Fixed Income Boutique

Euro mid-yield bonds: Calibrate your focus for consistent fixed income returns

Viewpoint

You arrived here, at this page, because you made a decision. In fact, you will make around 35,000 decisions today. That’s one decision every two seconds. According to research from Cornell University, on the subject of food alone you will make over 200 decisions in a day – bon appetit or en Guete, as we say here in Zurich.

Of course, the decisions you make will have consequences and sometimes the stakes are higher than deciding whether to add salt to your meal or not.

When choosing a course of action, the dominant driver is information. It could be data, personal experience, or the opinion of others, but information always plays the main role. For us humans, how we process that information is the result of evolution. However, when it comes to investing, we have one natural inclination that is often damaging to returns — the availability heuristic.

The availability heuristic means that we place more importance on recent information. This was a useful trait when we lived in the great outdoors with other predators. If you came across a lion in the wild, you would immediately know that extricating yourself from this situation would allow you to continue living. In such a life and death situation, reacting to the most recent information had the best payoff: survival. Things are different in today’s world of instant tweets and hyper-charged news cycles; the most recent information is often at best incomplete and at worst incorrect.

The fixed income universe is a place that rewards investors who base their decisions on fundamental data, information, and facts; not on negative news cycles and tweets. This is why investors, when hunting for yield, instead of relying on what is just in front of them, should grab a pair of binoculars and look out further and in more detail than the naked eye allows.

A source of stable returns

The negative-yielding environment remains with us and our message, going back several years, remains the same: We are living an age of low interest rates, due to the introduction of smart phones. This is not some phase that will transition like spring into summer, but rather this is a lasting revolution. In such an environment, corporate bonds, particularly in the mid-yield segment, offer investors an attractive yield pickup compared to government bonds.

Politics, central banks, the mood of the markets and overall daily news-flow noise will tighten or widen credit spreads. However, evidence shows that this effect is only marginal for the long-term investor. Even the global financial crisis and the euro-area crisis in 2013 show as mere blips in the total return of mid-yield bonds over the past 24 years. This is due to the one specific driver—coupons (see chart 1).

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Many investors focus on predicting interest-rate movements to decide on their bond allocation, this alone is not enough. In our view, what investors should be searching for are mid-yield bonds that compensate them for the risk they take. This, for active long-term investors, will often mean buying the dip. Historical evidence, while no guarantee of future returns, shows that good credit selection and riding the spread carry run have provided consistent returns with low risk.

Rating migration provides opportunities

The unique advantage of our approach, besides a strong focus on the mid-yield segment, is the 20% allowance in the non-investment grade BB-rating space (see chart 2) that allows us to capture spread tightening of potential rising stars at an early stage.

Every year, nearly 7% of bonds rated BB receive an upgrade to BBB (investment grade and mid yield). By capturing these “rising stars” before the rating upgrade, investors receive, on average, a tightening in spread of around 100 bps. Furthermore, the BB bucket is a sweet spot for yield-seeking investors as it acts as a stable “safe haven” for high-yield bond investors in times of market volatility, yet delivers more in spread compared to the higher BBB-rated bonds.

Our Vontobel Fund - EUR Corporate Bond Mid Yield offers investors a channel into the mid-yield segment with the opportunity of profiting from ratings migration. For non-investment-grade bonds, we invest only in the BB bucket, with a maximum of 20% of the portfolio (see chart 2). We have always remained committed to our belief that we have the fundamental capabilities to select corporate bonds where the spread premium more than compensates for the credit risks taken. Thus delivering returns to our investors.

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How we choose the right bonds

We believe that the credit market is slow to react to new trends offering opportunities for investors like us who reach for the binoculars and look in depth for the right credit.

We generate returns by building a diversified portfolio of high-conviction bond picks, enhanced by active segment allocation depending on the current risk environment. We do this by taking a thorough top-down/bottom-up approach. The mid-yield investment universe has around 3,000 bonds, which our process then whittles down to around 250 bonds at the portfolio construction stage (see chart 3).

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Invest with confidence

An investor can choose to make their investment decisions based on immediate events like the whims of a tweeting president. However, if we look further out through our binoculars, we can see that we are in an age of low interest rates. Digitalization will continue to keep inflation in check, by compressing both prices and wages, and as long as we do not see inflation picking up, then central banks will remain accommodative. This means that, while the markets will ebb and flow, the euro mid-yield sector will continue to do what it has done for several decades, in good times and in bad, delivering excess returns and income to those who invest in it.

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Opportunities

  • Broad diversification across numerous securities
  • Investments in foreign currencies might generate currency gains
  • Possible extra returns through single security analysis and active management
  • Gains on invested capital possible
  • Use of derivatives for hedging purposes may increase subfund's performance and enhance returns
  • Bond investments offer interest income and capital gains opportunities on declining market yields
  • Investments in bonds with medium and lower investment grade ratings may offer an above-average yield compared with investments in first-class borrowers

Risks

  • Limited participation in potential of single securities
  • Investments in foreign currencies are subject to currency fluctuations
  • Success of single security analysis and active management cannot be guaranteed
  • It cannot be guaranteed that the investor will recover the capital invested
  • Derivatives entail risks relating to liquidity, leverage and credit fluctuations, illiquidity and volatility
  • Interest rates may vary, bonds suffer price declines on rising interest rates
  • Mid-yield bonds may be more speculative investments than bonds with a higher rating due to higher credit risk, higher price fluctuations, a higher risk of loss of capital deployed.
Fixed Income Boutique
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