Phil Milburn

Be prepared to take the right kind of bond risk

Phil Milburn

Interest rates will be kept too low for too long as the world recovers from the Covid-19 crisis, with rising inflation as governments allow economies to run hot among several challenges for bond investors.

This may potentially push bond funds into taking more risk in either vulnerable longer-dated assets, or short-dated investment grade or high yield, but we see problems with all these options. Rather than chasing yield, we prefer to add to fund returns incrementally via low-risk alpha trades across the market; as for high yield, we maintain our long-term focus on quality – it is the quality of the companies paying the coupons that represents the risk in this asset class, not the time to maturity, and shorter duration is no hiding place from defaults.

Our view remains that consistently low or negative interest rates are counterproductive, leading to stagnation and destroying productivity by allowing zombie companies to continue. But with fiscal policy aligning more strongly with monetary in recent months, and fiscal measures having far more efficacy with ultra-low rates in place, we would expect the latter to remain depressed for far longer than they should.

If you look at central bank policy, the Federal Reserve’s dot plot chart in June shows current rock-bottom rates persisting until at least the end of 2022 and there is a similar picture for both the Bank of England and European Central Bank (ECB). Apocryphal they might be, but stories of the ECB looking to save paper by removing the pages about rate rises from its monthly voting packs show which the wind is blowing on the Continent.

At the same time as artificially low rates, we have more central banks considering explicit yield curve controls and huge quantitative easing programmes continuing (at $80bn a month minimum in the US), and all this means the inflation goalposts are moving. As stated, many governments are prepared to run economies hot to compensate for lost output and will be more tolerant of inflation, creating an environment in which fixed income investors will need to avoid getting burned.

A large part of this lies in the ‘anchoring’ of short-dated government bonds, with implicit yield curve controls effectively removing volatility from the short end and distorting the market. Typical curve trades, where managers look to exploit different levels of yield, are now effectively just directional bets on the longer-dated bond: pair trades only work if both legs can actually move in price. If we take five-year versus 30-year US Treasuries for example (as shown on the graph), the curve has steepened with record supply to finance fiscal deficits. But with the five-year bond basically anchored at 50 basis points, a 5s30 ‘curve trade’ is now just a play on the 30-year paper.

Given this situation, fixed income investors need to ask not just a fund’s duration but exactly where that duration is being taken, both geographically and in terms of maturity.

Steepening curve but anchored five year debt

So, what options do bond managers have as markets, and inflation, start heating up? If we look at short-dated investment grade for example (as a replacement for those anchored short-dated government bonds), spreads still offer reasonable value, recovering after a major dip in March and April, and this market is also supported by Federal Reserve buying via its Secondary Market Corporate Credit Facility (SMCCF). The major drawback is that yields are currently at their lowest-ever level, falling to 1.35% on US 1-5 year bonds in mid-June, so for income seekers, this area adds a little but not a lot.

Faced with such a low-yield dilemma, the natural tendency of many bond managers is to chase it in longer-dated bonds or by taking more credit risk despite the uneven recovery in progress across different sectors; social distancing is far more onerous for hospitality companies for example. As for longer-dated bonds in aggregate, the problem is that they are more vulnerable to that potential inflation pickup and there will also be record levels of supply to finance the fiscal deficits governments are running.

For us, rather than chasing risk either up the curve or into more stressed sectors, our solution is to add more low-risk alpha trades with low directionality to supplement returns, whether in rates, allocations (European versus US investment grade for example) or stock selection.

Another option for bond managers is high yield but we are not convinced by the argument that shorter duration HY is necessarily lower risk: over the last year, drawdowns from 1-5 year high yield have been in line with the broader market. Instead, our high yield focus remains on quality rather than duration, with 80% of the holdings in our Liontrust GF High Yield Bond Fund stock market listed. The average market cap of our listed holdings is greater than the average of the FTSE 100, which is the main reason we struggle with the junk label frequently foisted on high yield.

Our stock research and portfolio construction help us avoid accumulations of thematic risk in the portfolio (we are underweight energy, mining and retail) and that has largely prevented us having to sell bonds during recent drawdown periods.

As stated, we are expecting economies to be run hotter; even after growth returns, rates will be kept low and inflation allowed to tick upwards. This creates issues for bond managers, with longer maturities more vulnerable and drawbacks in shorter-dated bonds across the spectrum – ultimately, we continue to believe there are opportunities out there but fixed income funds must be prepared to take the right kind of risks.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Thursday, July 2, 2020, 12:16 PM