In an uncertain interest rate environment it is more important than ever to think differently about fixed income investment, argues Tom Rutherford.

And so it came to pass. In a year where latent economic recovery in western countries has confounded the sceptics, and where those equity markets have been a source for rejoicing, so it had been possible to neglect that this summer witnessed the worst sell-off in government bond markets for almost 20 years.

The technical reasons for the rise in bond yields owed much to market expectations around the pace of withdrawal of quantitative easing by central banks that has given life-support to the financial monetary system since the darker days of the financial crisis. Of course this was always supposed to happen and with bond yields having contracted to a 30-year low, few challenge the assumption that reflationary pressures will reverse that trend over time. Meanwhile traders and bond pundits obsess over every comment uttered by central bankers, like messianic followers giving catalyst to the long-awaited event.

Low yield

And yet the simple fact remains that bond and cash yields will offer little for a while. So the recent alarm call only accelerates the need to question the perceived wisdom of traditional fixed income investments. Not only do those holdings present the often underappreciated risk that their values will fall when yields rise, but also investors are being inadequately compensated for that risk.

Typically, the reaction of investors to the potential bond sell-off is to exit fixed income altogether, assuming increased portfolio risk through greater equity exposure.

However, this binary thinking obscures the fact that there are many different types of bond instruments often entirely ignored by investors. Too often the fixed income decision for charities has revolved around whether to invest in government issued bonds and how far to venture down the credit spectrum of corporate issued debt. {{image:{"asset":"06044B89-4770-4250-95D65418383C021E","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

However, there are a number of fixed income asset classes distinctly different from long maturity, fixed-rate core bonds that can be used as part of a well balanced fixed income allocation.

One example is extended credit, which includes high-yield corporate credit, leveraged loans, floating rate bank loans, corporate and sovereign debt in emerging markets and even convertibles.

Active and opportunistic investment strategies are something of an anathema to the traditional approach of institutional fixed income management, where most decisions are subordinated to an index of bonds sharing similar characteristics. While one position may be switched for another, the yield or value gain is often measured in basis points.

Thus the experience is predicated by that of the index since the portfolio remains fully invested. Due to institutional norms, charitable investments have derived reliance on being invested in exactly the same way as the pension fund market.

Yet for the most part, charity endowments do not have same absolute need to match liabilities, nor are they usually of such size as to require to be invested only in the largest bond issuances. Thus for justifiable reasons of convenience, comfort and convention, charities have become used to holding government, supranational and investment grade corporate debt , only ever asking “how much?” should they hold. We believe “what else?” is a much better way to approach the question of fixed income investing, whereby risk is considered in absolute terms and not around an index.