Institutional investors' overhaul of their fixed-income portfolios amid ever-lower interest rates and quantitative easing has fueled an exodus out of core fixed income into areas of specialization — particularly emerging markets, high yield and private debt.
Experts suggest that trend will continue over the next five to 10 years as market uncertainties such as the European debt crisis subside and the developed world works through deleveraging so economies eventually return to stronger growth.
Last week, the European Central Bank cut interest rates to a record low 0.75%, while the Bank of England announced a further £50 billion of quantitative easing. In June, the Federal Reserve extended its Operation Twist program to the end of 2012 after stating in April that interest rates would be near zero for at least two more years.
Government debt issued by the U.S., the U.K., Germany and others have been havens for investors buffeted by volatility in other asset classes, although the flight to quality bonds has driven down yields on these safe assets.
“We have seen acceptance (among clients globally) of the need to work bonds harder, something we have been pushing for a while. This has manifested itself in more global credit, more emerging markets debt, and generally mandates where there is a good prospect of boosting returns from active management; the casualty of this has been the narrow government bond mandate where we have seen very, very few plain-vanilla searches,” Ed Britton, London-based global head, fixed-income manager research, at Towers Watson & Co., said in an e-mail.
Across its global client base, Towers Watson conducted three U.K. bond searches in 2011, down from 28 in 2007, while emerging markets debt searches numbered 46 in 2011, up from zero in 2007.
Although other factors are in play, rock-bottom interest rates and falling yields on the safest bonds have pushed investors to search for better bond returns, added Thomas Brooke-Smith, investment consultant in Towers Watson's asset research team in London. The 10-year median real return assumption on U.K. gilts is now -1%, down from 1.6% in 2007. That's affected all spread strategies; however, the credit risk premium has risen since the global economic crisis. “We would think of credit assets as being more attractive on a relative basis at the moment,” Mr. Brooke-Smith said.
In fact, PricewaterhouseCoopers LLP estimates U.K. corporate plans could add a total of £20 billion ($31.3 billion) in investment returns by moving out of U.K. government bonds and into highly rated corporate debt.
“With another round of quantitative easing announced, sponsors and pension trustees need to ask themselves whether holding gilts is still the best option, depending on their attitude to risk and return,” Raj Mody, partner and head of pensions at PwC, London, said in a news release.