Fears are growing that the 30 year bond bull run may be coming to an end with the potential of a stimulus-pumped bust. In this challenging and uncertain environment, Fraser Lundie, Co-Head of Credit at Hermes Investment Management, believes that investors are best served to employ rational objectivity and challenge prevailing assumptions around allocation and protection.
What we do know is fixed income’s ability to preserve capital is diminishing. Investors now must accept if they are investing in assets that are yielding close to or below zero, upside is limited and downside could hurt. We also know the traditional diversification ballast of a mix of lower and higher risk assets is under threat due to rising correlations.
Event risk, such as the taper tantrum, has already forewarned us of how sensitive markets can be if the monetary policy punch bowl is taken away. Meanwhile, unprecedented central bank bond buying is distorting valuations as prices move further away from fundamentals.
In this new brave new bond world, investors need to access different risk models and approaches that have evolved to suit a radically altered investment environment. With this in mind, we look at six ways income and protection-hungry investors can look to evolve their investment strategy within credit.
Question long duration’s ability to absorb shocks
Low US bond yields and fears of a market bubble have called into question the role, if any, that a long-duration credit exposure should play in investors’ portfolios in the coming years. This concern is justified: the annualised 10 year yield to maturity of global investment grade bonds implies returns of just 2.40% in the next decade – a period in which interest rates in developed markets will likely increase from the extremely low levels set during the financial crisis.
Such low prospective returns undermine the ability of long-duration instruments to withstand future market shocks. As a consequence, we operate a very low duration exposure in Hermes Multi Strategy Credit Fund and instead allocate to defensive credit trades to preserve capital.
Find new ways to provide downside protection
We believe the key to downside protection is replacing the necessity to hold government and long-duration credit with defensive credit trades, thereby taking away the reliance on the relationship between interest rates and risk assets.
One of the credit strategies we use within the defensive bucket is curve trading, meaning we take a view on the relative value of different points on a name’s credit curve. This defensive trade works well on names where we are cautious on the longer term fundamentals of the business but have a favourable view of its liquidity profile, taking into account all sources including cash, committed credit facilities and levers available to the company such as asset sales or equity raises.
Avoid the great bond rush
The rush to corporate bonds means much of the market is exhibiting valuations that are increasingly difficult to justify. Instead, we have accessed credit default swaps in Europe, which fall out of the ECB’s buying programme, rather than physical credit.
We also believe US and hard-currency emerging market credit have the potential to continue to outperform European bonds. Europe is a region that remains over owned despite its lacklustre relative returns this year.
Focus on quality names in high yield
In the high-yield market, our focus today is on up-in-quality trades and we are avoiding stressed names that require more supportive macro environments to grow into their capital structures. We believe that declining recovery values, brought about by years of covenant weakness and subsequent asset leakage to preserve liquidity at any cost, imply that downside scenarios will be more malignant than in the past.
Access global mandates
Global high yield managers have this year been able to enjoy a significant tailwind from their allocation to regions outside of the US and Europe. Emerging market corporate bonds have undergone a remarkably rapid transformation from one of the least-loved asset classes to perhaps the most popular.
A return to fair value compels us to remain up in quality, but given the siren call for yield persists, and the exogenous catalysts of the BoE and ECB programmes are expected to endure, it is more important than ever to fully exploit flexible, global mandates to eke out returns where risk is deemed appropriate, and to fully utilise such mandates with nimbleness, rotating into areas of attractive risk adjusted return and away from overheated ones.
Increase vigilance in EMs
Valuations have now largely normalised despite the risks still remaining – primarily a renewed declining of the oil price and other commodities prices. Indeed, a Fed rate hike and geopolitical risks also remain as potential deterrents to continued outperformance. It is essential to combine a thorough assessment of operating, financial and ESG risks to identify companies that are able to prosper in an environment where many emerging market economies are still struggling to return to growth. A return to fair value compels us to remain up in quality and highly selective as the low-hanging fruit of the trend is now behind us.
 Bank of America Merrill Lynch. Data as at 23/09/2016 for corporate bonds excluding financials
Increasing numbers of investors searching for diversity
Unwrapping value in packaging debt