26May 2016

Graeme Caughey

Head of Pan Euro Macro

The beautifully diverse fixed income garden

To everything there is a season, and a time to every purpose under the heaven: a time to be born, and a time to die; a time to plant, and a time to pluck up that which is planted. (Ecclesiastes 3)

We like to think of fixed income as a varied, colourful and interesting asset class which can help you not only with your income and capital returns but also with your liabilities.

Think of fixed income as a garden. The green grass represents German Bunds and German inflation-linked bonds - because just as grass forms a base for the garden, Bunds and Bund/ei form the base for fixed income returns.

The trees might be likened to investment grade corporate bonds. Trees add a dimension to the landscape, offering shade and protection when the climate turns nasty. In the same way, investment grade credit can offer diversification, protection and extra yield. They also allow access to a wide range of corporate borrowers.

And the colourful plants that add colour to the garden? These might be high yield, currency, international bonds, emerging market debt, and more. Plants can be spectacular additions of colour to any landscape. But they can also be fragile, blooming only in specific conditions - much in the same way as currencies perform in different economic and political conditions.

Unintended consequences

During the 19th century, when the British ruled colonial India, the government was worried about the high number of poisonous cobras in Delhi. They set about a plan for eliminating the snakes – by offering a bounty for every dead cobra. At first, this looked like a winning plan: large numbers of snakes were killed for the reward. Yet cobra numbers still appeared high. The reason? A few enterprising individuals were breeding cobras for the income. Incensed, the government scrapped the reward programme. This caused the cobra breeders to set the now-worthless snakes free, increasing the wild cobra population even further.

Unintended consequences have been the snake in the grass of the fixed income garden. After the global financial crisis of 2008, the unconventional measures implemented by central banks have resulted in unintended consequences. Interest rate cuts, together with quantitative easing, means anyone holding fixed income has enjoyed significant returns in recent years. But the massive scale of government intervention has resulted in unprecedented levels of volatility.

The bigger picture

Source: BAML Indices, December 2015

Past performance is not a guide to future results.

If you look across the fixed income garden as a whole, there are some glorious patches of colour. To everything there is a season. Just as some plants thrive in springtime, while others bloom in early summer and yet others in late summer, the various fixed income asset classes each have their time in the sun.

The variation in returns is remarkable. Italian government bonds returned 4.8% in sterling terms in 2015, while US high yield lost 4.6%. In 2012, European high-yield bonds returned 28.6%, while UK Gilts returned just 2.7%.

International bonds should continue to provide a rich source of returns. In 2015, more than 20 central banks cut interest rates, driving bond returns higher. As commodity prices tumbled, commodity-dependent economies such as Australia were forced to cut interest rates – meaning Australian government bonds performed strongly.

The implications

The huge dispersion of returns from different asset classes over the last four years provides both challenges and opportunities. One must carefully consider diversification and making use of the full range of fixed income asset classes.

The outlook

In our fixed income garden, what do we expect to bloom and what not?

1 ) Inflation-linked Bunds
Inflation is set to pick up this year – an important consideration for those who are contemplating any improvement to inflation matching within their schemes.

The combined effects of a stronger economy, renewed wage growth and a low oil price should result in a pick-up in inflation. This means inflation-linked Bunds should outperform conventional Bunds; so now would be a good time to buy.

2) German Bunds and Italian BTPs
Long-dated German Bund yields have been falling. Will this trend continue? We believe yields are set to rise, driven by falling unemployment, rising wages and the positive impacts of lower oil prices. But when?

Both the US and the UK were able to quickly draw together coherent plans to help stimulate their respective economies, in the form of quantitative easing (QE). But the unwieldy structure of the European Union meant the ECB found it difficult to follow suit.

Eventually, in the spring of 2015, the ECB started its own QE programme, committing to purchase €60 billion of bonds each month (subsequently amended to €80 billion and now including corporate bonds). The recent decline in oil prices means less spending on energy and transport, leaving more for business to invest and consumers to spend. For the eurozone economy, this is good news – and could mean the ending of the QE programme by the end of 2016.

European government bond yields will move higher as QE winds down. (Of course, it’s not that straightforward. QE represents something of a step into the dark. It follows that ending it is fraught with risks. Like summer weather in northern Europe, there’s huge unpredictability.)

3) European High Yield
Central bank policies have had a bigger effect on highly-indebted businesses than on the investment grade universe. But banks do not want to see companies go into default – so they’re happy to “extend and pretend”. With funding available at such low rates, highly leveraged businesses will continue to benefit.


  • Bund yields higher on the back of a stronger economy. Better opportunities to buy Bunds at higher yields.
  • Inflation higher on the back of a tighter jobs market. A good time to buy inflation-linked bonds.
  • High yield spreads lower, on a continued demand for yield, presenting the opportunity for additional returns in excess of government bonds.
  • Opportunities in currencies. Weaker euro.

Graeme Caughey, Head of Pan Euro Macro



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Corporate Bonds

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Equity diversification

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