25th April 2015 by Chris Iggo
Bond markets suffer from suppressed yields, risk premiums that are insufficient and a lack of liquidity. How do you manage a bond portfolio under such circumstances? One way is to be flexible and to be very focussed on managing exposure to interest rates, inflation, credit and liquidity risk. Being able to invest across the bond market without the limits of an index-benchmark gives a bond fund manager the ability to respond in an unconstrained way to the changing risk environment and to protect against liquidity shocks. With Federal Reserve (Fed) rate hikes on the horizon and quantitative easing (QE) repressing yields in Europe, US high yield, inflation protection, high rated structured products and cash are assets that have some attraction today.
“Risk-free” or “risk-acceptable”? – In recent years it has become very difficult to identify what constitutes a risk-free asset. The global deterioration in government finances and the very real prospect of sovereign default, a weak banking sector, policies of financial repression and zero interest rates all mean that neither government bonds nor cash can be considered to be quite as risk-free as once they were. However, this notwithstanding, the core of any investment strategy remains the goal of achieving a satisfactory level of return that is commensurate with an acceptable level of deviation from the “risk-free” investment choice. In practice, in the modern investment industry, this takes the form of building portfolios that try to achieve a similar or better risk-adjusted return than some “benchmark” that represents the “risk-acceptable” rate. That benchmark could be a proxy for what traditionally has been considered the risk-free rate – like a 3-month Treasury bill, or a Libor rate. It could equally be some kind of benchmark based on a market index (or combination of market indices) where the investor has decided that the risks embedded in the benchmark are acceptable given the desired level of return and where there could also be some tolerance for the investment manager to take more or less risk than the benchmark in order to achieve a better risk-adjusted return. Or the benchmark could be some kind of long-term cash-flow requirement to meet future pension payments or other liabilities. However constructed, much of today’s investment business is based on the active management of risk relative to some target or desired level. Risk in its simplest sense is defined by the notion that returns on, and the return of, capital will be subject to some level of certainty. The more certain the return is relative to expectations, the lower risk the investment strategy, the more uncertain, the higher the risk.
Important to identify risk factors – Of course, managing risk is not just about minimising the deviation of returns from the “risk-acceptable” rate. It is about trying to maximise return as well. In order to do both (optimise the risk adjusted return) investors have to try to isolate and understand the risks that are inherent in their portfolios. That is not always easy because the more complex the investment strategy, the more risks there are. In the context of this discussion I am focussing on risks inherent in portfolios of tradable securities – bonds, equities, currencies and commodities and their associated derivatives. The performance of these assets can be reduced to what happens to certain risk factors – interest rates, credit spreads, inflation risk premiums, earnings risk, sector and country risk, exchange rate risk and political risk, amongst others. Much of investment research is concerned with assessing these risks, even vainly trying to forecast what might happen to them in the future, and how various asset classes respond to that changing assessment of risk. One can get very granular as well – interest rate risk in what currency? On what part of the yield curve? In terms of spot or forward rates? In terms of volatility of interest rate expectations? And so on.
The QE option – My world is the bond world and we have a well-defined process for basing our investment strategy on the understanding and assessment of the risk factors inherent in a fixed income portfolio. The key ones are interest rate risks – the risk of rates going up or down, changes in the shape of the yield curve and the divergence of interest rate spreads between different currencies; inflation risks – the risk that inflation can reduce the real return on nominal bonds; credit risks – the risk that credit spreads can increase as a result of any deterioration in the creditworthiness of a borrower that itself comes from deteriorating business conditions, management decisions, adverse commodity price developments, weak economic growth, changes in policy, changes in the competitive environment, changes in legislation or indeed, changes in the general level of borrowing costs; currency risks and liquidity risks. Typically our approach is to hedge the foreign exchange risk in bond portfolios – other managers don’t necessarily do that – but that still leaves us having to manage interest rate, credit and liquidity risk. Today, that is a challenge given the historically low level of interest rates, the prevalence of negative yields in the bond market and structurally lower market liquidity. A consequence of QE policies in developed markets is that the fixed income universe is now generally longer duration with less credit spread protection than it has been for a long time. Or to put it another way, bond portfolios are more at risk of negative returns from higher yields or wider credit spreads, and more at risk of negative real returns coming from an increase in inflation, than they have been for a long time. QE has suppressed risk and, in my view, lowered the compensation to investors for taking the underlying interest rate, credit and inflation risk. To put it another way, investors have been forced to pay an option premium (lower yields) for the insurance of central banks preventing a negative interest rate or credit shock. Investors are happy to buy peripheral government bonds in Europe at very low yields because QE is “insuring” them against a sovereign credit event, even though fundamentals in the region would not ordinarily justify current yield/spread levels. This was illustrated recently as sovereign spreads for the likes of Italy and Spain widened because of concerns about how badly the negotiations between Greece and its creditors were going. The existence of the QE put option explains why investors are buying bonds that yield very little, nothing or negative. The danger is that this option premium is over-priced.
