Down, but not out The Role of Fixed Income in a Low Yield Environment

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1 Down, but not out The Role of Fixed Income in a Low Yield Environment Charles Thomas, CFA Investment Analyst Vanguard Asset Management

2 The key questions we will answer today... What does the low yield environment mean for investors? How does Vanguard think about fixed income as an asset class? Tilt toward credit, EM, or dividend equity to boost yield? Shorten duration to avoid the coming rate increases? What are some simple things to focus on in a low yield environment? 2

3 Yield to Maturity For the past 30 years, bond yields have gone in one direction Falling yields have created an extremely favourable environment for bond returns 16.0% 14.0% 12.0% 10.0% 10-year Government Bond Yields Total Returns, UK US Germany Government Bonds 9.9% 8.3% 6.8% Equities 12.0% 11.2% 9.3% ERP 2.1% 2.9% 2.5% 8.0% 6.0% 4.0% 2.0% 0.0% United States United Kingdom Germany Notes: Figure displays the average annual 10-year government bond yield for each country from 1980 to Table displays the annualised returns of an investment in the government bonds or equities of each country. UK government bonds defined as the FTSE British Government All Stocks Index, US government bonds defined as the Barclays US Treasury Index, and German government bonds defined as the Rex General Bond Index. Equities are defined as the respective country index from MSCI. ERP, the realised equity risk premium, is the simple arithmetic difference between the two. All returns are expressed in the local currency, with income reinvested. Figures cover Jan 1980 to Dec Source: Vanguard, based on data from the US Federal Reserve, Bank of England, Thomson Reuters Datastream, FTSE, Barclays, Rex, and MSCI. 3

4 Realised 10-year Annualised Return on UK Fixed Income Perspective on starting yield and return 18% UK Fixed Income Returns vs. Initial Yield % 14% 12% Yield as at 31 March % 8% 6% 4% 2% 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Initial Yield on 10-year Gilt Notes: Figure displays the realised 120-month annualised returns ended Jan through Oct. 2012, relative to the initial yield on the 10-year UK zero coupon gilt from Jan.1976 through Oct UK fixed income index defined as FTSE UK Government Index Feb.1976-Feb.2000; Barclays Sterling Aggregate Index thereafter. Returns are in local currency terms, with income reinvested. Data as of 31 Dec Source: FTSE, Barclays, and Bank of England. 4

5 Yield (%) What about rate increases in the shorter term? UK Gilt Yield Curve March 2013 Spot Curve and Break-even Forward Curves Today s yield curve Years to Maturity What the market is pricing in for yields 10 years from now Spot Curve 31 March 2013 Implied 3 Year Forward Implied 1 Year Forward Implied 5 Year Forward Implied 10 Year Forward Notes: Spot curve from the Bank of England. Forward curve is derived at an annual frequency, from 1 to 5 years out. Source: Vanguard, based on data from the Bank of England. 5

6 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 What happens to a bond when rates increase? 5.0% Annual Return of a 10-year Gilt If the forward curve is realised 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Price Return Income Return Total Return Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Yield Change (bps) Price Return -1.7% -2.0% -2.0% -1.8% -1.6% -1.3% -1.1% -0.8% -0.7% -0.5% Income Return 1.9% 2.3% 2.7% 3.0% 3.3% 3.6% 3.8% 4.0% 4.1% 4.2% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 2.2% 2.7% 3.1% 3.5% 3.7% Notes: Displays the characteristics of a 10-year gilt investment, assuming the yield curve evolves following the forward curve derived from the 29 March 2013 spot curve. Assumes a 10 year gilt is purchased at the beginning of the year, held for 1 year, then sold, with the proceeds re-invested in another 10-year gilt. Source: Vanguard, based on data from the Bank of England. 6

7 Difference in Annualised Volatility Relative to the Global Equity Market Monthly Correlation to Global Equity Market Bonds: A source of... return? Or risk control? Risk characteristics of broad fixed income asset classes, % % % % -12% -10% % % % US Fixed Income Euro Area Fixed Income UK Fixed Income Volatility Difference from Global Equities Correlation to Global Equities Notes: Displays the difference in annualised monthly volatility for each fixed income market relative to the global equity market, and the correlation of monthly returns relative to the global equity market over the period Jan Dec Global equity market defined as the FTSE All World, US fixed income defined as the Barclays US Aggregate, Euro Area fixed income defined as the Barclays Euro Aggregate, UK fixed income defined as the Barclays Sterling Aggregate. All returns are measured at a monthly frequency, in local currency terms, with income reinvested. Sources: Vanguard, based on data from FTSE and Barclays. 7

