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Opportunity knocks for fixed income investors who are not forced to ‘hug’ market indices.
Whether it’s cliché or understatement to say so, we live in interesting times. Political uncertainties, changing monetary policy and resilient global growth all pose significant challenges for bond investors. Yields on 10-year US Treasuries have recently risen to their highest level for four years, prompting some commentators to call the end of the 37-year bull market in bonds.
Of course, we have seen spikes in bond yields during the long bull market – as in 2004 to 2006, for example, when the Federal Reserve embarked on a modest tightening cycle. But this time, things really could be different. Why? Because duration – sensitivity to changes in interest rates – is higher than it has ever been. And that means that markets are much more susceptible to a sustained move higher in interest rates than they were during previous periods of stress.
Meanwhile, the low base from which yields are rising poses dangers of its own. The total return on a fixed income index, we should never forget, is part coupon (the interest payment) and part capital appreciation (or depreciation!). When there have been moments of stress during the long bull market, delivering negative periods of capital return, the coupon payments have acted as a cushion ensuring that total returns have on the whole been positive. Today, with yields at significantly lower levels, there is much less scope for that as more recently issued bonds have reset at the current coupon rates, reducing the previously afforded protection.
But while these interesting times pose threats, they also create opportunities – particularly for active investors who have the freedom to exploit them and who are not forced to ‘hug’ market indices that might be poised for declines.
Firstly, the indiscriminate buying that we’ve seen as yields fall is unlikely to continue when things go into reverse – especially as price-insensitive buyers such as central banks scale back their purchases. Security selection should come to the fore. Historically, credit dispersion has risen along with overall credit spreads. In other words, a less correlated market offers greater opportunities for active managers who have the process and expertise in terms of credit research to both identify opportunities as well as avoiding unfavourable situations.
The most obvious advantage of an active approach is the ability to avoid the fate of the overall market. As bond indices are based on issuance, benchmarks inevitably lead you to the most heavily indebted companies: those that have issued the most bonds. Active investors have the opportunity to position their portfolios so that they can take exposure to companies that have stronger cashflows as well as clearly defined repayment strategies, in addition there is the opportunity to disaggregate credit risk from that of interest rate risk, focusing on shorter duration bonds than the broader market.
At a time when passive approaches are increasingly dominant in the equity markets, it’s worth noting that fixed income markets are very different from equities. Their upside is potentially capped, so it’s the downside – the risk of default – that you really have to worry about. And that is where active credit analysis can offer a real advantage.
Yet another consideration is the huge amount of variation within the bond market. Even the same company’s issues typically offer differing maturities and differing levels within the capital structure (either senior unsecured through to subordinate and contingent capital issues). An active investor carrying out in-depth analysis of these issues, would look to focus on maximising the risk adjusted return of their decisions and not own all the companies issues indiscriminately as would be the case within an index.
Liquidity is important too. Increased regulation has challenged liquidity at a time when banks are less inclined to act as market-makers than they were in the past. It is therefore imperative to consider the dynamics of both entering and exiting positions when considering the overall return dynamics of each active investment decision. Execution strategies continue to play an important role in the overall process.
So, as an unprecedented period of central-bank policy comes to an end, these are indeed interesting times for the bond markets. According to contemporary folklore, ‘May you live in interesting times’ is an ancient Chinese curse. But for skilled active investors, a market characterised by greater uncertainty and higher dispersions will provide the opportunities to deliver on the expected outcomes.
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