Asset Management

9 questions to our Fixed Income experts

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Mark Holman

Chief Executive Officer TwentyFour Asset Management, Portfolio Manager

Today, in an increasingly divided world, fixed income investors face unprecedented threats to their long-term investment objectives, so we asked professional investors in nine different markets to share the key questions they face. We challenged Simon Lue-Fong, Head of Vontobel’s Zurich-based Fixed Income Boutique and Mark Holman, CEO and Portfolio Manager of TwentyFour Asset Management in London to provide their perspectives on the answers.

While Mark and Simon have slightly different views, they do both agree that there are a great many opportunities if you “unfix your thinking” to take a fresh look at the fixed income markets.

1.    With interest rates so low (and even negative in some areas), what do you think should be the role of Fixed Income in a portfolio?

Holman: Despite low rates, for me the role of fixed income has not changed; it should be the defensive portion of portfolio construction and there as the most reliable source of income certainly when compared with equities right now. There are some additional benefits such as traditionally having negative correlations with other asset classes, but with rates so low these benefits are currently minimal, so as managers we have to unfix our thinking and positioning to best achieve the goals of clients.

2.    With more than 30% of the bond’s universe offering negative yields, where could clients look to invest for a positive yield?

Lue-Fong: Let’s look at the other side of that, 30% negative yielding means 70% is positive yielding. So the cup is over two-thirds full. Of course, a large chunk of that is barely positive, low-yielding bonds. For us, anything with yield is interesting and it’s the emerging markets and corporate credit asset classes where there are still plenty of pockets with substantial yield to be found, for both risk-averse and risk-taking investors.

Holman: History shows us we should look to embrace pro-cyclicality in credit to try to maximise returns as this new cycle progresses, but I think timing here will be critical. It also tells us that government bond yields will likely start to drift higher, led by the long end, so we must be wary of this as there would be losses in government bonds, particularly if the extraordinary policy actions do change inflation expectations. With strong support from governments and central banks remaining in place and a robust economic recovery anticipated in the second half of 2021, we see credit spreads continuing to grind tighter this year and we think investors should be predominantly invested in credit to try to benefit from this. However, it may still be slightly too early to be fishing in the very lowest rating categories in a meaningful way, as this is where historically the vast majority of defaults have occurred and we think the default rate is likely to still be increasing for the first part of the year. Instead, investors should favor companies considered to have robust balance sheets and greater visibility on future earnings. In our opinion, there are better sources of pro-cyclicality available at present, such as European CLOs, subordinated financials and corporate hybrids.

3.    What could drive credit spreads higher, and is duration the biggest risk for a credit investment in 2021?

Holman: In our view, by far the biggest risk to credit in 2021 remains a shock in relation to the COVID-19 pandemic. The rollout of various vaccines has offered investors a light at the end of the tunnel, resulting in a high degree of consensus around a very robust economic recovery in the second half of the year. However, this could change quickly if, for example, a new variant of the virus were to render one or more of the vaccines less effective and the large scale return to normality was threatened.

Interest rate duration has come more into focus with the Democrats taking control of the US Senate, boosting the prospect of further stimulus from the Biden administration and – in the view of some analysts – higher inflation pushing the Fed into earlier rate rises. Biden’s ‘Blue Sweep’ may change some investor projections, but while we do see inflation ticking up in 2021, we don’t see it becoming an issue for the Fed in the near term. Close to nine million US jobs were destroyed in 2020, and that considerable slack in the labour market means it is hard to see wage pressures building, which in our view is the main factor that would prompt the Fed to tighten monetary policy.

Having said that, there are a number of factors that are different today when it comes to the prospect of future inflation, perhaps most notably the growth of broad money as the banks are no longer shrinking their balance sheets, as they were for a number of years following the global financial crisis. We think inflation concerns are likely to surface as the year goes on as record stimulus continues to be poured on what we expect to be a robust recovery. We believe the upshot is likely to be a bear steepening of rates yield curves, in particular for US Treasuries.

4.    There seems to be consensus that the US dollar will weaken in 2021. What currency positioning makes sense for a euro investor in 2021?

Lue-Fong: I mentioned EM already and there the US dollar is a key factor. Therefore, euro-based investors need to pay close attention to that. Broadly speaking, the US dollar should be weaker through 2021. Many emerging market currencies suffered in 2020 and there’s still plenty of potential for EM currencies to progress. This means the much-maligned local-currency market has potential in 2021. Many EM countries tend to be exporters and in 2021, as the corona crisis hopefully recedes on the back of vaccines, these countries will start to experience growth along with the rest of the world. Local markets are relatively under-owned, combine this with interesting currency valuations and economic growth and we should see emerging market currencies reprice positively.

