TwentyFour Asset Management

A new playbook for finding fairly priced yields

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Mark Holman

Chief Executive Officer TwentyFour Asset Management, Portfolio Manager

While a decade-long bull market in stocks has led many to question a buy-and-hold approach for equities, sub-zero yields on 12 trillion US dollars of bonds argue for a new approach to fixed income management.

History tells us future fixed income market returns are highly correlated with starting yields – which were well below 2% for the Barclays Multiverse fixed income index at the start of 2020 – suggesting investors could be disappointed unless they adapt for the present environment.

Going forward, we believe the new fixed income playbook should emphasize the following:

  • A strong focus on volatility and risk management
  • Increasing credit quality while keeping credit spread duration in check
  • Utilise specialist asset classes to deliver risk-adjusted returns

Regardless of secular market direction, a truly global and flexible approach can help investors take advantage of opportunities created by market volatility.

Eye opener

In October 2019, a number of bond investors decided to pay the Greek government to look after their money.

In an auction of three-month treasury bills on October 9, Greece borrowed 487.5 million euros at a yield of minus 0.02%, joining a not-so-exclusive club of borrowers on whose debt investors were effectively happy to lock in a loss from day one.

This is the same Greece that was ostracised by international capital markets between 2009 and 2015 after three bailouts during the Eurozone’s sovereign debt crisis. The country’s newly discovered reputation as a reliable custodian of cash is merely the latest example of a seismic shift in global fixed income markets that has left them virtually unrecognisable from a decade ago.

Lower for longer

In August 2019, the stock of negative yielding debt globally hit 17 trillion dollars, or 30% of the Barclays Multiverse1 – it has since dipped to around 12 trillion dollars – and the story of how we got here is by now a familiar one.

Central banks have flooded the markets with liquidity and cut rates to historic lows (Chart 1), a huge transfer of assets from banks to asset managers has helped to fuel an ever increasing demand for income generating assets, and companies and governments have taken full advantage by terming out their debt at ever lower yields.

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As we head into 2020, the drivers behind this seismic shift are still in place. Central banks are back in easing mode (or never left it) and economic data suggests the cycle has more room to run, though the length of the cycle and lingering geopolitical risks mean uncertainty is high and volatility is likely to spike from time to time.

In short, the fixed income landscape has changed.  We believe portfolio construction should change along with it.

The limitations of the old playbook

The balance between the positive forces (yield and income) and negative forces (volatility and default risk) that traditional fixed income managers try to navigate has been tilted against them in recent years, and it seems this imbalance will remain in 2020 and quite possibly beyond.

This is shown in Chart 2, which plots duration as a multiple of yield on the Barclays Multiverse index, a widely used proxy for global fixed income markets.

As any bond investor knows, low yield and high duration is an ugly combination, as it means heightened capital risk. At the current duration-yield multiple of over 4x shown by the chart below, every 100 basis point rise in yields would cost an investor over four years’ worth of income.

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The basic problem for fixed income investors today is that they must therefore take on more units of risk per each unit of yield they want to add to their portfolio. And when yields are low, knowing which units of yield are fairly priced in terms of additional risk becomes critical.

Why low yields matter – a lot

Generally speaking, the lower the yield on a bond at the start of an investment, the lower investors can expect their returns to be for a reasonable holding period.

This relationship can be seen when plotting yield against total return on the BAML US Broad Market index, which essentially includes the entirety of dollar denominated fixed income, from sovereign and corporate bonds through to asset-backed securities.

Looking at data going back to 1985, the yield on a given date has been a key determinant of total return over the subsequent three-year period, as shown in Chart 3.

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When looking at the subsequent five-year period, the relationship becomes even tighter – over five years, 90% of returns on the index came from day one yield (Chart 4).

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No free lunch in reaching for yield

Faced with this dilemma (starting yields in 2020 are towards the extreme bottom left of the graph above), many investors will look to raise their portfolio’s overall yield with assets they probably wouldn’t be comfortable holding in a more normalised environment.

This might involve moving down the credit spectrum in high yield, taking leveraged exposure or moving into private or less liquid credit.

While these will certainly add yield they also come with additional credit or liquidity risk, leaving investors with assets that may be difficult to sell in times of stress and have larger drawdowns during bouts of volatility.

A new fixed income playbook

So what do we believe are the most effective tactics for this late-cycle, low yield world?

Fixed income investors are unlikely to achieve a repeat of their 2019 returns in 2020, meaning in our view portfolios should be more balanced.

We believe the key to achieving positive returns in 2020 will be a strong focus on volatility and risk management. Government bonds can offer some downside protection, and are unlikely to harm investors while inflation is absent and central banks are on hold, and it follows that a balanced portfolio should maintain a significant strategic exposure to these assets.

