What to do in bond markets

Richard Ryan explains what to consider to reduce risk when investing in fixed income

Investors in Europe’s bond markets could be forgiven for wanting certainty and direction.

In fact few people around today can remember a period of greater uncertainty. Who knows what Europe’s outlook for growth, inflation, interest rates and other economic indicators actually is?

Certainly not politicians. Yet that hasn’t stopped them intervening in bond markets, with the aim of maintaining confidence in the region or a specific country or currency.

If anything that can make for even more uncertainty – who can say, hand on heart, that they can predict the true whims and wishes of policymakers?

As the sovereign debt crisis rumbles on, the tremors and aftershocks continue to be felt in corporate bond markets.

The bellwether of volatility is the behaviour of corporate bond spreads – the additional yield demanded by investors in compensation for the extra risk of lending to a company rather than a government.

Spreads have risen and fallen rapidly and frequently, driven not just by concerns over sovereign solvency but also the solvency of the entire financial system and the prospects for economic growth.

The response from institutional investors has been fascinating. Even though the yields on many corporate bonds are (as I type) comparatively low, many have been buying as though this were their last chance to lock in a positive credit spread.

It would seem that the fundamental economic imbalances of the eurozone have been swept aside by the surge of liquidity that the European Central Bank promises to unleash.

What these bond-grabbing investors are essentially doing is building into their portfolios an expectation that the world will right itself and do so without any set-backs. The short term memory of the market is back in control.

In return, issuers of bonds, the world’s companies and their investment banking advisers, have been supplying the market with new debt – billions of euros’ worth in recent weeks and months alone.

You read that right. So convinced are they that investors will buy just about anything, companies are tapping bond markets to take advantage of historically low borrowing costs.

That wouldn’t be too bad but in a sign of the ‘return of the good times’ they are also trying to issue these bonds with little investor protection. That means, in a default or restructuring scenario, a bond investor’s rights have been deprioritised.

That doesn’t sound right. Bond investors can almost always lose more than they can ever gain. To that end they look first at the likelihood and possible extent of a bond’s losses before they look at the size and shape of the yield on offer.

Have we arrived at a place where institutional investors’ portfolios need a good outcome to perform?

A place where, out of the many possible outcomes, investors’ port-folios are tied to just one?

It’s hard to say. But what we do know is that predicting the future is no basis for a fixed income portfolio’s investment strategy, whether we face unprecedented levels of uncer-tainty or not.

Right now, a more prudent and flexible approach would be to put yourself in the position to buy cheap bonds. That means you have the opportunity to lock in high levels of yield. In the process, if you can select bonds that offer high levels of protection, namely a good claim on a company’s assets if things go wrong, then so much the better.

Any bond fund manager worth their salt should be doing this. Some of them will do it through a total return fund.

Often associated or confused with diversified growth funds, which allocate far beyond fixed income, a total return bond fund is where the client (usually with their adviser) sets a target, say a ‘cash plus one’, and then mandate a fund manager to meet or beat it over say three years, annualised.

In European fixed income, there seems little point looking outside a ‘cash plus 3 per cent – 5 per cent’ yardstick.

What should investors look for when considering this approach? They could start by asking three questions.

Total or absolute returns?
Over the medium term, a total return fund will tend to shoulder falling returns over brief periods when market conditions are poor, in anticipation of the bargains to come. That is often manifested in the opportunity to buy cheap bonds, when value is really starting to show itself and, when value remains scarce, the fund manager will balance that by sitting on the sidelines in cash and secure assets.

An absolute return fund will tend to go for a positive return in all market conditions. That’s fine if you want uniform, smooth, linear returns. However, to achieve that you will probably end up mandating your fund manager to use often complex long/short strategies. And that in turn can mean additional leverage, and the fund manager holding bonds that do not always behave in the way predicted.

Here, an old adage of fund management rings particularly true: the only impediment to taking a compelling investment opportunity is to be invested in that opportunity in the first place.

Broad or narrow universe of bonds?
If we are just looking at bond markets, and investors may not want to stuff their fixed allocations with diversified growth or multi asset type funds, the next question is which types of bonds should they select from?

A persuasive school of thought says you cannot arbitrarily divide credit markets into, say, investment grade, high yield, mortgage backed, covered bonds, loans and so on. It’s all just credit. Ideally you want to see the whole of the waterfront.

This means a fund manager should really have mandate to dip into the full range of public and private debt assets if need be.

Time was when the securities available from Europe’s loan market weren’t available to institutional investors. Today, sifting through that market issuer by issuer throws up opportunities to achieve better returns, or gain more security than may be available in Europe’s high yield bond market.

It’s hard to see how a fund that allocates to just certain parts of public credit markets – government, investment grade and high yield – can make these sorts of decisions.

How to navigate that universe?

One way to do it is to broadly divide the assets into attack and defence. That gives the fund manager the chance to thrust or parry based on whether the bonds available for purchase are offering adequate compensation for the risks on offer.

A good example is core country (such as Germany) industrial, invest-ment grade bonds. This band of issuers remains one of the most robust groups in the market.

However, spreads on many of these issuers have collapsed, giving windfall gains to investors. With the tiny spreads remaining these bonds offer no compensation for the ‘unforeseen’ risks.

These days, a flexible fund should be starting to accumulate cash, waiting for the moment to tilt the portfolio away from defence and into attack mode – the market can throw up plenty of cheap bonds in future.

Of course no-one knows when that will happen but a very plausible outcome is that uncertainty will continue to engender volatility. And an investor equipped with the tools to exploit volatility and an expectation of total returns may well fare better than one buying bonds in hope.

Written by Richard Ryan, alpha opportunities fund manager, M&G Investments

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