October 2022 / INVESTMENT INSIGHTS
A Flexible Bond Approach to Help Navigate Volatile Markets Article Fragment
How the T. Rowe Price Dynamic Global Bond Fund may help during this challenging environment.
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
Tough Period for Global Bond Markets
(Fig. 1) Fixed Income returns (AUD-hedged %) – year to date
It has been a tumultuous few quarters 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 volatile period is far from over. We have entered a new fixed income regime as markets prepare for life without the support of central banks.
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, are also reducing their balance sheets. This all comes at a time when economic growth is slowing.
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 central bank tightening is more fairly priced in sovereign bond markets and that we are moving closer to the point where there’s a potential window of opportunity to add duration. By contrast, in risk markets, such as credit, we remain cautious on the outlook as the environment of slower growth and higher inflation is likely to cause credit fundamentals to deteriorate. Therefore, we expect volatility to continue with potential for credit spreads to widen further. 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 in the credit space.
We believe that this new regime requires volatility management. In the T. Rowe Price 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.
What’s Your Diversifier?
(Fig. 2) Growth of $ in Dynamic Global Bond Fund vs Global Aggregate Index AUD-hedged
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.
In the T. Rowe Price 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.
(Fig. 3) T. Rowe Price Dynamic Global Bond Fund (I Class)
Benefits of Active Duration Management
(Fig. 4) Return analysis of the T. Rowe Price Dynamic Global Bond Fund (I Class) (Gross of Fees) during rising rate environments
Benefits of Diversification
(Fig. 5) Return analysis of the T. Rowe Price Dynamic Global Bond Fund (I Class) (Gross of Fees) during equity market sell-offs
Why the Dynamic Global Bond Capability?
In the T. Rowe Price 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 nine 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.
Gross of Fees1 Cumulative Returns since 28 February 2014
Looking ahead, we expect volatility to persist. The market environment remains highly uncertain, with worries continuing over geopolitics, slowing growth, rising inflation, and tightening financial conditions.
While this is likely to be challenging, we expect great buying opportunities to emerge at some stage. Beyond simply navigating a new higher-volatility regime, it will be crucial to identify when a potential inflection point emerges. Overall, we believe these are the conditions the fund is designed for, with built-in flexibility, a broad approach, and a strong emphasis on volatility management.
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