8 Bonds and equity downside risk protection 7.5% Return distribution during the worst months of equity returns % Return distribution during the worst months of fixed income returns % 2.5% 0.0% Clear downside protection during equity market downturns 5.0% 2.5% 0.0% 95 th percentile 75 th percentile -2.5% -2.5% 50 th percentile -5.0% -5.0% -7.5% -10.0% -7.5% -10.0% Downside protection, even when bonds are at their worst 25 th percentile -12.5% -12.5% 5 th percentile -15.0% Equities Fixed Income -15.0% Equities Fixed Income Notes: Displays the 10 th /25 th /median/75 th /90 th distribution of monthly returns for both global equities and global bonds, during a 10 th percentile or worse month for either the global equity market or global fixed income market from Feb.1976 to Dec Equity market defined as the MSCI World from , MSCI All Country World from , and the FTSE All World from 1994-on. Fixed Income market defined as the FTSE UK Government Index , Citi WGBI hedged to GBP Jan.1985-Dec.1989; Barclays Aggregate hedged to GBP Jan.1990-Present. Equity returns are measured in local terms. All returns are shown assuming income is reinvested. Returns through Dec Sources: Vanguard, based on data from MSCI, FTSE, and Barclays. 8

9 Be careful when reaching for yield 2.0% Median monthly return during the worst quartile of global equity performance % 0.0% 0.5% 0.8% -1.0% -0.9% -2.0% -1.9% -3.0% -4.0% -5.0% -4.2% Global Equities -3.2% UK Dividend Equities -2.8% UK REITs Commodities EM Bonds Corporate Bonds Diversified Global Bonds Notes: Displays the median monthly return of each asset class during the worst quartile of global equity market returns. UK Dividend Stocks as the FTSE 350 High Yield index, UK REITs defined as the FTSE/EPRA NAREIT Index, Commodities defined as the S&P GSCI index, EM Bonds defined as the JP Morgan Emerging Markets Bond Index, Corporate Bonds defined as the Barclays US Corporate Index from and Barclays Global Aggregate Corporate index thereafter, both hedged to GBP, and Diversified global fixed income is defined as the Barclays Global Aggregate index (hedged to GBP). All returns are in sterling terms with income reinvested,. Figure covers the period Jan.1994-Dec.2012 Sources: Vanguard, based on data from Barclays, JP Morgan, S&P, and FTSE. 9

10 Yield (%) Duration tilts with a steep yield curve involve a trade-off UK Gilt Yield Curve March 2013 Spot Curve and Break-even Forward Curves What the market is pricing in for yields 5 years from now Today s yield curve Maturity (Years) Spot Curve 31 March 2013 Implied 3 Year Forward Implied 1 Year Forward Implied 5 Year Forward Notes: Spot curve from the Bank of England. Forward curve is derived at an annual frequency, from 1 to 5 years out. Source: Vanguard, based on data from the Bank of England. 10

11 Gilt returns if the forward curve is realised 1 Year Gilt Year 1 Year 2 Year 3 Year 4 Year 5 Yield Change (bps) Income Return 0.1% 0.2% 0.6% 1.1% 1.7% Price Return 0.0% 0.0% 0.0% 0.0% 0.0% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% Cumulative Total Return 3.8% 10 Year Gilt Year 1 Year 2 Year 3 Year 4 Year 5 Yield Change (bps) Income Return 1.9% 2.3% 2.7% 3.0% 3.3% Price Return -1.7% -2.0% -2.0% -1.8% -1.6% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% Notes: Table displays the returns of various gilt investments, assuming the yield curve evolves following the forward curve derived from the 29 March 2013 spot curve. Assumes a gilt of the stated maturity is purchased at the beginning of the year, held for 1 year, then sold, with the proceeds re-invested in a bond of the original maturity. Source: Vanguard, based on data from the Bank of England. 11

12 3 Month return when equities are negative Short duration tilts mute the diversification effect of bonds 5.0% Performance of various maturity ranges of government bonds, during 3-month periods when global equity returns are negative Jan.1995 Dec % 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 1 to 3 yr 3 to 5 yr 5 to 7 yr 7 to 10 yr 10+ yr UK US Germany Notes: Both figures display the average 3-month performance of the stated maturity government fixed income investment for each country, during those 3-month periods when the global equity market has negative returns. Each country s government fixed income market is represented by the particular maturity and country component of the Citigroup World Government Bond Index, in local currency terms, with income reinvested. Global equity returns are measured by the MSCI World index, in local currency terms, with income reinvested. Figure covers the period Jan to Dec Source: Vanguard, based on data from Citigroup and MSCI. 12

13 Global diversification can help in a rising rate environment Yields are unlikely to move in lock-step across all major markets 1.00 Correlation of 10-year government bond yields with the UK gilt Notes: Figure displays the correlation of the monthly change in the yield of each country s 10-year government bond to the change in the 10-year UK gilt yield. Source: Vanguard, based on data from Thomson Reuters Datastream. 13

