singaporeen
Navigating bond markets in times of stagflation

Navigating bond markets in times of stagflation

18-05-2022 | Insight

High inflation and central bank tightening are already leading to rising yields and negative bond returns. At some point, though, higher yields and weaker growth will offer opportunities for bond investors.

  • Olaf  Penninga
    Olaf
    Penninga
    Portfolio Manager

Speed read

  • Bond markets torn between high inflation and weaker growth
  • Deep-sample evidence includes high inflation and stagflation periods
  • Dynamic Duration strategy well-positioned for current challenging environment

Stagflation is hitting the headlines again: high inflation and central bank tightening are already leading to rising yields and negative bond returns. At some point, though, higher yields and weaker growth will begin to offer opportunities for bond investors. To capture these opportunities when they arise, while also protecting portfolios against rising yields, active duration management is needed. But how do we know whether a strategy that was successful in recent decades will also work in a completely different environment?

To answer this question, we use the long-term back-test described in our academic paper ‘Predicting Bond Returns: 70 Years of International Evidence’. The back-test demonstrates that quant duration management works in an environment of high inflation and weak growth. Typically, it works best when bond markets move most – a positive finding given that the current environment is likely to cause significant market moves.

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Stagflation risk has risen

The risk of stagflation is clear as commodity prices have surged due to the war in Ukraine, and energy supply is threatened. US inflation has already reached levels unseen since the early 1980s and growth will be weaker as high energy prices hurt disposable income and force energy-intensive companies to reduce their production. Strict lockdowns are again implemented in economically important parts of China, while Covid-related supply chain disruptions and chip shortages are already limiting growth. Fiscal policy might cushion demand, but the resulting higher bond issuance could push yields even higher. Monetary policy has supported the growth rebound from the 2020 lows, but this support is now being withdrawn.

Back-test using a deep historical dataset

Robeco’s Dynamic Duration strategy aims to protect against rising yields and benefit from declining yields. Since its inception in 1998, the duration positioning of this strategy has been determined by a quantitative model. When the research leading to the creation of this model was performed in the early 1990s, the limited availability of historical bond market data was one of the challenges. Most academic research on bond market timing uses data sets starting in the early 1980s, a period characterized by a secular decline in interest rates. Periods of high inflation or stagflation are rare in these data sets and, as a result, evidence for bond market timing in such conditions was scarce.

In recent years, however, a much wider set of historical financial market data has been made available, thanks to researchers digitalizing archives of exchanges, central banks and newspapers. We recently published a paper in which we present evidence for bond market timing using a deep historical dataset. This back-test includes decades with higher inflation and periods of stagflation. In this article, we use the dataset from that paper to analyze the performance of bond market timing in different growth and inflation regimes, including periods of stagflation.

Figure 1 | US inflation, 1950 – February 2022

Source: Bloomberg, Datastream, Global Financial Data

Figure 1 shows the development of US inflation from 1950, and we can see immediately why we need to examine more than just the most recent decades: current inflation is higher than anything seen since the early 1980s. The combination of high inflation (above 4%) and a recession is very rare in recent decades, occurring in less than 5% of the time after 1982.

Our deep sample allows us to better study stagflationary environments: these occurred 23% of the time in the 1950-1982 period, mainly between the late 1960s and the early 1980s. We use a global dataset that includes six large bond markets (the US, UK, Germany, Japan, Australia and Canada) to study bond market timing all the way back to 1950.

Performance in times of stagflation

Our academic paper shows that bond market returns can be predicted using a combination of four variables: bond trend, yield spread, equity return and commodity return. This finding is robust over markets and over time periods. Figure 2 shows the cumulative back-tested performance of this strategy.

Figure 2 | Cumulative back-tested performance, 1950-2019

Source: Robeco

This figure indicates that the back-tested performance is good in the period with rising yields before 1982, as well as in the period of the secular decline in yields after that. In the paper, we provide formal evidence that the strategy’s performance is good in both these sub-periods, in recessions and expansions, and in periods of high inflation and low inflation.

In this article, we now take that analysis one step further by classifying periods based on a combination ofgrowth and inflation. We distinguish periods with low, moderate and high inflation (below 2%, between 2% and 4%, and above 4%) in recessions, and do the same for expansions (following the same classification of recessions as in our academic paper). Figure 3 shows the model performance in these 3 x 2 = 6 categories.

Figure 3 | Model Information ratio in times of recession and expansion, and different inflation levels

Source: Robeco. Period: 1950-2019

The blue bars denote the information ratio of the bond market predictability strategy in recession periods, the grey bars in periods of expansion, with the bars (from left to right) showing the results in periods with low, moderate and high inflation. The figure shows that the back-tested strategy worked in all environments. Bond market predictability is especially strong in periods of stagflation, where inflation is high in a recession.

Adding most value when markets move most

The strategy’s strong performance in times of stagflation is in line with the academic paper’s general conclusion that the strategy also works well in adverse economic and market environments, for example in periods with falling equity markets. Typically, the model generates most return when bond markets move most – also because its signals are more reliable (higher success ratio) in periods when markets move strongly. The Dynamic Duration strategy has also generated above-average outperformance in the periods with the largest moves in bond markets (for up as well as down moves) throughout its 24-year live track record.