The economic cycle is old, but it’s not the time to panic for credit investors yet. Consequently, we believe investors can mitigate volatility by upping credit quality, keeping credit spread duration in check, avoiding risky sectors and buying into strong cycle-enduring balance sheets.

Once the downside is under control, it is time to focus on where attractive risk-adjusted returns actually come from at this stage of the cycle.

A global approach can boost late-cycle returns

Digging deeper into the global universe of bonds can reveal a number of opportunities to improve the risk-reward profile of a portfolio, as well as boosting an investor’s chances of tracking down relative value and better risk-adjusted returns.

This is where we believe a truly unconstrained, flexible and, crucially, global fixed income strategy can gain an advantage over more restricted approaches, and there are several areas that we feel can boost returns in 2020 and beyond.

The first is subordinated financials in Europe. From an equity standpoint, European banks appear a bad investment; poor profitability, high capital requirements and lingering legacy asset issues make them unattractive when set against their US rivals. However, many of the things that can turn investors off the equity story should do the opposite for bond buyers. Fundamentally the European financials sector has defied the credit metrics trend and has continued to see upgrades to ratings, backed up by real relative value and we expect this to continue. For us it is a sector hard to argue against despite several years of good performance against wider credit markets. The Additional Tier 1 (AT1) capital instruments issued by European banks and the new Restricted Tier 1 (RT1) securities issued by European insurance companies both still carry a premium, along with some of the highest yields available across investment grade, hard currency global fixed income.

The second is European collateralised loan obligations (CLOs), where we see a lot of value and a lot of yield. Leveraged loans are possibly the most unloved sector in global fixed income at the moment, with investors wary of rising numbers of CCC rated and ‘covenant-lite’ loans, which are likely to feature fewer protections for bondholders. However, loan terms only come into play during restructurings or defaults, and default rates are expected to remain relatively low in 2020. In addition, the vast majority of CLOs (for which leveraged loans provide the raw material) have very low exposure to CCC and lower rated loans, and investors can source deals of older vintages when this problem was less pronounced. The main source of recent weak performance in this sector has been largely flow driven, as the market is predominantly floating rate and investors largely favoured fixed rate assets in 2019. For example, US leveraged loan funds had outflows in 58 of the 59 weekly periods up to January 1, 2020, some $43.5 billion of outflows in total2. We believe this shift is overdone, and the yields observable in the European CLO market as of January 22 – 3.8% on BBB rated notes and 6.5% on BBs in euros3 – look attractive given CLO bondholders regularly benefit from lots of subordination, whereas leveraged loan holders do not.

The third sector is emerging market corporate bonds, where we see relative value compared to the rest of global credit, and it is an area that has tended to attract money when that is the case. Right now, we can see EM corporates have around double the spreads of US dollar investment-grade bonds. We think they represent good relative value, they work well from a diversification standpoint, and they tend to do well in periods of US dollar weakness, which we might expect 2020 to be given we believe the dollar strength of 2019 is unlikely to be repeated moving into an election year.

The way forward

At a time when bond investors globally are rightly concerned about the draining effect of low yields, a truly global and flexible approach can boost an investor’s chances of maintaining performance while avoiding the typical pitfalls of a late-cycle environment.

By combining thoughtful risk management with rigorous credit work in areas where specialist bond investors can still find value, the new fixed income playbook can help investors navigate the sub-zero world.

Five Tactics for Late-Cycle Bond Investing

While every economic cycle is different, in our opinion there are certain tactics that should serve fixed income investors well through late-cycle markets.

1. Credit duration down, credit quality up
Once a cycle shows signs of ageing it often becomes more vulnerable to external shocks or surprises. This is a time for dialling in risk and having more balanced portfolios, giving investors a better chance of ensuring capital preservation should the cycle come to an unexpected end.
2. Increase rates exposure and duration
The outlook is growing more uncertain and market sentiment becoming more cautious. We believe aggressive risk taking is unlikely to be rewarded and portfolio positioning should be more balanced and prudent. A commitment to a substantial strategic ‘risk-free’ rates position then becomes essential.
3. Pick the right yield curve
Holdings in risk-off assets are usually there to try to protect returns rather than generate them, so selection should be made on the suitability for offering some protection and not yield. It is important to identify the government bonds that have the most to gain should conditions continue to deteriorate.
4. Don’t ignore relative value
Avoiding riskier names and sectors is important in late-cycle investing, but tracking down the remaining pockets of value is equally so. Flexible fixed income portfolios with a global reach can target more niche markets where risk can be well rewarded.
5. Stay highly liquid
The path toward the next recession is never smooth, and periods of spread widening can often be buying opportunities. Fixed income investors should stay highly liquid and nimble, holding a higher portion of a portfolio in cash or cash equivalents, in order to be able to react quickly to changes in conditions.

1 Bloomberg, August 2019
2 Lipper, LCD, Jan 2020
3 TwentyFour, Bloomberg, Jan 2020