Exploiting Opportunities in the Fixed Income Renaissance: Raman Srivastava | Insight Investment

Active fixed income managers have typically outperformed on a net of fee basis, passive managers or benchmarks, and there are structural and tactical reasons as to why one might consider active managers in fixed income. First off, if you think about the way fixed income benchmarks are constructed, they're constructed on a market value basis. So in other words, the more debt a company or a government is taking on, the more, the higher their weight is in the benchmark. And hence, if you're just blindly following the benchmark, you're gonna be forced to buy these companies or these governments that are taking on more and more debt. 

So that's not necessarily a good thing if a company or government is taking on more debt. So if you have the ability to be active, you actually have the ability to make a choice as to whether or not it makes sense to invest in that company that has a lot more debt on their balance sheets. and often it's not the best thing to do and hence there's a value in being active. Secondly, the way the benchmarks are constructed, one of the things that happens in fixed income on a regular basis is there's new issues that come to market daily. And these new issues, kinda like an IPO in equities, usually come at a discount, might be 10 basis points extra yield, 15 basis points. 

And so by regularly participating in these new issues, active managers can, benefit from this extra yield premium, whereas by the time those bonds go into the benchmark, that yield premium has gone away, so that's a structural thing. Similarly, if you think about investment grade benchmarks, when a bond gets downgraded or an issuer gets downgraded to below investment grade, that bond falls out of the index. And if you are, again, blindly following passively the index, you're gonna be forced to sell that bond as it comes out of the index. And often that's not the best time to sell the bond. In fact, often that's probably the best time to buy the bond 

or at least hold it for a period of time until the price volatility dissipates. So there's many reasons kind of structurally that is why active managers tend to outperform benchmarks or passive fixed income. 

So, thinking about liquidity an area where we believe investors should be spending more and more time. And there, and there's two different ways to really think about liquidity. One is, what are you getting paid in order to take on a less liquid position? So it's a risk premium like many other risk premiums in the market. And today, if you look at where that risk premium is priced, it's priced fairly tight. So again, much like whether it's equities at all time highs or credit spreads close to all time lows or implied volatilities at relatively low levels, similarly, what you're getting paid as an investor to take on illiquidity is relatively low versus 

where it's been many times in the past. so that's one consideration. I think a more important consideration is this idea of sequencing risk. And what that means is can you be exposed to be forced to liquidate a position when you don't want to? So if you're mismatched on liquidity, you may be forced to sell something you don't want to in order to meet a liquidity need. You don't want to do that. And one way to avoid that is actually to think about, constructing a portfolio of bonds that meets your liquidity needs in the near term. Call it three, four, five years through maturities, through coupons. And if you can do that and you immunize that piece, 

it reduces the sequencing risk and it arou, it allows the rest of your portfolio to benefit from being invested in growth assets. You know, it could be public equity, it could be private equity, it could be real estate, but you've basically used the tools available in fixed income to protect that sequencing or liquidity risk. 

There's many reasons why investors should consider diversifying beyond the US fixed income markets. I'll give you my top three favourites. So, first off is just diversification. You know, it's sort of investing 101. The more options you have, the better you can diversify your risks. If you're not only just exposed to one market, one potential central bank policy error, one potential default cycle, if you can immunize that risk across a number of different markets, you're just better off from a risk and diversification perspective. Secondly, if you look at the market in fixed income, say for example in US versus international, the majority 

of the exposures actually outside of the US. So in other words, you have a lot bigger pond to fish in when it comes to security selection in corporates, in other parts of the fixed income markets, the more opportunities you have, if you're doing your job well, the better your risk adjusted return should be. And opening up global fixed income allows for that possibility. And then thirdly, and this is a bit more tactical, if you look at where the markets are today, one of the interesting things in the market is you can actually get paid to hedge. So in other words, typically when you're trying to hedge a risk, it costs you something. 

If you're trying to hedge an equity risk, you got to pay a premium for an option - put option. Today in fixed income, when you're looking at global and hedging it back to the US, you're actually picking up yields. So for example, if a choice was you could buy a US treasury, you know, 10 year treasury, or you could buy a 10 year Japanese government bond and then hedge that currency back to the US, not only do you get diversification, you have, you know, two markets instead of one, you actually pick up another 70 or 80 basis points by investing in Japan and hedging it back. So those sorts of opportunities that exist in the global fixed income markets are available 

if you have that global lens as opposed to just looking domestically. 

So these days in fixed income, it's difficult to find glaring opportunities, but we believe there still are some, if you focus just purely on the sovereign space, in the US and in other markets, we believe there's risks to the, you know, to the back end of yield curves. But other, you know, some particular markets globally have steepened and hence there's opportunities to take advantage of relatively high yields in other markets outside of the US hedge back, to the US and government space. Outside of the government space because central banks and many markets are lowering interest rates, the intermediate part of the yield curve remains 

attractive to us. And specifically if you look at what we're, where we're finding value, there is in certain areas of the asset back sector where you have very certain cash flows, intermediate term duration, and also parts of the corporate credit market. Although you have to be selective because spreads are fairly tight. 

There has been a tremendous amount of pressure on the back end of yield curves. Unfortunately, it looks like because many governments are struggling to get their fiscal house in order and deficits are persisting. increased supply or continued supply in government bond markets will probably continue to pressure yields, especially in the back end of the curve, which are, you know, which are difficult to control from monetary policy in central bank policy rates. So we think that dynamic could very well persist. So when you're thinking about fixed income investing, the good news is the corporate part of the market 

balance sheets there are actually in very good shape. So in this environment where there is a lot of focus on, you know, policy rates and reducing interest rates and you have corporate balance sheets in good fundamental shape, we do think that lends itself well to, you know, corporate spreads and other spreads in the intermediate part of the curve. 

Investors often ask about how can they be resilient in this environment where there's so much political and other uncertainty. The good news in fixed income, you know, public fixed income is in the midst of a renaissance. So, you know, when you think about the big risks in fixed income rates or duration credit liquidity, the good news today is you don't have to stretch in any one of those dimensions to pick up reasonable and attractive yields. So you can get high quality fixed income exposure in the intermediate part of the curve, north of 5% yields, which is great. So, you know, one no longer needs to stretch and take on these additional risks to have resilience 

and still enjoy a good return. In fact, in some parts of the market, for example, in the muni market, municipal bonds, if you look at the taxable equivalent yield you're looking at yields 8% -9% plus. So this is very different than what it used to be prior to 2022, where some of these opportunities where you were avoiding some of the big risks in fixed income, you might've only get, you know, gotten a yield of 3%or 3.5% percent now, you know, you're looking at a much better environment. So it's much easier in today's market to actually build resiliency into a fixed income portfolio in the public markets without being overly exposed to risk. 

When we look at the macro environment today, we see a couple trends. You know, one is we do see employment slowing, but it's slowing off of a fairly strong and robust base. We see inflation being sticky, but our base case forecast today is not one for a recession. We do see growth slowing below trend but slightly below 2%. So overall we actually think it's an environment which should allow the Fed to begin to lower interest rates and support the macro environment. That said, it's gonna be difficult given the stickiness of inflation for the Fed to lower interest rates back to where they used to be prior to 2022. So if you think about the implications of that for, say, 

for example, the corporate credit or other parts of the market, it will provide a headwind to some of the issuers that are now gonna be forced to refinance their debt at higher interest rates than when they first took it on. And hence, we do think there's going to be pressure on corporate credit and you might be in a period of higher defaults than what we've seen historically, at least in the recent past.