Turning off autopilot

Fixed income is the biggest asset class in terms of invested capital but this can create challenges for investors.

Technical factors to consider:

Different actors, different motives

• It is important to note that different actors in the bond market are driven by different motives, creating market dislocations where active managers can add value. For example central banks are active in bond markets often to manage liquidity needs or as an explicit part of managing their inflation mandate, (as mentioned above). And then there are liability driven investors that have a focus purely on duration matching. Investor preferences and behavioral factors can also play a significant role, for example when investors are forced to sell bonds that are downgraded below a certain rating. The one thing all these investors have in common is that they tend to be insensitive to pricing or measures of fair value. This adds an extra dimension of market dislocations where active investors can add value, actively navigating the market structure.

Dangers in market-value weighted indices

• Owning debt is different to owning equity. While debt owners may be higher on the subordination scale (and bene- fit from certain protections), the return profile of bonds is highly asymmetric meaning a limited upside but potentially significant downside. The majority of fixed income indices are constructed on a market value basis
• which gives the largest borrowers the largest access to capital. This means index investors naturally have the biggest exposure to the most indebted companies or countries, which may not be appropriate. Clearly this is inefficient from an economic perspective and may encourage the build-up of credit bubbles. Given the extremely loose monetary policy seen post credit crisis, being “flexible” and “selective” is key.

• During times of market stress, when certain more liquid issues may underperform the broad market, investors tend to “head for the doors” indiscriminately selling what they can. This provides an opportunity for active investors, who can selectively act as liquidity providers, seizing the opportunity
  

Beyond Duration

As well as a longer duration there are other changes in global bond market composition that add to downside risks for investors. A more granular analysis of the Global Aggregate Bond Index shown in exhibit 2, highlights two further important points to consider:

• Negative Yields
  In several countries central banks have been prepared to take policy rates into negative territory as a tool to help them meet their inflation targets or to prevent an undesired strengthening of their currencies relative to others. Europe and Japan are prime examples of the former with countries like Switzerland and Sweden in the latter camp. This has a knock-on effect of pulling bond yields in those countries into negative territory, particularly in short and intermediate maturity bonds. As a consequence today roughly 20% of the Bloomberg Barclays Global Aggregate Index is trading at negative yields. It is possible this ratio might even increase in coming months, as some central banks wrestle with inflation running some way below target. Investors owning such bonds to maturity will be guaranteed negative nominal returns and so decisions to allocate cash to these markets require careful consideration. Active managers will be very selective in choosing which of such bonds to own and only have significant holdings when they offer good value relative to other markets.
• Credit Quality
  The deterioration in average credit quality of major global bond indices also poses a challenge for investors. Consider the Barclays Global Aggregate Corporate index shown below. Since 2000 the share of companies rated BBB (the lowest rating in the investment grade spectrum) has more than doubled from 22% to 51%. In many ways this is to be expected, because years of falling bond yields have allowed companies to refinance cheaply, often funding share buy-backs with debt and generally increase leverage (now reflected in the lower ratings). It is still the case that the default rate implied by the level of credit spreads today is higher than the historical realized default rate giving skilled managers an opportunity to earn excess returns in their credit allocation. However, the challenge going forward will be that any disruption to the global growth outlook might trigger a wave of credit downgrades that will be unprecedented compared with previous cycles. Active investors at least will have the flexibility to avoid exposures to those companies which they consider most at risk.

Exhibit 3: Global Aggregate Corporates Bond Index historical rating distribution

Investors in our global strategies benefit from:

• Independent portfolio construction utilizing local market insights. A dedicated global bond team drawing on the local market and sector expertise across our Fixed Income business.
• Independent and non-correlated sources of alpha that exploits the full opportunity set of duration, curve, country, currency, sector and security allocations.

A team of more than 25 career analysts with sufficient scale to offer comprehensive coverage of opportunities across global credit markets, whilst allowing analysts to focus on the areas of the universe that can add value to client portfolios.

Exhibit 7: Unique value proposition across Global Strategies – A strategy for each investment style

Active Global Bond Solutions