EUROPEAN FIXED INCOME

Transcription

1 EUROPEAN FIXED INCOME Investor attitudes, concerns and actions 218.

2 David Zahn Head of European fixed income Franklin Templeton Investments...European markets are at a critical inflection point. After several years of low volatility, it s time for investors to wake up to their European fixed income investments and seize greater opportunities FOREWORD It has been well over a decade since the global financial crisis. In this time, markets have experienced a sustained period of easy monetary policy. European fixed income investors specifically, have enjoyed periods of good returns and relatively low risks, thanks in part to the European Central Bank s (ECB) historic Quantitative Easing (QE) programme, and record low interest rates. But in 218 we are reaching an inflection point, as central banks around the world begin a slow path to reduced stimulus. In Europe, the situation is somewhat different. As the Fed embarks on a clear rate hike path, and starts to unwind its balance sheet, the ECB remains accommodative. We believe it will remain accommodative until it sees inflation in Europe at its target of 2%. We think this is unlikely to happen before 22. But this does not mean that European fixed income markets are safe from volatility. Despite the ECB reiterating its policy on several occasions, we are seeing isolated sell-offs in bonds occurring throughout the year as markets try and price the timing of a change in policy. Earlier this year, bond yields across Europe rose following the January ECB announcement despite no policy change announced. These bouts of volatility can have a significant impact on the performance of a fixed income portfolio. For example, a 1 basis point rise on a 1-year German government bond (bund) with an end of year yield of.427 would wipe out over two years of income. Investors can no longer afford to take a sleepy approach to their European fixed income investments. As volatility returns to the European fixed income landscape, investors may consider taking need to take an active, dynamic and considered approach. Those that do could reap significant rewards as lucrative buying opportunities arise through the volatility. In order to understand more about investor perceptions towards European fixed income, we surveyed over 3 European fixed income professional investors from France, Germany, Italy and Spain on their attitudes and concerns towards the changing market tides, their asset allocation and investment approach. The results were surprising and generally showed that investors were potentially being overly cautious in the management of their portfolios and expressed a generally low risk appetite. Despite this, when they did take risk, it tended to be in high yield, despite fears of stretched valuations. In addition, they did not take enough action when it came to concerns around low returns, and in some cases took too much action when it came to mitigating other concerns such as interest rate risks. In general the key themes from the findings were: Defensive positioning: Investors have low appetite for risk amidst concerns such as rising volatility Where investors are willing to take risk: High yield Lack of action: Despite the low yield environment, investors are still focused on core European markets with low returns Too much action: Despite thinking interest rates will stay low in Europe, investors are unnecessarily reducing duration, sacrificing precious yield Future trends: Emerging appetite for green bonds, Sustainable Responsible Investing [SRI] bond funds and impact investing funds

3 KEY THEMES Theme one: Defensive positioning: Investors have low appetite for risk amidst concerns such as rising volatility The investors surveyed exhibited concerns for rising interest rates and ECB tapering (82%), low returns (79%) and duration risk (7%). ECB changes dominate broad investor concerns Figure 1. - How concerned are you about the following, when it comes to European fixed income investing? Overall Rising interest rates/ecb tapering Low returns 82% 79% Duration risk High pricing/risk of asset bubble 7% 69% Draw-downs Volatility 63% 61% Limited liquidity 44% Bond defaults 33% France Low returns 93% Rising interest rates /ECB tapering High pricing/risk of asset bubble 89% 81% Germany Italy Spain Low returns 89% Rising interest rates /ECB tapering Draw-downs 83% 8% Rising interest rates /ECB tapering Duration risk Low returns / Draw-downs 85% 7% 69% Rising interest rates /ECB tapering Duration risk Low returns The chart shows the % of investors who say they are 'concerned' or 'very concerned' about the issues listed in the question. 73% 69% 66% Apprehension about low returns is prevalent in France (93%) and Germany (89%) while Spain (73%) and Italy s (85%) main concern on rising interest rates reflects the overall results. The European fixed income part of our portfolio is the conservative part. - Financial adviser, Spain These concerns are being reflected in European fixed income portfolios, with the majority of investors taking low to moderate risk. Investors are defensively positioned with overall low to moderate risk in their portfolios Figure How risky do you consider your European fixed income allocation to be? 22% Overall 3% 33% France 27% 19% Germany 35% 18% Spain 21% 18% Italy 36% 48% 4% 46% 61% 46% High risk Moderate risk Low risk David Zahn s view: Clearly the market has expressed concern for a number of key issues from pricing bubbles to low returns. And, given the point we are at in terms of monetary policy shifts in Europe, it is not surprising to see rising interest rates topping the list. This seems to be causing investors to position themselves defensively, with many wanting to keep the majority of their portfolio at low to moderate risk. We think investors are being too cautious and are potentially sacrificing yield. With a strong active management approach, investors who are willing to take a flexible attitude to their asset allocation can still stand to generate strong returns and take opportunity from the rising volatility we are seeing in European fixed income at present. 3

