(October 14, 2013) — The fixed income markets have become less efficient post-2008, a Goldman Sachs Asset Management (GSAM) report has argued.
With this decline in efficiency has come added opportunities for alpha returns independent from falling interest rates and beta exposures.
The paper concluded that the global fixed income and currency markets experienced a “tangible shift” in the roles of central banks and brokers and dealers. This has granted investors the potential to gather returns from relative value and idiosyncratic risk strategies.
This shift was the result of two significant changes following the financial crisis, according to GSAM. Firstly, broker dealers have been taking fewer risks and reducing market-making activities largely due to stricter regulations. Secondly, central banks have adopted a more interventionist role.
From these two major changes, post-crisis market activities have been driven more by policy objectives rather than profit-seeking motives, GSAM stated.
GSAM found that these changing trends also caused significant market volatility, which in turn decreased fixed income market efficiency and brought on pricing distortions.
Such market inefficiency increases opportunities for relative value and idiosyncratic risk, the authors noted. Price distortions were more frequent and larger post-2008 and the bond market has become more global while the circle of fixed-income investors has become smaller.
“These trends provide the potential to construct a broad and diversified portfolio of investment strategies focused on relative value, where the manager seeks pricing relationships that have become skewed by flows and then implements trades intended to profit from those value relationships reverting to previous norms,” the report said.
The effects of high volatility and complex and differentiated investment themes have been particularly felt in emerging market, the report found.
“The result of these shifts so far has been a broad sell-off in emerging market debt, with particular pressure on emerging countries with large current account deficits that rely on foreign inflows,” GSAM said.
In “capturing the opportunity set,” GSAM recommended investors seek alternative and unconstrained fixed income investment strategies—hedge funds, in particular—that would allow investors to take on alpha-driven trading methods dealers would normally utilize.
“Hedge funds can implement long/short positions and are not constrained by traditional boundaries between emerging and developed markets, investment-grade and non-investment grade sectors and other limitations on the types of instruments and strategies that can be employed,” the report argued.
Related content: Where Are the Sharpe Returns Now?, Lessons from Lehman