Investment practitioners are working in unconventional times, with roughly 50 percent of global central banks in quantitative easing (“QE”) mode. With interest rates in some of the major economies, including the U.S., Europe, and Japan, at the zero lower bound, what will the investment opportunities in 2015 be? And how will our investment outlook change when the U.S. Federal Reserve Board (“Fed”) starts raising rates after finishing its QE tapering? Marlene Puffer, PhD, CFA, is a partner at Toronto-based Alignvest Management Corp. and serves as trustee of the Healthcare of Ontario Pension Plan (“HOOPP”) and chair of HOOPP’s Asset-Liability Management Committee. In this interview, she shares her thoughts on how investors should be approaching fixed income and where the asset class is headed as QE draws to a close.

With interest rates at historic lows, what is the role of fixed income in portfolios today when it comes to strategic asset allocation?

Despite low yields, fixed income still plays a very important role in many investment portfolios. For example, it remains the best hedge for long-term liabilities for institutional investors such as pension funds and insurance companies. Increasingly, institutional investors use sophisticated liability-aware or liability-driven investing strategies to hedge the interest rate risk inherent in their liabilities. One approach is to divide the portfolio into two pieces: (1) a hedging portfolio that often consists mainly of long-term bonds, and (2) an actively managed, return-seeking portfolio. Although the expected return on the hedging portfolio is low in the current interest rate environment, its primary focus is to minimize funding risk by matching the changes in the value of liabilities as interest rates move. Derivatives and leverage can boost the size of the return-seeking portfolio to ensure that the overall portfolio meets return targets. The return-seeking portfolio may also include fixed income strategies, but that portfolio will focus on active yield curve-, credit-, and liquidity-related strategies to enhance returns in the context of investor views on relative movements of rates across markets.

How can investors and institutions respond to the challenge of rising rates in 2015?

What really matters in terms of investment strategy is not whether rates are going to rise or fall in absolute terms, but whether they are going to rise more or less than the expectations embedded in the yield curve or futures prices. Rising interest rates are already priced into a relatively steep yield curve. As a result, if investors elect to move into shorter-term securities because they believe rates are going to rise, timing is crucial, because they are not benefiting from the higher yield and roll-down on the steep curve. Investors who made this move too early have paid a heavy price for doing so. Therefore, it is important that investors who are short duration seek other ways to compensate for the cost of carry by exploring opportunities in credit, liquidity, or other asset classes. There is no free lunch, but there are ways to mitigate the risk of rising rates.

What are your thoughts on some of the post-QE opportunities and challenges in the U.S. and European markets?

The Fed has cautiously outlined its data-driven policy intention, based on various measures of economic and employment growth. In recent months, these U.S. metrics have been surprisingly strong, so that the QE3 purchases are now slated to end in October 2014. However, the Fed remains concerned about the depressed labour participation rate and the slow growth in hourly earnings. Therefore, the bias among most members of the Federal Open Market Committee is to raise rates slowly to avoid prematurely choking the economy. More insight into the Fed’s strategy will come toward year end.

An important question is whether the 10-year U.S. Treasury yield will find its way into a range of 4–4.5 percent, thought by many observers to be a long-term equilibrium range. Sluggish growth and persistently low inflation could keep rates below this range for an extended period. But the market reaction could be violent if the Fed’s tone becomes more hawkish. A cautious approach to duration calls is warranted. The experience in Europe, however, is quite different. The European Central Bank (“ECB”) has been dovish and will likely remain so, maintaining negative deposit rates, providing two- to four-year fixed-rate bank funding facilities, and supporting the asset-backed securities market. The importance of ECB support was emphasized in the recent successful bond issues by Greece and the relatively muted reaction in the sovereign debt markets to worries about the banking sector in Portugal.

The leverage level in several advanced countries reached unprecedented levels in 2013. Can you comment on this debt addiction trend?

Although debt levels look shockingly high when cited in aggregate, it is important to distinguish between private sector leverage and public sector borrowing and to understand the differences in specific markets. I’ll focus on the three major developed markets as examples. The U.S. public sector has leveraged up, while the U.S. private sector has deleveraged from pre-crisis levels. Despite the heavy government debt load and a rating downgrade by Standard & Poor’s in 2012, Treasury yields rallied. This reaffirmed the U.S. Treasury market’s status as the global safe haven and risk-free benchmark in the midst of the European crisis.

