After 30 years of bull market, more selective path required for fixed income, says ECM co-CIO Pamphilon

Ross Pamphilon, co-chief investment officer and portfolio manager at ECM, says that the current investment climate demands a more selective approach by investors in fixed income.

Financial markets started the New Year positively following news that the House of Representatives passed a compromise bill extending tax rises only to the wealthiest individuals earning $400,000 or more a year and avoiding cuts in federal programmes ranging from defence through to welfare. The improving sentiment towards the eurozone also contributed to lower peripheral bond yields and provided a good backdrop for the primary markets to reopen. However, while the equity markets enjoyed a strong start to the year the story was a little more complicated for fixed income.

Looking at fixed income, the biggest losers in January were clearly core government bonds with 10-year US Treasury, UK Gilt and German Bund yields 23bps, 27bps and 36bps higher respectively. Although the sell-off in core rates is more related with a rotation out of safe haven risk-free assets as systemic risk declines, the overall movement in yields was significant enough to push the total returns for major credit indices into negative territory on the month. Taking the euro-denominated investment grade corporate index for example, total returns were negative 1.17% on the month while non-financial high yield lost 10bps. However, looking at these same index returns but instead on a duration neutral basis tells a different story. The excess swap returns for the same corporate and high yield indices were positive 24bps and 94bps respectively on the month. In January credit spreads therefore tightened on the month while on an unhedged basis yields rose due to the related sell-off in government bond markets.

There is no denying that the 30 year bull market that has prevailed in the government bond markets has brought with it attractive nominal returns for fixed income investors. In our opinion, central banks are likely to remain accommodative for the next 12-18 months given low levels of economic growth and as a result we do not necessarily expect a material sell-off in core rates. However, while that remains our base case we also believe there is plenty of scope for further volatility and weakness in today’s core government bond markets. Furthermore, with core 5-year government bond yields at or close to all time historical low levels we find ourselves faced with both negative real yields and potentially insufficient “carry” or coupon to compensate in the event of meaningful increases in yield. Being invested in government bonds at this point in the cycle therefore presents the investor with an asymmetric payoff profile with limited upside potential.

So, staying within the world of fixed income, how can investors protect themselves in a low yield environment if they are worried about potential future rises in interest rates? Firstly, corporate credit spreads offer a significant pick up to government bond yields and can be readily hedged for interest rate risk by shorting swaps, futures or government bonds. This allows investors to capture the excess returns available from the credit market while actually benefiting from profits on hedges in an environment of rising rates.

Additionally, rather than hedging interest rate risk, it is possible to invest in credit instruments pre-manufactured for us in floating rate format. Floating rate corporate bonds, senior secured loans and asset backed securities are all issued with coupons priced as a spread over floating rate benchmarks such as Libor, while the loan market has introduced Libor floors over the last few years to protect investors from absolute low levels of floating rates. Additionally, CDS provides the opportunity for investors to gain exposure to credit in a form which is less sensitive to rises in interest rates. In our opinion, these types of non-rate sensitive instruments are likely to benefit from increasing popularity in an environment of rising interest rates and stand to outperform their fixed rate counterparts. As a result, within ECM’s multi-asset class credit strategy Dynamic Credit Fund (“DCF”), we have been targeting relevant non-rate sensitive investments and now have 20% of the portfolio invested in these types of assets.

In order to further explore the relationship between credit spreads (BBB – 10-year Treasury yields) and interest rates over the longer term we have charted in Fig.1 60 years of data and also identified those times when the economy was in outright periods of recession.

As can be seen, credit spreads generally widen during recessionary periods as corporate profitability comes under pressure, leading to weaker cash flow generation and increasing default rates.

Fig 1: 10-year Treasury Yields and BBB Spreads

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Source : Federal Reserve, Bloomberg, ECM

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