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Strategies for a brave new fixed income world

A perfect storm has been brewing in bond markets as yield-hungry investors reach ever so higher on the risk spectrum in an effort to meet their return objectives

Rising interest rates, the threat of higher inflation and the removal of quantitative easing all present a challenging set of circumstances for bonds. Investors will have to deploy tactical strategies and be flexible enough to ensure they can successfully navigate the tail end of an extended credit cycle.

Here are five ways investors can enhance capital preservation while maintaining an attractive level of income streams for the year ahead.

Beware of ‘covenant-lite’ loans
On the back of the surge in demand that followed from global central banks’ unprecedented levels of monetary stimulus, an environment that invariably favoured debt issuers, it comes as no surprise that some have sought to exploit the situation by foisting weaker covenant (credit) terms on to investors.

One thing of concern is that issuers have pushed the boundaries of how much collateral is put up, which is vitally important to the chances of recovery in the event of default.

Put another way, there will not only be less to recoup in a distressed credit scenario, but such assets are also likely to be of poorer quality.

The levels of distressed debt are also likely to rise if a global economic downturn were to materialise.

With investment banks having been regulated into playing a less active role in market-making, the liquidity required to sell these instruments would be scarce, implying heftier mark-downs for trades to clear as well as sizeable capital losses. It is therefore imperative that investors assess the strength of covenants in loan agreements and not reach for yield this late in the credit cycle. Borrowing from the age-old maxim, yield stories that appear too good to be true may be precisely that.

Use widening spreads to generate alpha
With the favourable funding conditions created by large-scale bond purchase programmes, corporate defaults are but a distant memory. Investors should not be lulled into a false sense of security, however. Policy normalisation is likely to be accompanied by an inevitable re-pricing of credit spreads as associated risks reassert themselves in the absence of QE’s dampening effect.

The credit spread widening of 2018 can be viewed as a precursor of such moves. In such settings, reaching for yield is likely to bear adversely on performance.

Bouts of market volatility and indiscriminate market sell-offs can, nonetheless, be used to pick up high-quality debt at wider spreads.

While better-rated bonds appear expensive, flexibility coupled with prudent security selection opens opportunities in which investors can take on debt of high-quality firms that may or may not possess credit ratings. The significance of rigorous bottom-up credit selection to this strategy cannot be overstated.

But in utilising such entry points, investors can gain exposure to attractive yields without materially adding to duration.

Be dynamic about duration
Shortening duration is a traditional strategy to protect against rising yields. As expected, we are already witnessing the wholesale reduction of interest rate sensitivity across portfolios in the Investment Association Strategic Bond sector.

It is not merely a question of slashing duration. In an increasingly uncertain economic environment that may also be prone to over-reacting, managers must take a nimble approach. While rates may be on an inexorable path upwards, it would be foolhardy to rule out the prospect of a return to QE should a recession materialise.

Lower relative duration exposure in a scenario of rising interest rates would result in outperformance against the broader bond universe. Should we see a downturn, though, the catalysts of which could range from geopolitics to a tariff-led decline in global trade, investors run the risk of forfeiting the capital gains that duration typically brings in the event of a sustained bond rally.

As such, the answer to this problem lies in taking a flexible approach and being constructive about duration. This could entail adopting a longer duration stance, particularly if the likelihood of recession were to increase.

Avoid the double negative
Cash positions have been augmented to provide more room for manoeuvre and holdings of short-dated gilts have been added.

This not only provides necessary liquidity, but also increases the overall portfolio quality and enables us to seize opportunities to pick up high-quality credits at points in time at which valuations are deemed fair – premiums on offer more than compensate for the inherent investment risks.

Gilts fare better in terms of capital preservation when compared to corporate debt, with the former unaffected by credit risk. Both react to shifts in the yield curve, nonetheless. Increasing the allocation to gilts limits exposure to the double negative – widening spreads and rising yields – buttressing the defensive attributes of a bond portfolio.

We see little value further out on the gilt yield curve, particularly for investors free from relative duration parameters or constraints.

Mind the carry
Whereas the spectre of rising rates warrants a cautious approach to the long end of the curve vis-à-vis duration risk, there are opportunities for investors in the shorter-dated bonds. At maturity tenors of three years or less, for instance, carry (a carry trade is borrowing at a low interest rate to provide higher return) can and often more than compensates for capital losses, with the performance impact of interest rate shifts diminishing as fixed maturity bonds approach their redemption dates. The 2018 outperformance of short-duration debt in the United States’ broad market owed much to this factor.

In a fixed income world where capital gains could prove elusive after the mammoth central bank bond purchases of yesteryear have been curtailed for the foreseeable future, investors may therefore do well out of keeping carry firmly on their radar for the period ahead.

David Katimbo-Mugwanya is manager of the EdenTree Amity Sterling Bond fund


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