Fixed income investors are currently navigating a highly uncertain environment featuring two competing market narratives. The first of these is a cautious risk-off scenario highlighting high corporate debt levels, the dependence of the market on central bank support (and the related market fragility), elevated unemployment in many economies and large gaps between potential and actual GDP. The opposing narrative is an optimistic risk-on scenario emphasising the gargantuan fiscal and monetary stimulus in response to the pandemic, as well as the ongoing COVID vaccine rollout and the anticipation of economies reopening. This case for optimism is dominating market sentiment at present.
But with an optimistic outlook comes reflation and concerns that rising inflation will take root. This has led fixed income investors to shun duration or rates risk in favour of credit – to turn to credit in the hunt for yield. Also behind the shift to credit is scepticism about whether higher levels of inflation will indeed prove elusive, allowing the US Federal Reserve to refrain from raising rates until its signalled 2023 time frame. Spreads are now trading at pre-pandemic levels, leaving little spread cushion in the event of market dislocation and a less optimistic scenario playing out.
Implications of the environment
This low-yield, low-spread environment has important implications for fixed income investors. One is that it is currently very challenging to invest for the long term given the enormous scale of intervention by monetary authorities. This monetary accommodation has depressed interest rates, which means investors need to place more emphasis on alpha generation to meet total return expectations consistent with the past.
A second implication of the current environment is that an active, flexible long-term approach within a broad global universe maximises the opportunity set for investors, as it allows different levers to be pulled to achieve alpha and total return targets.
A third implication is that as central banks encourage investors to take more risk in order to generate the same level of total returns as in the past. A strong investment research platform is key, not only to generating the alpha opportunities that security selection provides, but also to mitigating the risk of capital loss. Many investors have been lulled into a state of complacency regarding credit default risk given the current monetary accommodation.
Expanding the opportunity set
Investors who expand their opportunity set and embrace a flexible global multi-asset approach are arguably better placed to generate the alpha needed to sustain the required levels of risk-adjusted returns. However, they face a conundrum: Move too much into high-yield and emerging markets and you end up with a high correlation to equities and the risk of drawdowns; invest too little in higher-yielding credit and portfolios will likely fall short of return objectives.
Given the risks of misallocating capital today, it is valuable to be able to pull different levers to generate alpha in a portfolio while maintaining the defensive characteristics of fixed income. Although there is no silver bullet when it comes to ways for portfolio managers to add yield in a global multi-asset portfolio, here are four:
1. Duration is not much in demand, as mentioned. Dislocations in the rates markets can present alpha opportunities, though. It will be interesting to see how different markets emerge from the pandemic. For the first time, after years of highly synchronised rate moves, beta volatility and dispersion are expected to increase, presenting opportunities for active managers.
2. Credit. Investing in credit is a long favoured way of adding yield; however, given compressed spreads in many markets, including global investment-grade, global high-yield and even emerging market corporate bonds, prudent security selection and diversification are called for. The correlation between credit and equities is a further consideration, and drawdowns can be large on the lower rungs of the credit quality ladder.
3. Liquidity. Investors tend to say they don’t need liquidity until they do. Liquidity can be plentiful, until it isn’t! It is important to understand where liquidity can be drawn from in a portfolio, particularly in volatile market conditions. Ideally, you want to be the provider of liquidity in challenged markets and if you are going to hold illiquid assets then you need to get clear compensation for illiquidity risk beyond the spread compensation. Otherwise, liquid fixed income portfolios can become illiquid through illiquidity creep.
4. Leverage. Like duration, leverage is out of favour, but since the global financial crisis, it has clearly crept back into portfolios as a high-risk source of yield. As we have seen in recent hedge fund debacles, leverage is just as fallible today as it has always been; it requires a steady hand on the tiller with superior risk management.
Our approach to investing in global multi-asset portfolios is predicated on employing these levers within a robust risk management framework to provide diversification and a consistent level of alpha and risk-adjusted returns. An active, flexible long-term approach within a broad global universe and with a strong focus on security selection gives investors the benefit of a larger playing field so they might maximise the opportunity set for investors. Current levels of yields and spreads, combined with a high degree of market uncertainty, suggests this is more important than ever.
Pilar Gomez-Bravo, director of fixed income – Europe, MFS Investment Management
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