Japan’s enormous public debt load will remain sustainable for some time because it is almost entirely domestically financed at very low rates. There are some risks: Japan’s huge public pension fund is shifting its investments from bonds to equities, and the trade balance is now in deficit. But the massive amount of foreign assets accumulated by Japan over decades of current account surpluses can be drawn on as needed. Although there are long-term demographic concerns that will put pressure on the social security system, funding the debt load in the near term is not a crisis in the making.

Offering further support to the debt load, there is early evidence of the potential for economic turnaround due to Japanese Prime Minister Shinzo Abe’s three-pronged strategy. Japan’s annual consumer price index reached +3.4% on April 30, 2014 (although much of that is attributable to the one-time effect of the value-added tax increase), and gross domestic product (“GDP”) growth was 3 percent year-over-year to March 2014. Consistent policy efforts will remain critical, but the trajectory is promising.

“There is no free lunch, but there are ways to mitigate the risk of rising rates.”

In the eurozone, aggregate debt figures hide the well-known disparities between the sovereign debt loads in Germany and those in the periphery countries. The focus has been on the (now slowly improving) situation in Greece and its implications for the large sovereign bond markets in Spain and Italy. However, it is less widely understood that there are big differences between the characteristics of the debt loads in Spain and Italy. Italy has had a high but stable government debt load since entering the European Union (“EU”), while Spain’s was quite modest and improving before the crisis. In contrast, the private debt load in Italy has been and remains quite low, while Spain’s ballooned pre-crisis as the housing market drove mortgage lending to all-time highs. Spain’s rising public debt was a by-product of the bail out of its housing and banking sectors during the crisis. The road to target debt levels in the EU will be long, but the easing of austerity measures is now resulting in a modest rise in GDP. Growth is needed to bring the public debt loads down. The ECB played a crucial role in stabilizing the bond markets to set the stage for recovery.

Over the past two decades, we have seen the continued rise in importance of emerging markets— the BRICs and some of the frontier markets. What are some of the concerns you have for investors in these markets?

In contrast to the high public debt loads in a number of major developed markets, many emerging markets have strong fiscal situations. What merits closer attention in those markets is the increase in private sector leverage. Domestic currency corporate bond issuance has been growing rapidly. Investors have been searching for yield and may be in for disappointing returns in some cases. Of course, China’s debt buildup in the shadow banking sector is a global systemic concern. The question is whether the government will provide support to the banking sector if there is a crisis in this sector. The government certainly has the resources and incentives to do so. Political and social stability are highly dependent on continued economic growth. In the longer term, as China continues its development towards a more domestically driven consumer economy, Chinese demand for U.S. Treasuries may drop off, adding upward pressure on U.S. interest rates.

The 2008 financial crisis has changed the way we think about risk management practices. There are substantial changes in rules and regulations around derivatives, securitization, and bank capital. What are the implications for investors and financial practitioners?

With increasing government regulatory requirements and oversight in place, the rapid development of product innovation in financial markets has been slowed down. There will continue to be reduced appetite for risk taking in regulated entities (banks and insurance companies), and the banking sector will stick with conservative lending practices. This is presenting challenges for central banks because the usual monetary policy channels are clogged. In some cases, other capital market participants are stepping in to fill the gap, with more private debt funds popping up, for example. However, we are also seeing much less liquidity in secondary markets for corporate bonds and other credit products as investment dealers act more as agency traders than as principals. This has market participants worried that credit spreads could be stretched wider on any negative credit events.

At the same time, with increased regulatory efforts, we have seen a substantial improvement in transparency in derivative market operations. There is significant efficiency gain in counterparty credit risk management through initiatives such as centralized clearing, which in turn may improve the market liquidity of these products. As a result, investors are better able to hedge some risks using derivatives.

September of this year marks the sixth anniversary of the global financial crisis. Over the past six years, we have seen a lot of changes in financial markets. A number of these changes benefit investors, such as transparency in structured products and derivative markets, and stronger bank balance sheets. However, some of the regulatory responses have clogged the usual transmission channels for monetary policy, and the potential market reaction to exit strategies for unprecedented quantitative easing remains highly uncertain.

Going into 2015, low interest rates will continue to constrain returns, but some credit-related strategies and emerging market government bond markets present opportunities to enhance performance. The deleveraging cycle will continue to unfold, putting a damper on potential growth, but government and private debt overhang in some markets may be with us for years to come.