According to Jon Mawby, Head of Investment Grade Credit at Pictet Asset Management (Pictet AM), investors need to rethink the way they manage risk in their fixed income portfolios. Coming from a decade of double-digit US bond yields in the late 70s and early 80s, the “Total Return Fund” era started in the late 80s and during the last 35 years has benefited from the counter-cyclical monetary policies exercised by the Federal Reserve. In more than three decades, US government and corporate bond yields have experienced lower highs and lows. This has been largely driven by the monetary policy response implemented by Alan Greenspan, Ben Bernanke, Janet Yellen, and Jerome Powell, former and current Chair of the Federal Reserve Board, through a series of financial crises.
More recently, all the stimulus that has been pumped into the system to fight the coronavirus crisis, -the successive cuts in interest rates, the unlimited QE and the several lending programs that were announced back in March-, has left US bond investors facing close to zero or negative yields. This is a hugely different environment in which traditional bond investment can lead to losses in capital or in purchasing power, hence the need of investors to reevaluate the way they manage their fixed income portfolios.
The challenges faced by investors today
In Pictet AM’s opinion, after the Global Financial Crisis, the starting point for asset allocators of a traditional 60/40 portfolio is largely misguided. This is broadly driven by the fact that global government bonds in traditional fixed income portfolios were considered a vehicle to store value that offered a reasonable yield and that, in a wider portfolio context, had lower or negative correlation to risk assets. These three characteristics allowed traditional fixed income funds to deliver attractive returns and diversified risk across a wider risk asset portfolio over several cycles.
US 10-year Treasuries and many other government bonds in developed markets are now offering yields below the 1% threshold. At this level, government bonds have a limited upside and a potentially large downside risk if economies move from a deflationary to an inflationary environment. Therefore, investors can no longer rely on the traditional model to produce the same risk-return characteristics going forward.
This leaves investors with essentially two traditional choices in terms of long-term asset allocation, equity like risk assets (corporate credit, direct equity, or private equity) and cash. Hence, even though investors may not realize it, portfolios that follow this traditional 60/40 asset allocation mix are by design riskier than historical models will predict. This applies both generally to risk asset portfolios and more specifically to credit and fixed income products.
The macro drivers
The Fed has cut rates from 2,5% down to 0%, but the compressions in corporate bond yields came from 150 basis points to 75 basis point, this is quite little to cushion investors from the volatility around the credit markets. Hence, investors need a different way to think about how they manage risk in their fixed income portfolios.
In Mawby’s opinion, investors need to be a bit contrarian and value driven. They can no longer rely on their government bond exposure to offset the equity like risk exposure in their portfolios. Investors now need to think about managing fixed income in a more proactive way, it is no longer enough to have some degree of credit and equity risk long to effectively diversify a portfolio.
What are the investment implications of the COVID 19 crisis?
This crisis leaves some opportunities to explore. It has created dislocations in price, generating potential opportunities to pick up companies with strong balance sheets at attractive valuations. At the current levels, selected corporate hybrids and out of the money convertible bonds offer attractive opportunities. But investors need to remain highly selective in primary markets amid a deluge of corporate issuance. Additionally, the intervention of central banks continues to distort investment grade credit curves while US Treasury bonds volatility has recently receded back to pre-crisis levels.
On the other hand, there are many risks that need to be considered. There are ‘cheap’ value traps given associated with solvency, downgrade, and default risks. The path to emergence from lockdown remains mixed and fraught with potential obstacles for some industries, particularly for those associated with the service sector, like restaurants and airlines.
Meanwhile, dispersion is increasing across the credit market- there is a need to retain optionality in the form of risk overlays and downside protection, as there is still potential for further liquidity challenges in credit. This claims for an up in quality stance across both US and Europe.
Particularly, one of the areas that Pictet AM is a bit more cautious on is the subordinated debt in the financial sector, the Additional Tier 1 hybrids bonds could be affected by potential regulatory risk and this could have a ripple effect for coupons and dividends.
Given this backdrop, managing volatility is going to be especially important in the next 6 to 18 months in terms of navigating another downturn. When looking back in time, crises seem to be occurring in 18 to 24 months cycles – Sovereign debt crisis in Europe in 2012, taper tantrum in 2013, oil crisis in 2014 and 2015, Brexit in 2015, “Trumpflation” in 2017 etc.-, as intervention and rhetoric are driving more and more the alternation of increased volatility periods with other periods of yield and volatility repression. This gives an advantage to investors that think about volatility in a less traditional way.
Broader portfolio themes and opportunities
Starting with the “Powell pivot”, as the last monetary stimulus package launched by the Federal Reserve has become known, the new measures have brought interest rates back to 0 and have followed a QE program at unprecedented levels. In turn, these actions have created distortions and mispricing opportunities that can be exploited by investors, especially in convertibles, corporate hybrids, and QE eligible bonds. On the other hand, they have also created agency issues in the corporate sector related to historically low rates.
In addition, there are also opportunities driven by the increase of volatility, as uncertain environments create dispersion and dislocation in prices that can be released if investors think about risk in a proactive way.
Then, looking at high yield and idiosyncratic positions in the portfolio, sources of yields can be added when they make sense, selecting names with limited cyclicality, event-driven names, and rising stars (companies that are deleveraging their balance sheets and considered as credit upgrade candidates).
Looking to the medium-term, there is a probability that at some point the narrative could shift as lookdown emergence continues. The possibility of developed markets seeing double digit growth is a potential bullish catalyst for risk assets and is something the team will be monitoring closely. Therefore, it is important to keep a close eye on data releases and how they shape sentiment in the short-term.
Conclusion
Downside risks have increased, and fixed income portfolios have become riskier by design. In Mawby’s view, traditional fixed income strategies will no longer deliver what investors need from their asset allocation when they need it. Hence, it is necessary to rethink risk and how to navigate the cycle. Moreover, central bank and investor actions have distorted the playing field, that is why fixed income investors need to consider a contrarian and value driven stance, to get advantage of volatility when it occurs and to get what they want out of bonds: diversification, downside protection and income.
Information, opinions and estimates contained in this document reflect a judgment at the original date of publication and are subject to risks and uncertainties that could cause actual results to differ materially from those presented herein.
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