Finding quality in fixed income

As Forrest Gump said....you never know what you are going to get. And let’s be honest, while most of us would jump at the chance to dip our hand into a box of chocolates, no one wants the coconut crème! There are bad outcomes as well as all the good ones.

Outcomes are obviously important to investors, and a focus on quality is intended to deliver the good outcomes and minimise the disappointment. How can we enhance our chances of getting what we really want?

Fixed income is a sector where we know the potential upside, and at the moment with yields where they are, there is a lot more potential upside than we have sustainably seen for a long time. At TwentyFour, we always say winning as a bond investor is getting our interest on time, and all our principal back at maturity. We are not trying to solve for some strong equity valuation upside or dividend growth, rather we are about ensuring that we deliver interest and principal with certainty.

So we aren’t solely focusing on trying to pick the winners, quality investing for us is as much about making sure that we avoid the losers. We aim to filter out anything that could have a bad result to make the reliability of the outcome as strong as possible, and preserve the aggregate outcome across the portfolio.

How do we do this?

Don’t stretch – let’s start at a portfolio level. We understand what the outcome should be for each position we consider, so we have a clear view of what we can deliver to our clients, over what timeframe. Invariably there are times through the cycle when markets offer higher returns and times when it offers lower returns. When yields are low it’s possible to feel pressure to maintain a level of return that involves increasing risk. This adds uncertainty to the likely outcome. Instead we should be communicating what we think about market value and what is an appropriate level of return to expect, depending on the strategy in question.

Test yourself – we know that we can’t perfectly foresee what is going to happen in the future, and in particular in environments such as the one we are currently in; the big drivers of fixed income performance may move in uncertain directions and the timing is not under our control. We might be high conviction about a particular outcome, but regular stress testing of our portfolios means that we better understand the impact of the adverse outcome, and gives us a clear perspective to evaluate and minimise the probability of that outcome.

Identify weakness – it’s easy to know what a portfolio manager’s highest conviction positions are and to double down, as we add to those positions often this may mean less opportune yields. What’s harder is to continually focus on our lowest conviction holdings. We liked them enough when we bought them, but let’s keep the pressure on ourselves by regularly checking what we like the least. We can enhance this with our Observatory system which easily identifies and ranks both the market-wide opportunity and our holdings on a risk-adjusted basis. So, we try not just add to the best, but make sure we also spend as much time on our least favourite picks.

Look behind the numbers – any investor in corporate credit is going to talk about the importance of ratings, how they change and the standard drivers of those – leverage, free cash flow, etc. but we think we should also be identifying additional future drivers of credit underperformance, for example; in the last couple of years it would have been pricing power in the face of inflation – an issuer bypassing the cost of inflation by passing it on to their customers, and the level of exposure that financial issuers have to commercial real estate globally, when we saw the issues being created in the US regional banking space.

So while we cannot guarantee that every day we will see a positive total return, by managing the portfolios with a keen eye to avoiding the losers, we give ourselves a much greater chance of holding more winners, and that means we can have greater conviction that our clients’ needs will be met over a reasonable timeframe. That is the quality outcome that we are looking for.