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Sunday 20 October 2019

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No longer steady

Written by Sandra Haurant
November/December 2011

Sandra Haurant examines what’s happening in the no-longer-predictable arena of fixed income

For many investors, fixed income has long been seen as the part of the portfolio that provides steady returns. The low volatility part of a pension fund investment, balancing out riskier parts and offering a dependable income without too much risk.

Traditional safe havens such as European and US bonds offered relatively low yields but at negligible levels of risk. They may not have paid handsomely, but they provided investments with a safe income.

The idea of those countries not being able to pay back their debts was considered extremely unlikely. Those in search of higher yields would turn to emerging markets bonds, where greater volatility could translate into more dynamic returns, but higher yields came in return for the increased risk of default.

Now, though, the world of fixed income investment has been turned on its head. The safe havens of the past have become today’s choppy waters. What were once considered the low risk areas of credit investment are now the ones presenting the markets with the greatest concerns, while countries formerly considered very risky are becoming the go-to zones for those looking for a less bumpy ride.

Greece, Spain, Italy and Portugal, among others, have seen their credit ratings downgraded and their bond yields increase amid growing concerns that their level of debt is unsustainable. The European crisis has, many argue, provided evidence that the traditional approach to fixed income investing is, in fact, flawed.

Against this backdrop of deep uncertainty, many argue that the investment industry needs to take a serious look at how fixed income investment decisions are made. Indeed, Stratton Street fixed income portfolio manager Andrew Seaman says: “The whole fund manage-ment industry has been managing backwards for decades. It’s been a question of lending to most indebted countries, and those with low debt don’t get a look in.”

As things stand in traditional indices, the more a country issues debt, the more an investor in the indices is exposed to that country. The country becomes more and more indebted, and the investor is ever more invested in that growing debt. If the increasing debt becomes unsustainable for the country, the investor is exposed to a greater risk of default. As Lombard Odier head of rates Gregor MacIntosh puts it: “It goes against everything you are taught about not lending to the person who has the most debt.”

So the first question to ask, then, is not whether a country appears high up on an index, but whether it is able to repay its debt, which is the approach adopted by Lombard Odier. “We think it is very different to what everyone else is doing at the moment, and the approach has paid off handsomely,” says MacIntosh. “The big banks create indices and it serves their interests to do so. When you look at the consulting industry, they like to have a degree of comparability. But the core of our belief is, why do something that does not serve investors’ best interests?

“I would say that diversification is very important – having over concentration of risk is the first thing to avoid. It is important to construct a portfolio of countries that are able to service their debt.”

The current, broadly used system of indices is something of a house of cards, argues Seaman. It allows countries to rack up more debt, and leaves investors unintentionally exposed to higher levels of risk than they want to see in their portfolios. “Indebted countries issued more bonds regardless of any value. In early 2009 we published a list of 12 countries we thought were vulnerable. Iceland, Estonia, Latvia, Greece, Portugal were all on there. No one was talking about them being indebted in 2009.”

While yields are low, in theory a country may be able to service that debt. But once alarm bells are ringing over the percentage of borrowing to GDP, and yields increase based on increased risk, the debt becomes far more expensive to service. Italian yields increased to over seven per cent in November 2011, a sharp jump up from 5.8 per cent in October 2011, and Spanish debt hovered just below the seven per cent mark.

According to Invesco head of emerging markets Claudia Calich, a large part of the historical problem with exposure to European debt is that investors have looked at Europe, to some extent, as a single entity. “In the eurozone, until the Greek crisis, there was really not much distinction between different countries,” she says. “I think the way we look at them should change. Clearly you need to have credit distinction between all those countries.”

Indeed, she argues, the distinction between the developed world and emerging markets is becoming rather blurred. After all, certain countries in the developed world become greater credit risks than many of their emerging market counterparts. “Emerging markets tend to have a reputation of being the basket cases,” says Calich.

“But there are emerging market countries that are single A rated.” Which is somewhat more reassuring to investors than the dramatic downgrades that have been seen in Europe.

“Greece was a developed country. It has not become an emerging market country because of the crisis,” says Calich. It may have reached ‘junk bond’ status, but that does not necessarily mean it joined the ranks of the emerging market countries.

And, some might argue, European bond investment may well have benefited from an approach more akin to that of the emerging markets side. A tendency to think of European bonds as one broad area of investment rather than looking at individual countries clearly leaves investors at greater risk than taking a closer look at what is going on in each individual country, and Europe seems now to be learning lessons that have already made an impact on emerging markets. “We had so many crises in the 80s and 90s that countries learned
from those,” says Calich. “There has always been much more scrutiny. You always had to look at each on a case by case basis.”

And looking away from govern-ment bonds to the corporate arena, some argue that you need to look beyond the country to find value. “We are starting to see value in some of the Italian corporate bonds,” says Invesco fixed interest product director Lewis Aubrey-Johnson.

“In corporates like Fiat, for example. The bases are strong but yields having been rising because of its domicile.”

There is, argues Aubrey-Johnson, scope for opportunity in the rapidly changing landscape of fixed income. “Europe is facing profound challenges, but as we look further out our confidence grows,” he says. And DB Advisers portfolio manager for global fixed income Gordon Ross adds: “There is volatility, which creates opportunity. You could see this as a short-term phenomenon in the timescale of a pension fund.”

Certainly, there is no clear end in sight to the turbulence in Europe and beyond. Within Europe, contagion is a reality and the problems clearly spread further than the eurozone. Aubrey-Johnson believes Europe is heading into another recession, and Seaman adds: “Our global growth model suggests on verge of glwobal recession.”

It remains to be seen which approach to fixed income invest-ment will be the most effective, but what is evident is that the traditional models are certainly going out of vogue. Focus is shifting towards absolute returns and away from traditional benchmarking as a measure of success, and greater attention will be paid to the individual countries and their ability to repay their debts. The old, familiar safe havens may no longer exist, but Calich suggests that emerging markets could provide some of the dependable, steady returns that investors need to replace what they once had in Europe and the US. “We are in a new game now,” she says, “Which leads you to rethink your portfolio. You need to think about the rest of the world.”

Written by Sandra Haurant, a freelance journalist



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