4 Theme two: Where investors will take risk: High yield Despite the low risk appetite in portfolios overall, where investors are taking higher risk appears to be in high yield in their search for overall returns but that is despite fears of the sub-asset class heading into bubble territory. Over three quarters of those surveyed (76%) believe high yield is overvalued and is heading into bubble territory but the same proportion (75%) say they are likely to invest in high yield over the next 12 months. High yield is perceived as risky but investors buy it anyway Figure 2. - Do you agree or disagree with the following statements about European high yield bonds? Overall France Germany Italy Spain We see high yield as overvalued, but everything is overvalued currently. Risks are elevated which is why our allocation currently is at lower levels than usual. Normally we ll have around 15%. - Financial adviser, Spain 76% 53% 41% 83% 4% 33% 76% 68% Prices of high yield bonds are too high/heading for bubble territory Price is not a concern as long as the fundamentals are strong The return on high yield bonds is appropriate for the risk they present 41% % Strongly agree + Agree Investors more likely to invest in high yield and investment grade bonds over the next 12 months Figure How likely are you to invest in the following European fixed income asset classes over the next 12 months (either through funds or direct investments)? 78% 54% 44% 69% 53% 45% 76% 75% 63% 59% 42% 42% Investment grade corporate bonds (Local currency/eur) High yield bonds (Local currency/eur) Inflation-linked bonds (Local currency/eur) Foreign-currency-denominated bonds ex Europe Government bonds (Local currency/eur) Contingent convertible bonds (Local currency/eur) 24% 25% 37% 41% 58% 58% Likely Unlikely 1 David Zahn s view: We think the underlying fundamentals of the high yield market remain sound - but valuations have become stretched. Though the ECB does not buy high yield, the flood of extra cash and liquidity into the European corporate credit market by the ECB s QE programme may have caused investors to become more comfortable with sweeping up weaker credits. But a market correction may come. At this point in the cycle, robust security selection has never been more important. We are more focused on the higher quality end of the high yield market and are fully diversified across sectors and geographies as a rising inflationary environment will likely impact these securities in different ways. 4

5 Theme three: Despite the low yield environment, investors are still focused on core European markets with low returns Professional investors in mainland Europe are concentrated on core European markets with lower appetite for the periphery and Eastern Europe. High allocation bias towards core European markets Figure 3. - What countries in European fixed income are you invested in? % 2% 4% 6% 8% We invest in France, Germany, UK, Netherlands. We are staying away from southern Europe. - Discretionary fund manager, France Eastern Europe David Zahn s view It is not surprising to see a bias towards the larger, core European economies. But in this low yield environment, we believe investors are missing out on strong alpha generating opportunities elsewhere in Europe. We see specific potential in the central and eastern European markets (CEE), and particularly countries like Poland and Romania which we think offer attractive yield. These countries tend to be less well researched and require a broader and deeper set of resources to access effectively. But we also think there is a perception issue. Investors tend to see these countries as lower quality and higher risk areas of the market. But many are in fact investment grade. Polish sovereign debt is A-rated and we believe offers lower volatility and better fundamentals than many of the larger European economies such as Spain. 5