Flexible management – At some point the optionality disappears. At some point investors will need a higher premium to compensate for the risks. That means a steeper yield curve to compensate for higher interest rates in the future and wider credit premiums to compensate for the inevitable deterioration in creditworthiness once financing and economic conditions become less favourable post the period of emergency monetary policy. With that in mind, fixed income investors face a difficult time ahead. Today one part of return is known – the carry or the yield to maturity. But this is low and provides little compensation for future interest rate increases or credit spread widening. So our approach is to try and actively manage these risks in as diversified a way as possible. It also requires flexibility in terms of time horizons and the willingness to change investment strategy when it looks as though some of the risks are starting to crystalize. This approach can help generate better risk adjusted returns than being exposed to just one part of the fixed income market – rates, investment grade, emerging markets or high yield. Combining and actively managing those exposures delivers a superior outcome.
High yield and inflation – So where is taking risk best rewarded in the fixed income market at the moment? In our most unconstrained fixed income fund we have most concentration in high yield, particularly in the US where yields are still attractive relative to the default risk in the high yield market. The lower single B and CCC ratings sectors are attractive in that they offer yields in the high single digits. While we are still in a wait and see period for the Fed and in the midst of European Central Bank (ECB) QE, being exposed to high yield still looks more attractive than being exposed to interest rate duration. Yield curves are flat and even though the ECB will not raise interest rates for many years there is not much in the European interest rate curve to tempt bond investors. Indeed, the key interest rate risk for European government bonds does not come from the ECB but from the contagion of higher US yields once the Fed does start to increase official interest rates. Any duration exposure in Europe should only really come from investment grade and peripheral bonds, government bond yields are so repressed that there is no compensation for interest rate risk even if that interest rate risk does not stem directly from the European macro situation. On the inflation front there has been a gradual increase in break-even inflation rates since the height of the deflation scare at the beginning of the month. We still see longer term inflation risks, given that break-evens are still below the desired central bank inflation rate of around 2% for the Consumer Price Index (CPI). This is true for the US and the euro area and for the UK. If we take central banks by their word, policy is determined to deliver inflation at target and the likelihood is that there will be some modest overshooting as a result. So having exposure to inflation protection remains a core part of our fixed income investment strategy.
Dried up? – Finally, there is liquidity risk. For fund managers and all investors this should be a key concern at the moment. It is clear to all involved in the fixed income market that there is a structural problem with market liquidity. It is a topic that has recently been addressed by the International Monetary Fund (IMF) and other institutions and there is a concern that, should markets react negatively to an increase in US interest rates, there will be market dislocations exacerbated by poor liquidity. For managers of mutual funds this may result in a sharp increase in redemptions from clients wishing to avoid drawdowns on their fixed income holdings as interest rates rise. Providers of market liquidity (banks) already face significant regulatory and capital constraints on their ability to provide liquidity (compared to pre-crisis days) and this would be accentuated by increased risk aversion in a distressed market. This is not to say holders of bonds would not be able to get out of their positions or that there would be no buyers, but pricing may be much worse than would otherwise be the case. Indeed, pricing may become more volatile and imply a much worse “credit” environment than the fundamentals would justify. Even in 2008-2009 bonds that traded at very low prices because of distressed selling and lack of liquidity were ultimately “money good” and, for those with the foresight to have been buyers at that time, generated a very nice return. Trying to forecast a liquidity event is difficult but it is fair to say that higher volatility will be intertwined with worse liquidity and both could be triggered by the beginning of a new Fed interest rate cycle. Having an unconstrained approach to managing fixed income – or other types of funds for that matter – provides that ability to hold more cash than usual when liquidity risk is possibly going to increase. After all, the opportunity cost of holding cash is low in a world where traditional safe haven low risk assets are providing a negative yield. Holding cash into a potentially more volatile market period also provides fund managers with the option to invest at much more attractive prices. Better still is to replace some of the traditional liquid high grade bonds with more structured assets such as asset backed securities (ABS) and collateralized loan obligations (CLOs) which have very low duration but spreads that are – in many cases – superior to investment grade. A combination of cash and high quality structured products is a good defensive anchor for an unconstrained bond portfolio today.
Be flexible and strategic – All of the preceding discussion highlights the importance of understanding risk exposures in bond funds and having a view on what to do should either the compensation for taking risk become less or should the risks themselves begin to become more apparent. We know that there is a risk in being exposed on the US Treasury curve as yields are likely to move higher across the market when the Fed begins to raise interest rates but it is also clear by market action that investors are not yet convinced this risk becomes reality in the short term. The talk recently has been of the Fed delaying the first move from June to September or even beyond then. If you know that for sure then why not buy longer dated Treasuries and benefit from higher yield? But you could be wrong and the Fed might embark on a series of hikes beginning quite soon. The bet in Europe is that QE will prevent any contagion from Greece spilling over into other peripheral countries and that justifies the crowded positions in peripheral debt and the willingness of investors to take more duration risk by extending to longer dated Spanish and Italian debt. But is there enough carry to protect against the political risk? A better quality bet, in my view, is that inflation will be higher than current break-evens are suggesting and that high yield spreads more than compensate investors for the default risk in the short to medium term. All of these risks and probabilities of them becoming reality constantly change as the macro-economic, business, policy and political cycles evolve. Having a strong focus on the top-down influences on markets, an unemotional assessment of valuations and the balance of current carry to risk, and a flexible approach to managing bonds in a liquidity constrained environment should generate high quality returns through the cycle. After all, bonds should be low risk and returns should be relatively stable and this approach is one way of achieving this investment result.