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Nick Tolchard, Invesco

Emerging challenges drive renewed appetite for core fixed income investments, says Invesco

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Many investors believe that the sustained post-financial crisis period of calm in fixed interest markets is coming to an end as central bank intervention is withdrawn, according to Invesco’s first Global Fixed Income Survey.

The report finds that the majority of investors are defining what comes next as a period of ‘new normalisation’ in fixed income investing, characterised by lower yields, low inflation and renewed central bank intervention. A significant minority have a contrary view of a deflationary storm caused by an end of cycle downturn in still fragile economies. Relatively few see an inflationary boom commonly associated with the end of an economic cycle, despite this being implicit in the policy objectives of the Trump US administration. 
 
The study, conducted face-to-face amongst 79 fixed income specialists and CIOs across Asia Pacific, EMEA and North America, shows that over half (58 per cent) of the fixed income investors interviewed believe the global economy is on the path to recovery, but not the typical normalisation which has historically occurred after an economic slump. According to the majority of investors surveyed, a shift has occurred and improvement in key metrics is expected to be subdued with moderate rates of economic growth; gradual increases in central bank interest rates, resulting in yield curves rising at the short end faster than at the long end; and little concern over the risk of rising inflation.
 
Over the last three years, the dominant challenge facing investors has been navigating the low yield environment as yields have fallen further with each successive year. However, whilst the low yield environment is still seen as having the biggest impact, there are a new set of challenges which will impact fixed income portfolios.
 
Ageing populations is a major concern for pension funds, both defined benefit (DB) and defined contribution (DC). DB pension funds face the biggest fallout from ageing populations, with funding deficits and asset-liability mismatches already significant and at risk of increasing further. Despite typically not funding guaranteed liabilities, DC funds are now having to cater to an increasing number of needs, ranging from those that are approaching retirement, to those that are just starting their career. Accordingly, the needs of these investors are different and this creates additional complexities in managing a DC fund. 
 
For insurers, tightening regulation is the major concern, with Solvency II in Europe and Risk-Based Capital and C-Ross in Asia all aiming for greater transparency and better risk management. These will be particularly challenging for insurers with large guaranteed books which have high return requirements to ensure guarantees are met.
 
Increasing geopolitical uncertainty has caught the attention of fixed income investors due to the success of populist political parties, the risk of a Eurozone break up and the unpredictability of the Trump administration. Despite geo-political events having fairly limited impact so far, 70 per cent of investors believe that they will have an impact in the next three years, compared to 55 per cent currently.
 
The range of sub-asset classes within fixed income has grown significantly over recent decades and now spans a broad range of diverse investments. While traditional core fixed income assets continue to play a foundational role in many fixed income portfolios, alternative credit is increasingly part of the institutional fixed income investor’s landscape.
 
Alternative credit provides fixed income investors with the opportunity to diversify portfolios away from traditional return drivers such as rates and term, towards alternative drivers such as illiquidity and manager skill, as well as to pursue absolute-return strategies unconstrained by traditional benchmarks. Investors see a range of benefits, with the leading rationale for investing in alternative credit being to increase alpha, slightly ahead of diversifying portfolios by accessing the additional risk premia not available in core fixed income, and generating higher income returns
 
On average, the investors interviewed allocate 19 per cent of their fixed income portfolios to alternative credit strategies, with the largest appetite in North America at 26 per cent. In addition, larger investors (AUM greater than USD15 billion) typically have higher allocations to alternative credit. Smaller investors (AUM less than USD15 billion), which typically have fewer internal resources and smaller ticket size requirements, are not able to exploit alternative credit strategies to the same extent as their larger peers.
 
Over the past three years investors have been reducing allocations to core fixed income portfolios and increasing allocations to alternative credit portfolios. However, the majority of investors (63 per cent) surveyed expect to rotate back towards core fixed income over the next three years, funding this predominantly from equity portfolios. Investors still expect to allocate to alternative credit but at slower rates as appetite becomes constrained by higher prices and a reduced set of opportunities.
 
Contributing to this approach is the view that certain alternative credit sub-asset classes are now expensive, in particular high yield debt, structured credit, and to a lesser extent, direct lending. Investors are also tempered in their appetite by concerns that these asset classes are susceptible to negative shocks from the economy. With a growing view that the global economy is approaching the end of a business cycle, some investors express concern that high yield debt and structured credit maybe hit hardest in the next downturn.
 
The area of alternative credit which remains notably in favour is emerging market debt, with respondents currently allocating 3 per cent on average, with 29 per cent of respondents expecting to increase this allocation over the next three years. Investors believe there are opportunities here because of the improving economic fundamentals, shrinking current-account deficits, and lesser direct impact of raising US interest rates.
 
Nick Tolchard (pictured), Head of Europe, the Middle East & Africa (EMEA) for Invesco Fixed Income at Invesco, says: “With the global economy on the path to recovery and central banks starting their journey back towards more conventional policies, fixed income investors sense an end to the long march down in yields, but are uncertain about what comes next.”
 
“Whether the perceived ‘new normalisation’ or another scenario unfolds, pressure remains on fixed income investors to meet performance expectations. The toolset available to investors to do so has become much broader, and they are increasingly making use of it, either via their own teams or more commonly with external asset manager partners.”

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