The current environment combines several potential drivers of strong moves in bond markets: high inflation, central bank tightening and increased bond issuance (to fund investments in defense and alternative energy supply) could push yields higher, while these higher yields and downside risks to growth could also offer opportunities for bond investors. Dynamic duration management can help to navigate these markets, both to offer protection against rising yields and to benefit when bonds rally again. The deep-sample back-test described in our academic paper shows that bond market timing works well in adverse environments, including during periods with high inflation and low growth.

Important information

This information is for informational purposes only and should not be construed as an offer to sell or an invitation to buy any securities or products, nor as investment advice or recommendation.
The contents of this document have not been reviewed by the Monetary Authority of Singapore (“MAS”). Robeco Singapore Private Limited holds a capital markets services license for fund management issued by the MAS and is subject to certain clientele restrictions under such license.
An investment will involve a high degree of risk, and you should consider carefully whether an investment is suitable for you.

Logo

Important Information

Warning/Important note: This website contains information which is only available to qualified investors as defined below. If you are not a qualified investor, please click “I Disagree” to leave the website.

By clicking on "I agree", I declare that: 

  • I am a qualified investor as defined under 1
  • I have read and understood the Terms and Conditions and Disclaimers as described under 2

1 - This website may only be accessed directly or indirectly by the following persons in Singapore:

1) “institutional investor” under section 304 of the Securities and Futures Act (Cap.289)(“SFA”), which means:
(i) the Government; (ii) a statutory board as may be prescribed by regulations made under section 341 of the SFA; (iii) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is (A) to manage its own funds; (B) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or (C) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country; (iv) any entity (A) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and (B) whose funds are managed by an entity mentioned in sub-paragraph (iii); (v) a central bank in a jurisdiction other than Singapore; (vi) a central government in a country other than Singapore; (vii) an agency (of a central government in a country other than Singapore) that is incorporated or established in a country other than Singapore; (viii) a multilateral agency, international organisation or supranational agency as may be prescribed by regulations made under section 341 of the SFA; (ix) a bank that is licensed under the Banking Act (Cap.19); (x) a merchant bank that is approved as a financial institution under section 28 of the Monetary Authority of Singapore Act (Cap.186); (xi) a finance company that is licensed under the Finance Companies Act (Cap.108); (xii) a company or co-operative society that is licensed under the Insurance Act (Cap.142) to carry on insurance business in Singapore; (xiii) a company licensed under the Trust Companies Act (Cap.336); (xiv) a holder of a capital markets services licence; (xv) an approved exchange; (xvi) a recognised market operator; (xvii) an approved clearing house; (xviii) a recognised clearing house; (xix) a licensed trade repository; (xx) a licensed foreign trade repository; (xxi) an approved holding company; (xxii) a Depository as defined in section 81SF of the SFA; (xxiii) an entity or a trust formed or incorporated in a jurisdiction other than Singapore, which is regulated for the carrying on of any financial activity in that jurisdiction by a public authority of that jurisdiction that exercises a function that corresponds to a regulatory function of the Authority under this Act, the Banking Act (Cap.19), the Finance Companies Act (Cap.108), the Monetary Authority of Singapore Act (Cap.186), the Insurance Act (Cap.142), the Trust Companies Act (Cap.336) or such other Act as may be prescribed by regulations made under section 341 of the SFA; (xxiv) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere; (xxv) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors; (xxvi) the trustee of such trust as the Authority may prescribe, when acting in that capacity; or; (xxvii) such other person as the Authority may prescribe.

2) “relevant person” under section 305(1) of the SFA, which means:
(i) An accredited investor; (ii) a corporation the sole business of which is to hold investments and the entire share capital of which is owned by one or more individuals, each of whom is an accredited investor; (iii) a trustee of a trust the sole purpose of which is to hold investments and each beneficiary of which is an individual who is an accredited investor; (iv) an officer or equivalent person of the person making the offer (such person being an entity) or a spouse, parent, brother, sister, son or daughter of that officer or equivalent person; or (v) a spouse, parent, brother, sister, son or daughter of the person making the offer (such person being an individual).

3) any person who acquires the units [in a collective investment scheme] as principal if the offer is on terms that the units may only be required at a consideration of not less than $200,000 (or its equivalent in a foreign currency) for each transaction, whether such amount is to be paid for in cash or by exchange of units in a collective investment scheme, securities, securities-based derivatives contracts or other assets, and if the following condition is satisfied: (i) the offer is not accompanied by an advertisement making an offer or calling attention to the offer or intended offer; (ii) no selling or promotional expenses are paid or incurred in connection with the offer other than those incurred for administrative or professional services, or by way of commission or fee for services rendered by any of the persons specified in section 302B(1)(d)(i) to (vi) of the SFA; and (iii) no prospectus in respect of the offer has been registered by the Authority or, where a prospectus has been registered (A) the prospectus has eAccxpired pursuant to section 299 of the SFA; or (B) the person making the offer has before making the offer 1. informed the Authority by notice in writing of its intent to make the offer in reliance on the exemption under this subsection; and 2. taken reasonable steps to inform in writing the person to whom the offer is made that the offer is made in reliance on the exemption under this subsection.

