Is a passive approach to sovereign bond management sensible?

The old world of zero rates and deflation

The financial crisis in 2008 was the spark that set light to a 13-year bull market for bond investors. The resultant collapse of interest rates towards zero and diminished inflation expectations meant that bond yields were in perpetual decline over that period.

In the sovereign bond universe, global central banks embarked on quantitative easing (QE) that pushed yields even lower and, in most cases, took sovereign yields close to zero or even into negative yield territory (where investors essentially pay to hold a bond) in several markets.

Regular and large annual sovereign issuance was swallowed up by central bank buying via QE, with the effect being a sovereign universe starved of volatility and therefore limited active relative value opportunities. In this low yield environment fund fees (always important) became a key factor in determining whether investors chose to pay for active management and many investors instead settled for an index tracking approach in a falling yield environment at a low fee.

A new world of rate moves and inflation fears

The Covid pandemic delivered economic shocks for many, including global central banks. The initial reaction saw inflation expectations plummet as the world shut down. However, the global monetary easing response to pump money into the system (via excessive QE), combined with pent-up consumer demand and supply chain backlogs resulted in an enormous inflationary pulse that rippled around the globe and has since seen interest rates skyrocket. With the addition of the Ukraine war and global sanctions (Russia and China), many countries have adopted an onshoring strategy that has continued to fuel labour shortages, in turn pushing up domestic inflation and wages.

As well as raising interest rates central bankers have also decided to embark on quantitative tightening (QT). This will see central banks sell back the government debt accumulated under QE to the market over the course of the next few years. This comes at the same time as regular debt issuance is expected to remain very high. To put this into context, this year we expect UK net gilt issuance to be three times larger than the historical average over the next few years.

The active v passive debate

Conventional wisdom says that government bond markets, both in the UK and overseas, are amongst the most efficient within the fixed income universe and thus passive investing is viewed as sufficient. In our view, conventional wisdom is not correct: recent events in the UK following the Kwarteng ‘mini budget’ and subsequent pension fund liquidity crisis has highlighted the extent of market inefficiency and potential opportunities available to active investors.

This volatility arose due to supply and demand imbalances within the market with no ‘buyer of last resort’, namely the Bank of England. The official forecasts show that these supply and demand imbalances which create volatility will persist for the foreseeable future and as a result we make the following observations:

• Persistent market inefficiencies in government bond markets give rise to multiple active opportunities
• These opportunities cannot be exploited by passive investors due to their requirement to track indices with low volatility

The unfolding environment has never been better for an active manager in the sovereign bond space, and we see the following strategic and tactical opportunities persisting for several years:

Strategic (longer-term)

• Macro data surprises continuing to drive interest rate volatility and fiscal policy moves
• Geopolitical uncertainty impacting yield differentials and asset returns
• De-globalisation / onshoring themes raising inflation expectations

Tactical (shorter-term)

• Excess and frequent global bond supply and demand events (auctions and index changes)
• Central banks moving from buyers to sellers (QE to QT)
• Changes to pension fund strategy creating bond volatility via restructuring

How do active managers take advantage of these inefficiencies?

Utilising multiple diversified active strategies, managed in a risk aware style, accounting for volatility and market direction, the following active opportunities can be employed:

• Duration: Central banks are likely to remain more reactive and flexible with their monetary policy toolkit, leading to greater volatility in the level of yields. We can take long or short duration positions relative to our benchmark to capitalise on these moves.
• Curve: Greater monetary policy flexibility and changing supply/demand dynamics will lead to greater volatility in the shape of the yield curve. We can overweight or underweight certain parts of the yield curve relative to the benchmark dependent on these known outcomes.
• Cross-market: Central banks’ monetary policy and supply profiles may diverge more over the coming decade, creating numerous cross-market trading opportunities. We can underweight bonds in one country versus another on a hedged basis to add value from spread moves.
• Inflation: The debate around hard v soft landings, tight labour markets, geopolitical risks will lead to changing inflationary expectations and greater volatility in inflation break-evens. We can switch nominal bonds into index linked bonds or vice versa to reflect our inflation view.
• Relative Value: QT sales and heightened volume of supply will increase the opportunities available to trade the relationship between specific bonds along the yield curve.
• Credit: Utilising money market instruments, secured credit and supranational bonds, we can enhance portfolio yield by switching into these out of short-dated low yielding sovereigns.

Why RLAM

RLAM’s government bond team averages over 20 years’ investment experience and have worked together for over 10 years delivering strong performance through several market cycles including the Great Financial Crisis, Covid-19 pandemic, and the pension fund liquidity crisis.

RLAM has developed a repeatable investment approach that combines research and portfolio construction to support strategic and tactical positioning across these multiple diversified opportunities in a risk-controlled manner. This allows us to successfully achieve the objective of consistent and incremental strong performance across our range of funds which include all-maturity and short duration options, index linked funds and strategies focusing on UK and Global opportunities.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.