Deep Dive: Bond Managers Must 'unlearn' The Past Decade Of Central Bank Lessons

Speaking to Investment Week, Adrien Pichoud, chief economist and senior portfolio manager at Bank Syz, explained that a decade of ‘ZIRP', or zero interest rate policy, had forced investors to extend maturities, or climb down the credit rating scale in order to secure positive yields.

However, with a return to interest rates levels not seen since 2008, resulting in cash rates between 4% and 5% across USD, GBP and EUR, credit and duration risk were "no longer unescapable", he said, and had instead become "directional options" as "risk-free money market instruments" offer such yield.

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"They are now to be implemented in a tactical way based on portfolio managers' views and their assessment of the risks and opportunities," Pichoud argued. "The ZIRP era is gone, bond managers must adapt and ‘unlearn' the way they used to invest during the previous decade."

Laith Khalaf, head of investment analysis at AJ Bell, added that since 2008, central bank policy had been "one of two driving forces in markets", with the transformative effects of advancing technology the other, driven by loose monetary policy that has boosted asset prices widely.

However, the past twelve months has seen a "partial reversal of that trend", with the "significant repricing" leading to a new environment for asset allocation.

He argued bonds and cash were "no longer a dead weight in terms of generating return", with risks also more balanced across fixed income.

"Central bank policy still holds sway here," Khalaf said. "It seems we are now entering the endgame for interest rate rises, but the next question will be how long rates are maintained at this level, or whether they need to be cut.

"Quantitative tightening will also play a part in demand for fixed interest rate securities, as in the UK will reforms to Solvency II, which encourage insurance companies to ditch bonds in favour of racier assets."

Macroeconomics, and central banks in particular, play a crucial role in tactical asset allocation, according to head of multi-asset strategies at Robeco Colin Graham.

"Anticipating how today's data dependent central banks shape business cycles in their quest for price stability becomes an important piece of the tactical asset allocation puzzle," he argued.

Khalaf agreed, suggesting that while "second guessing the decisions made by handful of people within a central bank should not be a mainstay of portfolio allocation", valuations in the market can influence tactical decisions.

Deep Dive: Role of alternatives in portfolios remains despite higher bond yields

As central banks have shifted from discretion to rules-based policies during the Great Moderation that partly defined the two decades from the mid-1980s to 2007, resulting in greater transparency helping shape market expectations, diversification in a traditional 60/40 portfolio has become trickier, Graham explained.

"For instance, the bond-equity correlation has led the actual Fed policy rate by three months in the last decades, with the correlation becoming outright positive when the Fed tightening cycle enters its final stages as is the case today," he said.

"Thus, anticipating diversification within a traditional 60/40 portfolio would be harder to achieve. As central banks progressed in their tightening cycle, we tapped into other sources of diversification during 2022."

Pichoud suggested selective exposure to credit risk "makes sense" in a scenario where pronounced recession is avoided, while allocation to long-term sovereign bonds "can have value" in a scenario of worsening economic conditions, recession and slowing inflation.

"As the equity/bond correlation has turned negative again, those high-quality long-term bonds would benefit from a pull-back in rates, bring diversification and help a multi-asset portfolio to weather a deterioration in market sentiment," he said.

Looking to the future, senior strategist at SuMi TRUST Katsutoshi Inadome predicted the global economy "may not return to an era of low inflation and low interest rates as seen in the period up to the 2010s", with a negative impact "unavoidable".

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"Central banks in the United States, the United Kingdom, and Europe from 2008 to 2019 managed to avoid inflation, financial instability, or excessive market turmoil," he said.

"In 2020-2022, central banks were not so sure footed. Despite the difficult conditions, excessive monetary easing resulted in high inflation and financial turmoil.

"Whilst monetary tightening causes pain for highly debt leveraged companies and stifles economic growth as borrowing costs rise, it is necessary to prevent the greater evil of out-of-control inflation, as we have seen in Europe and the UK in since the end of last summer."

He noted that while Japan's central bank "remains an outlier", the nation "will not avoid the negative impact on the global economy of rising US rates".

Khalaf concluded: "The tectonic shift in central bank policy witnessed in the last 16 months may yet cause more tremors."

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