One caveat for euro-based investors to keep in mind is that as the US dollar declines, then it’s likely that the euro appreciates. So, from a euro to emerging local-currency perspective, the overall move might not be as generous as for US dollar investors, thus taking away some of the profit. Therefore, for euro investors, I would say taper your expectations for currency appreciations, but take advantage of the growth and value available in emerging market local-currency bonds.

5.    Where are you seeing opportunities in EM?

Lue-Fong: We think investors should look to EM corporate bonds. In our experience, we believe the great thing about emerging markets is that the perceived risks are often higher than the actual risks.

With the less-liquid corporates, it takes time for them to come back, but the price does come back, when the market starts to price them correctly. We’ve now reached a point that people are beginning to come back into the market and high-yield emerging corporates still look attractive, in our view. The repricing is still in play.

With many EM fund managers if there’s uncertainty in the air, they tend to invest it in the liquid stuff. When the markets are completely blossoming, that’s when they start going down the risk curve. That’s usually the worst time to go in. We’re still in the repricing phase with EM corporates, which we believe is great for active investors.

6.    How do you factor in ESG criteria for EM countries?

Lue-Fong: ESG is (and will become even more of) a key criterion in the decision-making processes of investors. We think the starting point is to accept that EM should not be judged on the same basis as developed markets.

We believe that with EM, the direction of ESG travel is important. We’re looking for countries that show a willingness to improve ESG. It’s the momentum that’s matters: how they manage and implement ESG criteria.

For this, Governance is where investors can monitor and assess how well countries and companies are implementing ESG into their daily operations.

7.    After the narrowing of spreads in high-yield and the absence of a default wave, could these bonds offer attractive risk/return opportunities at current spread levels?

Holman: We think there are still basis points to play for in high yield. Income has become a very scarce commodity; with cash rates near zero and looking well anchored, we believe that the demand for income in this decade can be fulfilled by credit. High yield spreads have tightened a long way, such that we are now around 100bps from the tights of the previous cycle on a yield-to-worst basis in global high yield, but we expect this gap to close further in 2021, so there are still opportunities there. We see high yield outperforming investment grade quite reasonably this year, but expect there to be spread compression between ratings bands. There are areas of high yield where investors will so far have been more wary of getting involved, companies with balance sheets that don’t look quite as robust or without as many reserves to see them through this tough environment. So we could see CCC spreads catching up with single-Bs, single-Bs with BBs and BBs with investment grade. All that said, it doesn’t mean you can just buy everything. I would expect to see defaults rise to around 7% in the US and 5% in Europe before dropping again towards year-end. As a result we think a healthy dose of caution is warranted in the very lowest ratings bands, where historically the overwhelming majority of defaults have come from.

8.    As an active manager, what levers do you think investors should use to target positive returns despite low initial yields?

Holman: For us active management is about being able to respond quickly to changes in economic and market conditions, both to try to protect our clients from emerging risks and to try to make sure they can benefit from opportunities. We expect this flexibility to play a big role once again in 2021, initially investors should look to become more pro-cyclical and steer clear of rising rates curves, but subsequently look for opportunity to rebalance with more risk-off positions should credit spreads hit their targets. We think that rebalancing opportunities can be key in protecting clients from any pull-back in credit spreads, and it is a tool passive strategies cannot replicate.

Lue-Fong: One thing that has struck me about joining the Fixed Income Boutique is that we’re high-conviction investors, we’re not closet benchmarkers. As yields stay low, active management becomes a bigger part of the potential overall returns. In recent years, investors have moved to ETFs and passive vehicles, but I firmly believe choosing an active manager becomes even more important for investors to reach their goals. We have found that by having a bias towards the bottom-up and knowing the names you invest in, an investor can discover true value in the market. In this environment, as an investor, I want someone who is active and knows where value is.


9.    Are there certain asset classes/sectors that investors should avoid?

Holman: As mentioned a few times above, we would be wary of longer-dated government bond debt as yields reset higher. Similarly, high quality corporate debt may not have enough spread to compensate for this movement. Additionally we think investors should be wary of confusing a cyclical downturn with structural change and disruption in certain industries. Travel and hospitality are sectors clearly that look to have been worst hit by the pandemic, but retail and automotive for example were already under pressure from structural change pre-COVID. Commercial property is another sector facing accelerated structural change due to the pandemic. We will also be keeping our eye on regulatory change. Just like the banks in the wake of the global financial crisis, we would be surprised not to see other sectors that required assistance in 2020 facing regulatory change to try to make them more resilient for the future. While initially markets don’t tend to respond well to increased regulatory burden on any industry, these changes could present a new range of opportunities for bondholders – as they did in the banking sector post-2008 – as balance sheets in the newly burdened sectors should begin to improve.