DWS’ Torsten Strohrmann looks for the art of balancing yield versus risk in fixed income

Torsten Strohrmann, manager of the DWS Covered Bond Fund, has compared the insolvency and other risks of sovereign, corporate and covered bonds against desired yield.

Demand for safe investments is high. Regulators were alarmed and in shock due to the financial crisis. The Pavlov reflex by the regulators was to secure the financial industry by unwinding risky assets and investing in so- called ‘safe assets’. This led to an immense demand for AAA securities excluding Asset Backed Securities (ABS) or Mortgage Backed Securities (MBS). Banks and other market participants bought AAA Sovereign bonds down to 0% yield and in some cases even below that, not because they thought it was a bargain, but just to wash away the image of being risk takers to their stakeholders. Additionally banks were demanding more high quality assets as collateral for loans and derivatives than before, increasing the demand further. Insurance companies now have problems in finding high quality assets for their life-insurance customers.

Where to look for value in the fixed income space in 2013.

Sovereign debt has lost the nimbus of invincibility as the Greek situation has shown. Yields of the peripheral EMU Sovereigns are between 3 and 6% for 5 years, compared with 0,4 to 0,9% for the core EMU Sovereigns. For private investors, experiencing negative real yield, the core EMU Sovereigns look expensive, not being the “hide-out” of safe haven that investors are seeking. Peripheral Sovereign bonds do offer more, but carry increased risk. The Greek example proved that there is no hiding for the write-downs when a default hits We can’t sue anyone or got to a court to claim assets, because there is no insolvency procedure.

Corporate bonds however, have clear insolvency procedures allowing investors to claim assets together with other similarly ranked creditors. Yields however are still not very high, so indices (like the BarclaysEuro Aggregate Corporates) tell us we may get between 2 and 2.5%. When BBB rated bonds are trading in yields close to the rate of inflation, this may not be sustainable.

But there seems to be fear combined with so much liquidity that everything – given it has a coupon – is bought, and so yields are falling, very often below 1%. Money market funds are also suffering because the yield is as high as the costs, leaving investors struggling to find positive yield after costs.

Covered Bonds provide a bit more yield. They are collateralised, meaning an issuer guarantees the obligation and additionally pledges a pool of collateral assets for the sake of the covered bond investors. If the issuer is going to default, regulations ensure that the investors receive the interest and redemption for the covered bonds from the collateral. Yields however, are also low, around 2 – 2.5% but here, price performance should be considered, as this level of yield can be viewed as unfairly high compared with corporate or sovereigns. Covered bonds are, on average, better rated and provide comparable yields, so the yield of covered bonds should go down in comparison. As we all know if yields go down – prices go up. This could provide another 1-2% per year. To escape the low yield environment careful selection is key as not everything is fairly priced

Central Banks suggest inflation may stay low for the foreseeable future and leave repo-rates where they are, so real interest rates – yield minus inflation – is more depending on the yield levels. If yield levels are below inflation rates – ok, you end up with negative real yields and purchasing power of your investment goes down. So, to find positive real interest it is necessary to go for the higher yields, but either or both credit and interest risks are usually higher then. The Art is to choose the lowest risk for a given yield.


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