June 2022 / INVESTMENT INSIGHTS
A Flexible Bond Approach to Help Navigate Volatile Markets
How the T. Rowe Price Funds SICAV–Dynamic Global Bond Fund¹ may help during this challenging environment
- The Dynamic Global Bond Fund delivered a positive return in the first four months of 2022 during an environment of heightened volatility and a heavy sell-off across bond markets.
- Fixed income markets have entered a new regime where volatility is likely to be more persistent due to the withdrawal of central bank liquidity support.
- Investors should think differently about diversification as the stock/bond relationship is showing signs of changing.
1The fund is actively managed, and the manager is not constrained by the fund’s benchmark, which is used for performance comparison purposes only.
This year has been extremely challenging for bond investors, and volatility is set to continue as markets prepare for life without central bank support. We believe this environment will suit our absolute bond return approach, which is flexible, has a strong emphasis on active duration management, and employs defensive hedges to provide diversification against risk assets.
Volatility Is Set to Continue
It has been a tumultuous few months in fixed income, with sovereign bond yields rising sharply and almost every segment of the asset class declining (see Figure 1). The unprecedented moves have left many investors questioning how much longer the rout can continue. Although it is difficult to envisage further moves of the same magnitude, particularly in sovereign bond markets, this turbulent period is far from over. If anything, it is only just beginning. We have entered a new fixed income regime as markets prepare for life without the support of central banks.
Tough Period for Global Bond Markets
(Fig. 1) Performance breakdown of major bond market segments
Across developed markets, central banks are responding to multi‑decade high inflation by withdrawing liquidity and hiking interest rates. Furthermore, some central banks, most notably the U.S. Federal Reserve, also plan to begin reducing their balance sheets. With quantitative tightening on the horizon, we believe that it’s likely to be a lot faster and larger in scope than ever experienced, especially if multiple global central banks all do it in unison.
Against this backdrop, it is difficult to see how volatility in bond markets will ease anytime soon—on the contrary, we believe it is here for the long term. In the current climate, we feel that risk markets, such as credit, are particularly vulnerable as they have not fully priced in the prospect of quantitative tightening even after the recent sell‑off. Therefore, we expect credit spreads to widen further as the market grapples with tighter liquidity conditions, slowing growth, and higher inflation. While this could be challenging, at some point there is likely to be an inflection point at which valuations become attractive again and strong potential buying opportunities emerge.
We believe that this new regime requires volatility management. In the Dynamic Global Bond Fund, we implement defensive hedging positions in seeking to help anchor performance during periods of risk aversion. Flexibility will also likely be essential in this environment. Heightened volatility may result in prices becoming dislocated, so our ability to be tactical can be beneficial. This proved to be the case in March 2020, when we responded to a huge sell‑off in credit and added select corporate bond exposures that were dislocated from fundamentals and identified as attractive by our bottom‑up research process.
Time to Rethink Risk Diversification
Fixed income markets are going through a period of strategic change as central banks retreat from supporting markets. This environment means that investors can no longer rely on the post‑global financial crisis investment playbook and will need to think differently—particularly regarding diversification. At times this year, stocks and bonds have both sold off simultaneously, demonstrating that the stock/bond relationship is not always constant and can change, especially in the current climate where central banks are withdrawing liquidity support. Given this, we believe that it will be vital for portfolio managers to adapt to the changing nature of correlations to avoid suffering losses from both major asset classes at the same time.
What’s Your Hedge?
(Fig. 2) Rolling 252‑day correlation of the S&P 500 to 10‑year U.S. Treasury return
In the Dynamic Global Bond Fund, we do not assume that fixed income will always be a diversifier that typically performs well when risk markets such as equities sell off. Instead, we focus on actively managing the portfolio and maintaining a liquid profile. This provides us with the flexibility to adapt to changes in market conditions. We also consider the full toolkit available to help with diversification efforts, including using currency and derivatives markets alongside traditional interest rate management.
Why the Dynamic Global Bond Capability?
In the Dynamic Global Bond Fund, we seek to achieve three core goals:
- Provide a regular return;
- Act as a diversifier during times of market stress; and
- Manage downside risks such as rising interest rates.
The volatile market conditions experienced so far in 2022 have provided an important test of our approach, and we have delivered on these goals. The fund produced a positive return during the first four months of 2022 at a time of a deep bond market sell‑off and heightened volatility across risk markets. Our use of active duration management was central to this achievement, as we dynamically managed exposures over the period. This approach helped us deliver gains from a variety of positions, including short positions in select developed market sovereigns, allocations to inflation‑linked bonds, and occasional tactical long exposures.
(Fig. 3) T. Rowe Price Funds SICAV–Dynamic Global Bond Fund
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June 2022 / INVESTMENT INSIGHTS
June 2022 / INVESTMENT INSIGHTS