Many a market practitioner has been humbled in recent years trying to project the direction of US interest rates. Professional forecasters, futures markets, and even the Federal Reserve have all consistently gotten their interest rate calls wrong over the last half-decade. At MFS, explains Bill Adams, MFS Chief Investment Officer, Global Fixed Income at the firm, “we devote a great deal of fundamental analysis to forecasting rates, duration and the shape of the yield curve, and those elements make up an important part of our alpha generation toolkit”. However, given the extraordinarily difficult and unusual market environment of recent years, the firm recognizes there is an unusually low probability of getting one's rate call correct, and an even lower probability of getting it right consistently. That is simply not a reliable or durable source of alpha generation within a well-managed fixed income portfolio.
In our view, says Adams, consistent alpha generation depends on actively managing multiple sources of risk. “We view the portfolio construction process a bit like an inverted pyramid. At the bottom of the pyramid are the factors hardest to consistently anticipate—rates, duration, and curve positioning. Next come currencies, another piece of the portfolio notoriously difficult to forecast. Against the present market backdrop, unduly influenced by global central bankers, these are the lowest conviction pieces of our alpha pyramid”, points out the CIO.
In the current environment, MFS believes that it can add more durable and sustainable alpha by engaging in a thorough process of analyzing and underwriting both corporate and sovereign credit. So security selection and sector and regional allocations are areas we approach with the greatest conviction. While you cannot generate excess returns without taking risks, we believe it is critical to take risks that are appropriate.
“Allocating assets to multiple regions is an alpha source we embrace”, explains Adams in the MFS blog. “Bringing together securities from multiple regions and reducing home country bias in a fixed income portfolio helps improve risk adjusted returns, in our view. It is also important to look beyond absolute levels of return and focus on relative return opportunities. In isolation, a 10-year US Treasury bond yielding 1.80% is not all that attractive. But compared to a Japanese 10-year JGB with a negative yield or a German 10-year bund with a yield not far north of zero, the value of the US security becomes clearer”.
As we move up the inverted alpha pyramid, the conviction grows. Moreover, MFS prefers underwriting individual credits by leveraging our global research platform to trying to make a significant call on the direction of 10-year Treasury yields. That research capability allows the firm to better manage risk. This is where MFS place its greatest conviction, with a deep understanding of both sovereign and company credit fundamentals. “Our global research platform leverages not only fixed income analysts, but equity and quantitative analysts as well, who provide a deeper understanding of individual corporate credits. To truly understand credit fundamentals, an investor must assemble a complete view of a company's capital structure”, says Adams.
In the unusual global economic and interest rate environment that exists today, MFS believes fundamental, country-by-country and company-by-company analysis is a much more durable and sustainable alpha source than interest rates bets.