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Continuing the search for yield

Written by Lynn Strongin Dodds
December 2013 - January 2014

Amidst the ECB rate cut and the Fed’s hinting at tapering, the search for yield in fixed income portfolios continues unabated, Lynn Strongin Dodds finds

The European Central Bank’s (ECB) recent decision to cut its benchmark interest rate to 0.25 per cent, a historical low, may have surprised markets but it did not move the needle on the fixed income investment compass. Institutional investors are staying on the unconstrained course, looking across the credit and duration spectrums with some also heading into real asset terrain.

“The impact of the ECB rate cut is pretty limited because rates were so low anyway but it has a symbolic impact because it shows that the central banks will do anything to stimulate growth,” says J.P. Morgan Asset Management international CIO of fixed income Nick Gartside. “Investors are now more comfortable to take risk because they see the ECB being proactive.”

Few market participants though expected to see the central bank move so aggressively. “The timing was surprising,” says Henderson Global Investors director of fixed income Kevin Adams. “On the face of it, the economic data in the eurozone looked a bit stronger but the ECB has concerns over falling inflation and they wanted to avoid a Japan-like situation.”

According to ECB president Mario Draghi, the recent interest-rate cut was aimed at providing a “safety margin” to keep inflation from falling too close to zero. It is currently running at 0.7 per cent, well below the targeted rate of 2 per cent and if it continues to hover around this level or drop, some market participants believe that interest rates could slip into negative territory.

The eurozone’s economic woes are not the only problems hanging over fixed income markets. The mixed messages from the US are also taking their toll. In its latest financial stability report, the ECB said that the risks to the region’s financial system from outside the currency bloc had grown since May on the back of the Federal Reserve’s talk of tapering its $85 billion-worth of monthly bond purchases. This caused a major re-pricing in global bond markets as participants geared up for the reduction.

In the end, the Fed unexpectedly pulled the plug on the idea but the general consensus is that it is only a matter of time before tapering is back on the table. “Central banks are walking a tight rope with their forward guidance,” says Threadneedle Investments client portfolio manager, fixed income James Waters. “They want to provide more guidance and hence help reduce the uncertainty premium, but if they step away from that guidance it can seem like empty rhetoric.”

Despite the talk and the divergence in central bank policy in the US and Europe, the search for yield remains unabated. As Waters puts it on the beta front, investors have three options: “to go out on the curve, down the credit structure or take more illiquidity premium. The other choice is to focus more on adding more alpha and absolute return strategies although they have received mixed press over the last few years. This is why investors need to look for managers who have been successful at generating additional value.”

State Street Global Advisors head of investments, EMEA, Bill Street says: “Manager selection is always important but if you are in an absolute framework, there is no hiding place. The alternative is to be tied to a benchmark and exposed to market risk. I think given the record low yield environment, it is an ideal time to look for opportunities in an absolute return framework. Investors will however need to do the right due diligence.”

Gartside also sees pension funds migrating away from benchmarks to take advantage of a larger opportunity set. “They are looking at absolute return funds which promise to deliver consistent returns regardless of market conditions as well as total return funds which take a more strategic view and try to make the journey smoother although there is an acceptance that things may go wrong at times.”

There are of course different flavours within these strategies. For example, in the absolute return arena, some funds adopt a macro-based approach that expresses top-down views on interest rate, currency, country and sector exposures while others follow a more concentrated path. This involves investing across the broad fixed income market or specialising in a single sectors region. There is also the hybrid fund which encompasses both methodology and looks at the full range of global fixed income sectors, rate markets, and currencies.

According to Neuberger Berman fund manager Jon Jonsson, the firm uses what it calls a ‘state-space analysis’ framework to help shape the asset allocation within its global absolute return fund. This incorporates what current market expectations are for the return for a given fixed income sector, what each sector team expects the return to be, and what confidence they have in that expectation, which is a key component of the teams fundamental asset allocation strategy. A range of fundamental variables are factored in and the probability of these scenarios materialising.

New strategies are also being formulated on the credit pitch with the return of the multi asset credit or MAC fund with the majority seeking to combine exposures to high-yield bonds, leveraged loans, mortgage and asset-backed debt securities, emerging markets debt and distressed debt. “We are definitely seeing more investors looking to outsource their credit allocation,” says Blair Reid, institutional portfolio manager for BlueBay Asset Management’s asset allocation products. “One of the main benefits of these funds is that they allow managers to change allocations in a timely manner because they are not benchmark driven. We can rotate in and out of different asset classes plus we have the ability to move into cash if we need to.”

Adams has also noticed greater allocations to multi credit strategies. “High yield, asset-backed securities and loans are in the sweet spot because they are floating rate notes which not only generate a decent return but also are not particularly sensitive to interest rates.”

High yield in particular has caught the imagination because it is negatively correlated with government bond markets and more in tune with equity markets. This is why the asset class rebounded quickly after volatility sent bond markets across the board spiralling after the Federal Reserve hinted at tapering. Returns to date have been around 5.5 per cent to 6 per cent, approximately twice the return from equity dividends and fund managers are optimistic about next year’s prospects due to the ongoing improvement in high yield issuers’ balance sheet quality, and the market’s abundant liquidity.

Atlanticomnium (UK) CEO and manager of the GAM Star Credit Opportunities Jeremy Smouha believes investors should not ignore companies higher on the ladder. “The search for yield can take investors to risky countries and companies in the high yield and emerging market debt space. Our strategy is to invest in the junior or subordinated issues of investment grade companies. We conduct detailed analysis and identify strong companies with a very low probability of default. This enables us to go lower down the capital structure and generate higher returns regardless of market conditions.”

While fixed income and credit are proving to be fertile ground, investors are also venturing into real assets which are attractive for their potential to garner equity like performance but with greater downside protection. “I think real assets can be a substitute for fixed income,” says Dexion Capital founder Robin Bowie. “The positive is that they are not correlated with equity markets and can hedge some types of inflation risk, while the negatives are that sourcing these assets requires specialist skills.”

Legal & General Investment Management head of fixed income product specialists Shelly Moledina adds: “Assets such as real estate or infrastructure debt are not as liquid as bonds and do not have a natural benchmark. However, they are strategically important and can generate income as part of a diversified portfolio.”

Lynn Strongin Dodds is a freelance journalist



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