6 Theme four: Too much action: Despite thinking interest rates will stay low in Europe, investors are unnecessarily reducing duration, sacrificing precious yield Eighty-one percent of professional investors in Europe do not expect interest rates on the continent to rise by more than 1% within the next three years. Investors expect minor interest rate rises Figure 4. - Over the next three years, by how much do you expect the ECB to raise rates? Overall We monitor duration for investors in respect to their liabilities. We typically maintain short duration to reduce the risk. - Discretionary fund manager, Germany Between -.25% Between.25.5% Between.5-1% Between 1-1.5% Between 1.5-2% More than 2% 9.1% 31.3% 4.6% 1.6% 6.6% 1.9% 81% Despite this, 7% are concerned about duration risk [see fig 1. on pg 4], and over half (54%) of those surveyed have actively reduced their duration over the last three years. Rates concern leads to decreasing duration Figure What is the average duration of your European fixed income portfolio? Average duration of European fixed income portfolios 4.1 years How has this duration changed in the past three years? 28% Increased 18% Stayed the same 54% Decreased David Zahn s view In a normal rising rate environment, where rates would rise considerably bonds would sell off substantially. In those circumstances, there is a case for duration reduction. But the market consensus, which we agree with, is that rates in Europe are unlikely to rise by more than.5-1% - barely bringing them back into positive territory. We think many investors are unnecessarily reducing duration and by doing so, are sacrificing valuable yield, especially if they are positioned in mainly the core European markets where the short end of the yield curve is in low to negative territory. 6

7 Theme five: Future trends: Emerging appetite for green bonds, SRI bond funds and impact investing funds The asset management industry is experiencing a seismic shift in relation to attitudes and demand for Environmental, Social and Governance (ESG) informed investments. While initially more focused on the equity markets, we are starting to see this spreading to fixed income markets. Almost half (46%) of professional investors in this study say they are considering investing in SRI bond funds. Two fifths (4%) are considering investment in green bonds and 14% are thinking about allocation to impact investing funds. Interest highest in SRI bond funds Figure 5. - Which of the following are you considering investing in? SRI bond funds Green bonds Impact investing funds David Zahn s view: 46% 4% 14% ESG is quite attractive and with more impact on the liquid segment. But it is difficult as it is still a young world and there is no common agreement around the value. It is something that deserves a lot of attention and discussion. - Discretionary fund manager, Italy This is an area of the market that will see significant growth over the next few years as more people will want to take advantage of the significant opportunity in this space. At the moment, much of the issuance in the green bond space is in the corporate market, but we think this will progress towards the sovereign market as well. We see good value in green bonds. Some of these bonds are trading either flat or at a premium to their nongreen counterpart so in many cases you are getting paid extra to get the same bond but with lower carbon emissions. Julie Moret s view: Head of ESG Franklin Templeton Investments The industry continues to see growing client appetite for ESG informed investing. The Global Sustainable Investment Alliance estimated that assets under management incorporating ESG criteria reached $22.89 trillion globally, representing a 25% increase since Fuelled by the growing relevancy of sustainability changes such as climate transition risks, changing investor preferences from millennials looking to align positive financial return alongside positive societal or environmental impact and growing sustain bility focused government policy and regulatory pressures. We see ESG in fixed income investing as the sleeping giant given this is the world s largest asset class. We believe there will be continued focus in this asset class as evidenced by initiatives from credit rating agencies such as S&P and Moody s. We are only seeing the tip of innovation in this asset class and believe there will be continued growth opportunities which the survey results seem to support. 1 Source: Global Sustainable Investment Alliance (GSIA): 216 Global Sustainable Investment Review 7

8 METHODOLOGY Franklin Templeton Investments commissioned CoreData Research to carry out a study on European fixed income investment among professional investors (advisers and discretionary fund managers) in four European countries - France, Germany, Italy and Spain. Responses were collected from 32 investors (24 advisers and 8 discretionary fund managers) during January 218 to better understand their attitudes and behaviours towards European fixed income. The study also included six qualitative interviews in each country. This document provides insight into what is weighing heavily on the minds of professional investors in the countries under review and how they look to manage the risks resulting from these concerns.

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