4) Or otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA.

If you are not any of the types of persons described above, you are not authorized to enter this website and you should leave this website immediately.

2 Terms and Conditions
You acknowledge that you have read these Terms and Conditions (“Terms”) prior to accessing the website located at www.robeco.com/sg (“Website”) and you agree to be bound by the Terms.  If you do not agree to all of the Terms, you are not an authorised user and you should not use the Website. The Website is owned by Robeco Singapore Private Limited (company registration number: UEN. 201541306Z), which is licensed by the Monetary Authority of Singapore (“MAS”) pursuant to the Securities and Futures Act (Cap.289) (“SFA”) of Singapore, and is managed by Robeco Singapore Private Limited and/or its affiliates (collectively, as “Robeco”). The Website is intended for and should be accessed by institutional investors or accredited investors (as defined under Section 4A of the SFA) of Singapore.  The Website is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject the Robeco to any registration or licensing requirement within such jurisdiction.  It is your responsibility to observe all applicable laws, rules and regulations of any relevant jurisdiction. The content contained in the Website is owned by Robeco and/or its information providers and is protected by applicable copyrights, trademarks, service marks, and/or other intellectual property rights.  You may not copy, distribute, modify, post, frame or link the Website, including any text, graphics, video, audio, software code, user interface, design or logos.  You may not distribute, modify, transmit, reuse, repost, or use the content of the Website for public or commercial use, including all text, images, audio and/or video.  Robeco may terminate your access to the Website for any reason, without prior notice. Neither Robeco, nor any of its associates, nor any director, officer or employee accepts any liability whatsoever for any loss arising directly or indirectly from the access of the Website.  You agree to indemnity and hold Robeco, its associates, directors, officers or employees harmless against any and all claims, losses, liability, costs and expenses arising from your use of the Website due to violation of the Terms. Robeco reserves the right to change, modify, add or remove any parts of the Terms at any time and for any reason.  The Terms shall deemed to be effective immediately upon posting. The Terms shall be governed by, and shall be construed in accordance with, the law of Singapore.

Disclaimers
The Website has not been reviewed by the MAS. Accordingly, the Website may not be accessed directly or indirectly to persons in Singapore other than (i) to an institutional investor under Section 304 of the SFA, (ii) to a relevant person pursuant to Section 305(1), or any person pursuant to Section 305(2), and in accordance with the conditions specified in Section 305, of the SFA, or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. 

Nothing in the Website constitutes tax, accounting, regulatory, legal or investment advice.  The Website is for informational purposes only and should not be construed as an offer to sell or an invitation to buy any securities or products, nor as investment advice or recommendation or for the purpose of soliciting any action in relation to Robeco’s businesses, or solicitation by anyone in any jurisdiction in which such an offer or solicitation is not authorised or to any person to whom it is unlawful to make such an offer and solicitation. Any reproduction or distribution of information from the Website, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited.  By accessing to the Website, you agree to the foregoing.  

The funds referred to in the Website are for information only.  It is not a recommendation or investment advice, nor does it mean the funds is suitable for all investors.  The contents of the website is not reviewed by the MAS.  Any decision to participate in the funds should be made only after reviewing the sections regarding investment considerations, conflicts of interest, risk factors and the relevant Singapore selling restrictions.  You should consult your professional adviser if you are in doubt about the stringent restrictions applicable to the use of the Website, regulatory status of the funds, applicable regulatory protection, associated risks and suitability of the funds to your objectives.

Any decisions made based on the information contained in the Website are the sole responsibility of yours.  Any investments made or to be made shall be with your independent analyses based on your financial situation and objectives.  The investments and strategies contained in the Website may not be suitable for all investors and are not guaranteed by Robeco.  

Investment involves risks and may lose value.  Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future.  The value of your investments may fluctuate.  Past performance is no indication of current or future performance.  The Website may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies and such projection or forecast is not indicative of the future.  The information contained in the Website, including any data, projections and underlying assumptions are based upon certain assumptions, management forecasts and analysis of information available on an “as is” basis and without warranties of any kind, whether express or implied, and reflects prevailing conditions and Robeco’s views as of the date published or indicated, and maybe superseded by subsequent events or for other reasons.  The information contained in the Website are accordingly subject to change at any time without notice and Robeco are under no obligation to notify you of any of these changes.  Robeco expressly disclaims all liability for errors and omissions in the information presented in the Website and for the use or interpretation by others of information contained in the Website.

Robeco Singapore Private Limited holds a capital markets services licence for fund management issued by the MAS and is subject to certain clientele restrictions under such licence.  An investment will involve a high degree of risk, and you should consider carefully whether an investment is suitable for you.

I Disagree