14 Costs and low expected returns Weighted average active fund expense ratio versus benchmark yield 2.5% 2.0% 2.24% 1.93% 1.86% Expense Ratio Yield as at 31 March % 1.5% 1.34% 1.0% 0.85% 1.02% 0.63% 0.5% 0.0% Costs as a percentage of yield: GBP Diversified Bonds EUR Diversified Bonds USD Diversified Bonds Global Bonds 28% 44% 55% 77% Notes: Displays the asset-weighted average of all share classes of funds available for sale in the United Kingdom, in the stated Morningstar category. The expense ratio is taken from either the 2012 or 2011 annual report, whichever was available. Assets are defined as the average of monthly net share class assets in 2012, where available. Yield is from the applicable Barclays benchmark: Sterling Aggregate, Euro Aggregate, US Aggregate, and Global Aggregate. Morningstar data as at 22 February Source: Vanguard, based on data from Morningstar and Barclays. 14

15 The key questions we answered today... What does the low yield environment mean for investors? Bond returns should be expected to be low going forward. How does Vanguard think about fixed income as an asset class? Its enduring role is to provide diversification, risk control and stability. Tilt toward corporate or EM to boost yield? Be aware that these strategies increase risk, akin to increasing one s equity allocation. Shorten duration to avoid the coming rate increases? Yield curves reflect market expectations, making duration tilts difficult to benefit from. What are some simple things to focus on in a low yield environment? Global diversification and keeping costs down. 15

16 Appendix 16

17 There is a tail risk that bonds outperform, despite low yields The Japan experience, while not the most likely outcome, is possible 5.0% Japan Sovereign Yields Jan.1997 Dec Real Growth of 100 in Japanese Asset Classes Dec.1996 Dec % % % 1.0% % Year Bond Yield 3 Month Bill Yield Stocks Bonds 60/40 Cash Notes: Japan sovereign yields from the Japan Ministry of Finance. Japanese stocks defined as the MSCI Japan Investable Market Index. Japanese Bonds defined as the Citigroup Japan World Government Bond Index. Cash is inferred from the 3m bill yield. All returns in yen terms, with income reinvested, adjusted for consumer price inflation from the Japan Statistics Bureau. Data through December Source: Vanguard, based on data from MSCI, Citigroup, Japan Ministry of Finance, and the Japan Statistics Bureau. 17

18 US history provides an example of a modern tightening cycle US Treasury Yields Jan to Dec.2012 Traditional level shifts were more typical as inflation expectations were moderating Average Annualised Return of US Treasury Investment 1 to 5 year 5 to 10 year 10+ Year Oct.1993 to Dec % -5.0% -8.4% Oct.1998 to Jan % -3.8% -5.6% May.2003 to May % 0.4% 0.9% Bear Flattening occurs when inflation expectations are well anchored Fed Funds Rate 3-year 5-year 7-year 10-year Notes: Figure displays the yield of US Treasury bonds of the stated maturity, from the Federal Reserve, along with the Fed s target for the Federal Funds Rate. Realised returns in the table display the return of the corresponding maturity component of the Barclays US Treasury index, in dollar terms, with income reinvested. Source: Vanguard, based on data from the US Federal Reserve and Barclays. 18

19 Gilt returns if the forward curve is realised Year 1 Year 2 Year 3 Year 4 Year 5 Cumulative 1 Year Gilt Yield Change (bps) Income Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% Price Return 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% 3 Year Gilt Yield Change (bps) Income Return 0.3% 0.6% 1.1% 1.7% 2.2% 6.1% Price Return -0.2% -0.4% -0.6% -0.6% -0.5% -2.2% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% 5 Year Gilt Yield Change (bps) Income Return 0.7% 1.2% 1.7% 2.2% 2.6% 8.7% Price Return -0.6% -1.0% -1.1% -1.0% -0.9% -4.5% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% 10 Year Gilt Yield Change (bps) Income Return 1.9% 2.3% 2.7% 3.0% 3.3% 13.9% Price Return -1.7% -2.0% -2.0% -1.8% -1.6% -8.9% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% 15 Year Gilt Yield Change (bps) Income Return 2.6% 2.9% 3.2% 3.5% 3.7% 17.0% Price Return -2.4% -2.7% -2.6% -2.3% -1.9% -11.3% Total Return 0.1% 0.2% 0.6% 1.1% 1.7% 3.8% Notes: Table displays the returns of various gilt investments, assuming the yield curve evolves following the forward curve derived from the 29 March 2013 spot curve. Assumes a gilt of the stated maturity is purchased at the beginning of the year, held for 1 year, then sold, with the proceeds re-invested in a bond of the original maturity. Source: Vanguard, based on data from the Bank of England. 19

20 Important Information This document is directed at professional investors and should not be distributed to or relied upon by retail investors. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not an indication of future results. The information contained in this presentation does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority Vanguard Asset Management, Limited. All rights reserved. 20 VAM

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