It has been eight years since the global financial crisis, but in many ways, the impact is still being felt today — in lackluster economic growth around the world, in negative interest rates in several major economies, and in muted inflationary pressures. In order to build sustainable bond portfolios in today’s environment, it is important to understand how we got here, the structural changes in the global economy and financial markets that have resulted from the crisis, and the challenges ahead that still need to be addressed.
- Contemporary fixed income markets can be divided into three periods: the crisis period from 2007–2009, the post-crisis period ending in late 2014, and the present post-post-crisis period.
- Recent ineffectiveness of monetary stimulus paired with global interconnectedness makes prolonged low interest rates and low inflation globally more likely in this post-post-crisis period.
- The current period can be characterized by weaker economic growth and lower asset price returns than markets have seen historically, but with more volatility.
- Bond investors in this period should keep the following considerations in mind: avoid bond strategies with “scope creep”; give broad consideration to tax-exempt funds; expect lower tax-equivalent portfolio yields, likely in a range of 3% to 4%; and aim for liquid investments.
Three Distinct Periods in Fixed Income Evolution
In the past decade, there have been three distinct periods in the financial markets, defined by the nature and direction of market moves: the global financial crisis period of 2007–2009, the post-crisis period of 2009–2014, and the current post-post-crisis period.
The crisis period was marked by the culmination of the housing market excesses and the free fall in most financial assets. The Federal Reserve’s commitment to employ all available (including unconventional) policy tools helped asset prices to finally stop their descent in March 2009. The post-crisis period that followed was defined by extremely accommodative monetary policy in the United States, which included a federal funds target rate of 0% and several quantitative easing programs. As interest rates across the yield curve fell to all-time lows, investors reached for greater yield and return potential, resulting in a strong “risk-on” period for the markets.
The current state of the world, which we refer to as the post-post-crisis period, coincides with the end of quantitative easing in the U.S. Compared to the previous two periods, the post-post-crisis period has been less straightforward. Since the Federal Reserve concluded its third quantitative easing program at the end of October 2014, there has been no clear direction for risk, as depicted in the table below. Although rates have remained low, asset returns have been mediocre at best.
There is nothing to suggest the current environment will change anytime soon. Return expectations are much lower today and a far cry from the post-crisis period. In its recent report, “Diminishing Returns: Why Investors May Need to Lower Their Expectations,” the McKinsey Global Institute suggests that equity and bond total returns could be between 1.5% and 4% and 3% to 5% lower, respectively, compared to the returns experienced over the prior 30 years.1
Adding insult to injury, it’s possible that these unimpressive returns may continue to be generated alongside increased volatility. This was evident in the first quarter of this year, when asset prices gapped to the downside on concerns about the slowdown in China’s growth rate, and then fully recovered by the end of the quarter as market sentiment reversed. Given these new market dynamics, a focus on the liquidity of investments will become increasingly important.
With the central banks of several major economies experimenting with highly unconventional monetary tools on the one hand, and the Fed attempting to normalize policy on the other, we should be prepared to see further bouts of high volatility. In addition, as investment banks continue to step away from their traditional role of providing liquidity in periods of sharp market moves, we suspect this sort of volatility will remain common.
Below, we take a look at the macro-economic crosswinds at play and ways to think about building bond portfolios given the uncertainty of the current environment.