Many investors have focused on difficulties with fixed income in an environment of rising interest rates but few have considered the challenges of an environment characterised by low volatility and questionable valuations.
Such an environment makes it difficult for investment managers to outper-form without taking significant risks in bet size or correlation of positions We believe investment managers have three options:
Do nothing – track the benchmark and underperform due to trading costs and fees.
Increase the size of individual trades – bigger bets may result in better performance, although failure to get these bigger trades right could be devastating.
Increase the number of individual trades – a greater variety of trades provides more possible sources of alpha and limits the downside of any failing strategy.
Questions with regard to value and low yields within the conventional segments of the bond market have forced some managers to look at alternative ways of adding value.
Contrarian investing is gaining popularity in a market where value is hard to find. It is not something that the fixed-income team at Fidelity consider key to their investment philosophy but identifying opportunities that may have passed under the radar of other investors is. In particular, we challenge our analysts to look closely at the companies we describe as unloved, unglamorous or misunderstood.
We believe many investors are influenced by others and are afraid to be different or contrarian. Emotions often cloud the evidence of facts and judgement, which can lead to an overstatement of investment risks. Companies that fall foul of this psychology can be described as unloved.
A good example of such a company is American reinsurer Marsh McLennan. It was the subject of an investigation by Elliot Spitzer for misselling and many investors reduced their exposure. Despite the company being fined, client retention was strong and cashflow and liquidity remained favourable. The market had overreacted to the risks and this provide a buying opportunity for investors focusing on fundamentals.
Dutch insurer Eureko is an excellent example of an unglamorous issuer. As a relatively small issue, this company’s 2015 bond fell under the radar of many investors. These investors failed to identify a well diversified business, substan-tial market share and increasing ownership by AAA-rated Rabobank. These investors missed an excellent investment opportunity.
Many investors fear the unknown and anchor their views on past perceptions. Debt markets are becoming more complex and understanding these complexities requires hard work and experience. Russia is an example of mis-understood issuer. Many investors focus on the past default of this emerging market sovereign and fail to consider the recent improvements in credit quality, a strong commodity base and rising cash reserves.
Within the corporate market the relationship between parent companies and their subsidiaries is also frequently mis-understood and value can often be found by looking past the most senior issuer in a corporate group.
Looking forward we feel that fixed income professionals with the ability to identify small pockets of value will be more successful in managing the current environment than those adopting contrarian or singular investment strategies.
Ultimately the case for fixed income in a diversified portfolio is difficult to dispute. However, in an environment where upside in the corporate market is limited, adopting a unique of investment strategy becomes more and more important.
Paul Lavelle is portfolio manager, fixed income at Fidelity International