The worst is yet to come for traditional fixed income investors. When a bull market persists for multiple decades, it jades people’s thinking. They don’t see the possibility of losing money in the asset class. Nowhere is this truer than in fixed income right now, and I hope that investors diversify before it’s too late.
There are three factors that will drive the dynamics of fixed income markets over the next cycle – rotation, the economy and the political environment. Are investors positioned opportunistically with regard to these factors, or are they going to be whipsawed by them?
Let’s review. The rotation you’re seeing is of the classic variety – what’s good for equities is not good for fixed income. But think about it: overly aggressive monetary policy has distorted that conventional relationship and it has become normal for bonds and stocks to rally together. I’ve never really bought into that concept.
Typically, what’s good for risk is good for things like equities or lower quality debt. And the further down the quality scale you go, conventional wisdom says, the more return you will get in a ‘risk-on’ environment. Expectations for lower corporate tax rates, loosened regulations or potential deregulation, and changes in the health care system will be fairly good for risk, which we have already seen since Trump’s election.
I expect these trends to continue although possibly in fits and starts. One thing is for sure, the environment is not likely to be good for rates – and whatever is not good for rates is not good for traditional fixed income, such as government bonds, investment-grade corporates, agency bonds and agency mortgage-backed securities. These sectors are very highly correlated and do not offer the diversification element investors should be looking for in a rising rate environment. Even diversified traditional fixed income funds have and will continue to struggle in a rising rate environment. The way to diversify is to be unconstrained and opportunistic, to ensure that all opportunities in the market are exploited.
From an opportunistic point of view, credit rate risk is still benefitting fixed income investors. The single most important thing to consider when you look at a lower rate of credit is whether or not it has been overbought. In complete contrast, things like emerging market debt, local currency emerging market debt, traditional bond funds, are all overbought. They’ve been the recipient of massive flows for quite some time, whereas high-yield has only just started to get flows. In fact, high-yield flows just turned positive toward the end of 2016.
High-yield still has room to run. We’ll know it’s been overdone when we see heavy retail flows, and that hasn’t happened yet. In an opportunistic fund, when we do see high-yield get overbought, we will take a hard look at those allocations, raise cash, raise short positions, and focus more on other errors of the market where securities are mispriced. We won’t just be stuck with high-yield. Our flexibility allows us to do this. It would also allow us to get back into securities with sensitivity to interest rates if rates go high enough – for example, mortgage-backed securities on the agency side, rather than just the non-agency side.
It’s impossible for investors to predict how many times the Fed will raise rates, but the time to get positioned is now. The Fed’s forecasts have been imperfect for years now, so there is no point in trying to guess how many lifts we may see this year. But if the economy picks up the way we expect it to, and there are a few hikes, there will also be inflation.
So how should investors diversify away from traditional fixed income? Generally speaking, for a long position to be of interest to us in this environment it needs to have three things: a margin of safety, in other words a big enough coupon and/or income stream to offset the fact that we may be early on the allocation; reasonable technicals, which to me means that it’s not over-owned; and, fundamentals.
We’ve made moves like hedging some of our Double B exposure, moving down in quality, moving more of our fixed-rate exposure to floating-rate exposure in the form of loans in closed-end funds that are targeting loans, deemphasizing double B, and maintaining a reasonable cash position, which is 23% to 24% right now. There will be opportunities during many volatility spikes in the next market cycle. And we’ll find more things to do with cash, possibly even in the traditional arena at some point. Rates will have to adjust quite a bit further to find opportunities in more traditional segments of the market. As a result, our strategy has absolutely no correlation both short term and long term to traditional fixed income portfolios which is what makes it a very good non-correlated diversifier.
It’s time to start thinking outside the box in fixed income and diversifying holdings. Just because a benchmark holds a security doesn’t mean you have to. There’s a really big difference between doing what is easy and doing what’s right. Now is not the time to do what is easy.
Bill Eigen is a fund manager on the JPMorgan Income Opportunity Fund