The Portfolio Construction Files

Alpha Opportunities in Fixed Income

BlackRock |25-May-2018


Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

The opinions expressed are as of July 2018 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

A changing fixed income landscape

Emerging trends in the fixed income market pose an interesting new set of challenges for investors. A great deal has been made of US 10-year treasuries touching 3%. For the first time since the financial crisis, US dollar investors can earn positive after-inflation returns from more traditional bonds. Having been forced to seek yields from riskier assets, they can potentially now return to a core source of income – especially if treasury yields hit 3.5% or 4%.

More broadly, global economic activity indicators point to synchronised growth and inflation is expected to continue rising slowly. As we end the era of loose monetary policy, opportunities are emerging at the short end of yield curves particularly in the US. But there are different speeds of monetary policy ‘normalisation’. The US is pressing ahead with its rate rises but other central banks are in a less propitious position.

There are a multitude of duration, yield curve, credit and macro considerations to take account of – and there is no doubt that we are entering a more volatile period for markets. So, what role should fixed income play in portfolios and what are the alpha-seeking opportunities?

Different sets of interest

The first thing to remind ourselves of is the many roles fixed income plays. Income generation and liability matching are the two most obvious, closely followed by capital preservation. But fixed income also helps diversify from equity market risk and provides many opportunities for capital appreciation.

The fixed income market is also diversified in terms of participants. Some, such as insurers or those seeking to match future liabilities, prioritise income. Others, such as those managing reserve assets, prioritise price stability. An end investor, meanwhile, will probably be seeking income and to diversify equity exposure – or both.

Different sets of opportunities

So what is the role of alpha in all of this? The simple answer is that bond markets are more fragmented and idiosyncratic than most other markets. A well-known investment grade firm may have tens of different types of bond in issuance at any one time – and each will have its own merits in terms of seniority, maturity, currency, coupon and myriad other considerations. Establishing the relative value of these different issuances can yield substantial alpha, but it requires rigorous analysis.

More practically, the bond market does not operate in the same way as exchange-traded securities. Bonds are traded over the counter. This means analysis of spreads, liquidity and security structure becomes a vital differentiator.

And that’s just traditional bonds. There’s also the securitised market, which has a wide spread of securities but its own unique risk factors. Mortgage-backed securities have idiosyncratic risks such as prepayment. Asset-backed securities need ongoing assessment of the underlying collateral. You can securitise a pop artist’s future royalties and even concert tours – but you need to understand the underlying risks.

Having what it takes

Analysing and capturing these return opportunities takes skill, insight and experience. We try to look at the opportunity set through four main disciplines. Our security selection strategies focus on bottom-up opportunities, while our macro strategies seek to identify themes across the market. Add to that an assessment of when beta (market directionality) is most appropriate plus the use of carry (yield seeking) trades and there is a full armoury of investment strategies to capture returns in fixed income.

With divergent monetary policy a major factor, we believe macro strategies can add a lot of alpha. And, as differing interest rate regimes have divergent impacts across countries, industries and currencies, this generates many opportunities for bottom-up and carry opportunities in the market.

The opinions expressed are as of 23 May 2018 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

Ahmed Talhaoui, CFA
Managing Director, is the Co-Head of Product Strategy for BlackRock's Global Fixed Income Group.

Diversification and asset allocation may not fully protect you from market risk.

Risk management cannot fully eliminate the risk of investment loss.

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