Fixed income account managers find themselves faced with a conundrum: prevailing global interest rates are at historical lows and credit spreads painfully tight, so where do they go to pick up the kind of returns that form their targets?
At first glance, much would appear to be stacked up against fixed income fund managers. The list of obstacles to overcome in order to satisfy the kind of returns demanded from internal performance mandates is long and varied. Short-term lending rates in the major currencies are next to zero, safe government bond yields are not much higher and the benefits of taking on additional credit risk is, at least in investment-grade bonds, minimal.
In addition, the interest rate market is effectively at – or very close to – the point of reaching the end of a 34-year bull run.
“You can’t put money into a plain vanilla bond fund any more and expect a 5% return,” said Charlie Diebel, head of rates at Aviva Investors. “There is no return without risk. If you are after absolute return of that magnitude, you need a clever trade for alpha and to manage the risk appropriately.”
That is a view shared around the investment community.
“Investors will have to get used to lower returns (compared to the last 30 years),” said Alex Gitnik, investment director of fixed income and absolute return at Standard Life Investments. “There’s an acceptance that benchmark-agnostic investing can deliver better risk-adjusted performance, and investors will have to change their toolkit in order to supplement performance.”
That suggests that the strict internal mandates that dictated investment strategies in the past are being relaxed.
“Mandates have become more flexible over time,” said Roger Webb, senior investment manager at Aberdeen Asset Management. “Mandates are not completely strict, with investment-grade funds able to go off benchmark into high-yield, for instance.”
Mandates unchained
There is a move in the fixed income world from traditional benchmark investing into taking unconstrained exposure – at least with a proportion of the portfolio. That proportion varies according to the aims of the investor. Institutional investors and pension funds will still need to buy bonds to match specific liabilities, but even within the more conservative names in the industry there are signs of investment parameters being loosened in order to seek out absolute returns.
Absolute return funds allow the fund manager to branch out into yield-enhancing opportunities by, for instance, going short, going down the credit spectrum, investing in non-traditional assets and taking views on the expected shape of the yield curve.
Moving to a more dynamic approach to investing also brings with it added responsibility on the fund manager. Choosing the right manager with the necessary skills to take on this responsibility is becoming increasingly important.
“Reaching out into new instruments comes with risks,” said Gitnik. “You have to be diligent with respect to the manger you hire.”
As the market treads water at the bottom of the interest rate cycle, fund managers are positioning portfolios to accommodate future tighter monetary conditions. Many had expected the US Federal Reserve to start tightening following the September FOMC meeting. But no hike was announced but, the parlous state of the world economy cited as the reason. Instead, what was forthcoming was a lowering of the end-2016 Fed funds target to 1.4% from June’s 1.6% projection.
It looks clear that low interest rates will prevail for the foreseeable short-term future.
“Looking at inflation, there’s still time for monetary policy to run hot rather than cold,” said Diebel. “Even though the markets are well poised for the Fed to pull the trigger, it’s looking like lower interest rates for longer.”
Nevertheless, with tighter money in mind at some point next year, the market remains defensive and volatile.
“There are degrees of defensiveness,” said Andrew Readinger, head of institutional fixed income sales at Commerzbank. “There are those that are chugging along, resigned to the low interest rate scenario and those that are piling up the cash, preparing for a market meltdown.”
While holding a proportion of cash is an option for some investors, fundamental support for the interest rate and credit markets prevails and is underpinned by activity within the central banks (as they continue to pursue their quantitative easing policies) and demographics, where an aging population brings with it pension liabilities. This is reflected in market activity, where seemingly every time yields rise, there is a reallocation of funds back into fixed income.
Even at current levels, there is value in the market: the yield curve continues to offer positive carry, while the increased discretion given to fund managers allows them to reach out into credit markets or into more esoteric positions.
“Trades that have positive carry and roll down positively make a reasonable amount of money and you can supplement those returns with high-beta positions,” said Diebel.
Investment-grade bond spreads, while tight, still offer a relatively good return over risk free assets while moving out into high-yield or emerging markets brings with it the accompanying returns.
“It’s been a very robust year for high-yield in Europe,” said Readinger. “Investors also extend their remits below investment-grade for the right names and there’s been increasing demand from high-yield funds.”
A move into sub-investment-grade or down the capital structure also brings with it a requirement to fully understand the credit, and credit research is an essential aspect of investing in these sectors. Corporate names in demand are those seen as relatively safe, perhaps those that may have slipped down the ratings scale in recent times and ones that are linked to growth sectors with cashflows that will benefit from an uptick in cyclical economic momentum.
Taking positions in high-yield or emerging markets has the additional risk of illiquidity. Liquidity, in general, has become an issue in the wholesale market where action by the regulators has resulted in a dwindling appetite for risk in the investment banks.
While liquidity is something taken into consideration as part of the investment rationale, it does not appear to be a huge issue for the buyside.
Investors are not constrained to taking short-term trading views on the market. They have the luxury to take a step back and think about how the world will evolve.
“We’re not in the market trading for 5bp,” said Diebel. “We’re looking for bigger, much longer moves.”
Even so, portfolios are constantly being analysed and positions adjusted – there may just be some delay in getting the business done as markets gyrate between bid only or offered only, depending on the day. The market is adjusting to the new paradigm in different ways.
“Portfolios consist of smaller sized holdings to mitigate illiquidity, as well as to offer diversification,” said Webb. “We can also use derivatives to hedge out specific risk or, with the indexes, hedge against volatility.”
Liquidity is still important, however. “We’d still like to pay for liquidity rather than be paid for illiquidity,” said Webb.
Fortunately, the primary market has been busy providing an element of liquidity as borrowers stock up on cheap, absolute funding with the foresight to offer new issue premiums to those afforded by secondary trading levels.
Private party
The lack of secondary liquidity is also fuelling activity in other sectors of the bond market, as investors with different time horizons react to the current trading limitations.
“What’s the value of benchmarks versus structured products and private placements?” said Readinger. “We’ve been active in private placements across a number of sectors, both large size and with club-type deals. We’ve also seen more and more business on the structured notes side.”
This kind of business has attracted a variety of issuers into the market. For instance, firms that have traditionally tapped the syndicated loan market have been tempted to venture further out the maturity spectrum by issuing bonds over and above the historical five-year limit of bank lending. Deals are printed in the popular seven-year maturity and some go out much further to the 20 or 25-year mark.
Conversely, there are opportunities for the traditional bond market investor to take a look at, and participate in, the syndicated loan market.
Structured notes are typically built around a series of calls or with constant maturity swaps, as investors express their views on future interest rate levels and the shape of the yield curve.
“The view seems to be a steeper curve in dollars and in euros it’s flat,” said Readinger.
Trades capturing expectations as to the future term structure of interest rates are popular but there is no consistency as to the likely outcome.
A likely steepening of the dollar curve is corroborated by Aviva’s Diebel, who also thinks steeper term rates are not out of the question in euros. “We like forward-starting steepeners in dollars,” he said, “And there are some attractive entry points for steepeners in euros.”
Standard Life’s Gitnik prefers to express a different scenario in the US. “We are exploring relative value along the curve with a butterfly position in the US,” he said. “We expect the curve to flatten over time as short-term rates start to rise.”
The turnaround in the interest rate cycle may yet be some way away and the pace of any tightening may be limited, but fixed income as an asset class will continue to be an essential investment vehicle. However, it will be one that no longer offers the kind of returns investors have been used to for decades and one where fund managers will have to look further afield in order to generate additional levels of performance over benchmark investing.
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