Future of Fixed Income

Market Update

• Just as the global financial crisis changed the way we thought about fixed income materially, the coronavirus pandemic will have far-reaching consequences for bond investors for years to come.
• The sell-off this time around was much more severe; some of the market moves over three weeks in March 2020 took eight months over 2008 and 2009.
• This deep recession is unique as it should be relatively predictable. Q2 2020 is very likely to be the worst quarter of the downturn, and while Q3 and Q4 are expected to look terrible in year-on-year terms, we expect both will be improvements on the previous quarter and the trend will be positive, which should be good for markets.
• We have seen unprecedented support from central banks and governments, but the scale of these programmes is a big logistical challenge and they will not reach everyone they need to. We will see individuals and SMEs defaulting, and in our world of credit we also anticipate a sharp pick-up in the default rate.
• Investors can expect to see several more years of near-zero interest rates, and we believe income in the next decade will be just as scarce a commodity as it was in the last. Bonds could be a good solution for those looking for income.

Positioning

• We have seen the return of market dislocations and relative value, by rating, sector and currency. Active managers can benefit from these conditions.
• We were not positioned for deep recession at the start of 2020, but we were positioned with late-cycle, expensive markets in mind and therefore we had a lot of liquidity and cash compared to what the fund would normally hold, which meant we were able to effect portfolio change quickly.
• Government bonds and cash stood at 35% in early March, this has been taken down to our new target of 22% by the end of April. The average credit quality of the portfolio is BBB, and the yield has been significantly increased. Credit spread duration has increased from 2.2 years to 3 years, with rates duration reduced to 4.3 years from 6 years.
• Credit generally looks attractive, and we have been looking to add yield by taking longer duration in higher quality bonds, rated BB and above.
• The portfolio managers are focusing on issuers that look to have robust balance sheets in sectors we like, such as insurance, banks, utilities and high quality RMBS, where we believe there is greater resilience and visibility of earnings compared with other sectors such as transport and retail.
• We are positive on the banking sector. It is certainly a tough time for banks, it looks inevitable that 2020 will be a bad year for them and they will suffer losses. However, we believe this is an earnings story rather than a solvency story.
• Avoiding defaults will be key in helping to capture the many value opportunities we think are available in credit. Historically, some 95% of defaults come from CCC, with the rest mostly coming from single-B. Our focus will be away from lower rated credits at this early stage of the cycle, but investors must also be wary of ratings migration, whereby investment grade credits are downgraded into lower ratings bands before defaulting.
• Emerging markets tend to see higher defaults, so here we will look to focus on even higher quality bonds.

Outlook

• In a typical recession, we might expect not to return to the productivity levels of Q4 2019 until some point in 2022. However, given the unprecedented monetary and fiscal interventions, the recovery this time around could be much quicker.
• We do not expect to see significant inflation coming through in the next five years, but the chances of this have materially increased given governments and central banks have undertaken one of the most inflationary actions in the history of financial markets.
• We now hold government bonds for a different reason, which is liquidity. Given the low yields, ‘risk-free’ markets have become ‘return-free’ as well. In our view, government bonds do not offer investors the same protection now that they have in recent years, so shifting to less volatile, shorter dated govvies makes sense.
• We believe the recent rally in credit is justified, and the worst is behind us here. Investors tend to get comfortable with solvency before they get comfortable with earnings, which is one reason why credit tends to lead equities in the recovery.
• This time around there is the added complication of government support for companies, and the restrictive impact this will have on dividends and share buybacks, so we are confident credit will outperform equities in this recovery.
• We note the recent breakthrough on the €500bn EU recovery fund that has received backing from Germany and France, and while a positive step we see this as too little, too late. We cannot rule out more political risk around Italy.