Fixed Income: Beneath the waves

OPINION | Chris Elsmark and Laurent Auchlin 

Is it time to consider a new playbook for fixed income investors? To help us articulate a response to this question, we have devoted some time to write down our initial thoughts. By sharing our collective opinions here, we hope the professional investor might benefit from our reflections and contribute to thoughts around this topic.

The COVID-19 pandemic is a human tragedy, as well as a social, political, and economic challenge. We are convinced that humanity can survive this pandemic (thanks to health professionals and other key workers), but we will be judged by how we survive it. What type of society will emerge depends on what concerns come to the fore and how they are dealt with. 

What is clear is that the old policy playbook has been thrown out. Monetary and fiscal policy responses have been swift to ease market liquidity problems and dampen the risk of significant economic and financial fallout from COVID-19. The speed of adjustment, especially in the fixed income markets, has caught investors off guard. Investors will be closely watching the interaction of monetary and fiscal policy. As we write this, oil is trading at negative prices; so the best that can be said is that market volatility isn’t going away anytime soon. 

Investors were anxious about both present and future prior to COVID-19, but the crisis has accelerated these emotional states. In response, investors should aim for a tone of disciplined calmness to reflect whether they need to adjust their portfolios to meet their investment objective, time horizon, liquidity needs and risk tolerances. Fixed income investing, typically, serves three central roles in a balanced portfolio; namely, a ballast to a portfolio (capital preservation), while providing income and, at least in part, diversification benefits from equities and other riskier asset classes. It feels strange when bonds don’t go up in value when risky assets go down. Fixed income funds have seen significant outflows on the back of investors’ need for liquidity, fears that there will be waves of corporate defaults, and a desire to re-balance their portfolios. Further demands by investors to redeem their investments in daily liquidity fixed income funds should see more forced sellers in the corporate credit markets.

Investors are understandably cautious and future returns could look very different to previous periods. What we want to emphasize is that investors should pause and consider the different possibilities for their fixed income allocation. An active approach can potentially make sense of businesses and segments of the markets most at risk, as well as take advantage of dislocations between price and structural credit strength as they arise. In turbulent times, investors could benefit from active fixed income managers that show an ability to manage returns, but also risk.

That is particularly true when we are talking about high yield markets and Bank Loans, where indices (the market) will have a very different composition than the portfolios of active managers. The COVID-19 sell-off has turned some investment-grade bonds into so-called “fallen angels”. One of the highest profile downgrades was that of Ford (which represented more than USD250bn debt) from investment-grade credit rating to high yield (junk) bonds. Further downgrades from investment grade into high yield should be expected in a recessionary environment; leading to expectations of more forced sellers who are bound by law (and/or internal guidelines) to make some of their investment decisions dependent on the ratings.

Caution is advisable, as there is still a lot of uncertainty. Defaults will rise, although there remains some doubt whether a cascade of defaults should be expected. The global default rate on US High Yield, which was on a long-term history close to 6% pa, dropped to 2% p.a. for the last 36 months as of December 2019. There is talk that it most probably will rise to more than 10% p.a. for the next 12-24 months. Dislocation provides opportunities for active managers, while on the other hand investors who have an exposure through passively managed strategies might wish to reconsider, especially should this orientation not meet their investment expectations (or that of their clients). Risk averse investors might also wish to consider their exposure to bank loans as risks have been building in some sectors of that market. When assessing opportunities, it is critical to be selective.

For many experienced investors, a crisis is not uncharted territory. A key to successful fixed income investing is to recognize what pitfalls are inherent in trying to achieve a sustainable outcome from an unreliable market. Even more than before, fixed income indices are giving more complexity than investors may have bargained for. We believe investors should revisit the benefits of more dynamic and flexible fixed income investment strategies that are adaptive to markets. Fund/manager selection should help to identify those with the skills to assess, and flexibility to take advantage of fundamental opportunities relative to compensation across a broad opportunity set. 

As an introduction to this article, we’ve included a photo of a black swan (courtesy of a talented photographer friend, Tero Viherto). COVID-19 has proved again that black swans exist. As we have seen this last quarter, a fascination with yield (with little regard for long-term risk) can result in some unexpected and unpleasant consequences. Keeping an open mind and adaptability in your asset allocation will be essential to prosperity and capital preservation in these changing market conditions. The bottom-line is there are still too many unknowns. 

This opinion article is for general informational purposes only and is for professional investors (not for retail). These are the opinions of the authors at the time of publication and may differ from the views of their respective employers and colleagues. While the information contained herein is believed to be reliable, there is no guarantee to the accuracy or completeness of any statement in this article. This article may be subject to change, revision, and rethinking.  The information in this article does not qualify as an investment recommendation. As of April 21st, 2020.