moves back to a more
normal growth rate, the RBA’s ability to
raise interest rates will be constrained.
“The RBA would only be able to get back
to around 3.5 per cent before it started to
be a restrictive force on economic growth
once again – much, much lower than
we’ve seen in historic interest rate cycles,”
he says.
“So in that context, the fear around
bonds should be dismissed. Even if we
miraculously move into a much stronger
growth profile for the Australian economy,
interest rates can’t move that far before
they start to become a restrictive force on
economic growth again; and sure enough
they’ll have to start coming back down if
they start to hamper any additional growth
potential, given the backdrop of a high
level of leverage.”
BEWARE THE WORST
OF BOTH WORLDS
If the outlook for bond yields in
coming years is historically subdued,
investors would be forgiven for looking to
alternatives to traditional fixed-income
securities. These alternatives include
hybrid securities issued by banks.
“Alternative forms of income, whether
it be in contingent convertible form or
hybrid form, there can be a place for
them in a portfolio, but it shouldn’t be
as a substitute for your core fixed income,”
Mead says.
“It can very sensibly be a substitute
for risk assets, because they have risk
associated with them, both in terms of
mark-to-market risk and also capital
risk. If you’re being paid for that risk then
those instruments make perfect sense.
“But I think it would be a complete
mistake to completely fund that allocation
out of the bond or risk-free or low-risk or
defensive component [of a portfolio].”
The fixed income investment group
FIIG has warned that a particular style of
hybrid security – called a bail-in hybrid,
or contingent convertible security (CoCos)
– is likely to perform much more like an
equity than a bond in a market downturn.
32 PROFESSIONAL PLANNER Dec 2014 – Jan 2015
That’s probably the last thing an
investor expects or wants if they have
allocated money to a security for its
presumed defensive qualities.
FIIG’s head of markets, Craig Swanger,
said in a paper published in late August
that the hybrids in question were issued to
provide capital to banks in the event of a
repeat of a crisis like the GFC of 2008-09.
But they are designed to convert to
equity – with no reference to investors
before doing so – at precisely the wrong
moment: when a bank is “in trouble but
still a going concern”.
“Investors in these new securities will
take a significant haircut on their capital
when they convert,” Swanger said.
While the securities might display fixedincome-like characteristics and exhibit a
superficially attractive high yield prior to
conversion, Swanger said regulators regard
them as equity, not as bonds, for the
banks’ capital adequacy purposes.
“Fixed income is supposed to protect
investors in a downturn and provide
regular, reliable income throughout the
cycle,” Swanger said.
“Hybrids failed to offer protection in
2008-09, but the major banks’ bonds –
without the bail-in provisions – fell just 2
to 3 per cent, and recovered immediately.
“Bank equities fell by 40 per cent on
average, but you accept that risk because
you also have the chance for upside, as
investors that held on to their bank stocks
have now found.
“With these hybrids, you get neither
the protection of bonds nor the upside
of equities.”
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