Sourcing resilience in fixed income

Peter Gailliot |Sep 23, 2019

A “slower-for-longer” economic backdrop, political uncertainty and a reversal of the Fed-led move toward global policy normalization suggest the need for greater resilience in fixed income portfolios. We identify six themes that we believe are critical in helping to build those more resilient portfolios.

Back to square one

For most of the decade, fixed income investors have had to contend with an increasingly challenging rate regime. Sourcing portfolio income has become a fundamental problem given the combination of low absolute rate levels and persistent uncertainty about when and how this regime will end. Investor optimism was therefore relatively high when the Federal Reserve began to unwind its crisis-era policies at the end of 2016. In the US, in particular, this resulted in a steady climb of yields, toward – and then above – 3% with a variety of market participants targeting 4% or even 5%. Some even started to wonder whether portfolios should return to more traditional allocations, become more ‘core’ and less ‘plus’.

This scenario came to an abrupt halt – and dramatically reversed – at the end of 2018, as highlighted in Figure 1. Slower than expected global growth, particularly in China, convinced the market that the Fed would have to pause and potentially return to easing. Trade tensions and political developments heightened that perception, with the messaging, and increasingly the actual policies, from global central banks eventually following suit. The market subsequently priced in over 100 bps of Fed rate cuts by year-end, with one actual cut having occurred to date, meaning global yields are now back at, or even below, 2016 levels as shown in Figure 2.

Figure 1: Anticipating central bank action

Anticipating central bank action

Source: Bloomberg, Standard & Poor’s. Data as of 2 August 2019.

Figure 2: A round trip

Fixed income sector yields

Source: Bloomberg, Standard & Poor’s. Data as of 2 August 2019.

A greater need for resilience

It now seems clear that any idea of waiting out the end of the low rate cycle is premature. At the same time, the economic backdrop has evolved from above-trend US growth, which supported investors’ shift from core into alternative strategies, to one where lower growth is likely. While an economic downturn or recession is not our base case, we see a ‘lower-for longer’ scenario as likely. This, in our view, calls for greater resilience.

Quotation start

We believe investors are justifiably less sanguine and see a need for greater resilience.

Quotation end

Six key themes for portfolio resiliency

  • The central theme is to look for quality sources of income, both when choosing sectors and picking investments. This is a good time to begin separating out management teams that consistently deliver on both cash flow results (not necessarily earnings per share) and leverage metrics. Particularly in sectors that have seen heavy M&A activity, quality is tightly linked to achieving de-leveraging goals articulated in pro-forma numbers that come with most deals.

    In securitized markets, look for underwriters focused on their core business rather than on expanding market share in this environment. Consistently question underwriting, investment banking, and rating agency assumptions and be cautious around changes to criteria from any of those sources.

  • We think stresses in the turn of the cycle will mostly come through long-run themes and issuer-specific events. While idiosyncratic risks are hard to predict by definition, they warrant special attention. The most likely path to identify them is through traditional fundamental research. This holds true across asset classes. It is also a good time to avoid investment theses with binary outcomes, particularly if they are linked to legal or regulatory factors. There may be scope for such positions when a growing economy can smooth out the effect of adverse outcomes. Now is not such a time.

    In addition, optimization along mean/variance dimensions may miss forward-looking factors that suggest the need for caution at a turn in the cycle.

  • Over recent years, insurers have been seeking out less liquid asset classes for additional risk premia, potentially without increasing duration or credit risk. From a resilience perspective, it is now worthwhile assessing how much liquidity was ‘sold’ and what sources of liquidity remain. Such an analysis will of course have to reflect specific factors such as liability profile and regulatory environment, but a broad framework can help.

    First, any analysis should recognize how liquidity varies dramatically between normal and risk-off times. Assets that are easily sold in the first state may not see any bid in the second. Outside of US Treasuries (and other reference government bonds) there are gradations of liquidity based on factors such as issue size or time since issuance, which we think warrant a dynamic assessment, at least annually.

    Second, beyond having robust buffers in cash and short duration government bonds, insurers need a good sense of how much liquidity they could source from the asset portfolio if required. Recent volatility has underlined the need to think hard about this. For example, a single A-rated corporate portfolio may look liquid now but during a heightened downgrade cycle, the portfolio may experience a shift down in credit quality and liquidity. A robust liquidity assessment should be part of standing risk management practice, regardless of the current environment, but now may be an opportune time to revisit your approach to liquidity and test its robustness against a range of scenarios.

  • Most prominent among which is the ongoing disruption of traditional industrial sectors by technological change. Portfolio and risk managers need to consider how those trends accelerate or shift in a slower economy. Understand also the growing importance of fiscal, regulatory and political developments. This encompasses the obvious trade disputes and tariffs, but also emerging threats such as supply chain disruption or policy volatility linked to growing populism in developed countries.

  • It is increasingly apparent that successful business strategies need to incorporate a commitment to sustainable practices. Management teams need to have clearly articulated strategies and implementation plans to respond to evolving environmental, social and governance realities as late movers will likely lag in performance terms and possibly face reduced access to capital.

  • The search for income will continue to drive flows globally, across investor types, into new and emerging sectors. Addressing income needs now entails optimizing balance sheets across a much wider variety of investment types. In no way is this a call for abandonment of traditional fixed income. In fact, we would argue that a well-constructed fixed income allocation can still create meaningful opportunities (from both a capital and liquidity standpoint). However, we advocate relinquishing the concepts of ‘core’, ‘alternative’, or ‘plus’ sectors in favor of a relative value perspective that spans the entire fixed income portfolio.

Peter Gailliot
Global CIO, Financial Institutions Group
Peter Gailliot, Managing Director, is the Global CIO of the Financial Institutions Group (FIG) and Head of Fixed Income FIG Portfolio Management.
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