Opportunities and misperceptions in fixed income | Insight Investment

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Text on screen: Opportunities and misperceptions in fixed income. Peter Bentley, Global Head of Fixed Income

Hello everyone, my name's Peter Bentley. I'm the Global Head of Fixed Income Insight Investment, part of the BNY group.

And I'm here today to talk to you about opportunities, but also some misperceptions before we get onto that in fixed income.

So moving forward, first of all, to set the scene, I think on the left-hand side, of course, many people understand fixed income to be an asset that can give them, as the name would suggest, a steady flow of income.

But also, it's important to reiterate that, and indeed educate for some people, that there are a whole bunch of other purposes that fixed income can deliver depending on how you structure your investments.

So more on that later.

I'll give some suggestions of, in the current environment, what looks particularly interesting in those different regards.

But first of all, on the right-hand side, why don't we set the scene just with some frequent misperceptions I come across that it's important to address before people make those investment decisions about what's best for their investment objectives.

So the first of those is volatility.

Now, we often hear that volatility, that's potentially a bad thing.

Well, actually in fixed income, it isn't necessarily so.

Why not?

Well, onto the next page, here's an example of why not.

The reality is that higher volatility really lends itself to good active management, and absolutely that is the case in fixed income.

And I'm not talking here necessarily about a bad environment where you get a big risk rally.

And as you've seen at the moment in the current market, indeed, a bad environment geopolitically doesn't necessarily mean a bond market rally.

What I'm talking about here is dislocations get created by volatility and opportunities to exploit.

On this slide here, we just give an example of this.

Well, on the left-hand side, you've got the three-year outperformance of managers, and on the bottom axis, you've got the measurement of volatility from the credit market.

You would hope and expect that there's a positive correlation between both of those numbers for good active managers, and indeed, the light green line shows there is some correlation there across the industry.

But ideally, if you have a genuine active manager, as indeed we would have in some of our strategies, you would expect to see a very strong correlation exploiting that volatility, and that's the dark green line for our active, for example, global credit portfolios in this case.

And it's a similar story in rates.

If you move on to the next page here, volatility here gives, again, opportunities to exploit.

Now, one simple example of this right now is there's a big difference between expectations of cuts and hikes in central bank base rates across the different economies.

At the moment, potentially, there's a difference of opinion and maybe an opportunity, depending on what your views are, to exploit those differences between the US and other markets.

Now, depending on when you view this webinar, of course, these numbers are going to change.

They're going to move around.

But that's the point.

Again, as these things change, these expectations move.

That creates opportunities for good active management in the rates market as well as the credit market.

And indeed, more on that, at further maturities across the curve, you can also exploit those differences in pricing.

So examples here on the left-hand side, you've got the so-called implied terminal rate, looking at five-year forward indicators of fair value in the market, or market expectations rather, that you can assess your fair value against.

And look at those.

There's interesting ones at the top of that table, notably one we highlight there, Australia, where, yes, absolutely rates have been, relatively speaking, under pressure.

But guess what?

Has that gone too far and is there an opportunity there?

That's a good one to look at.

Equally, on the other side, if you look at even longer maturities, again, another part of the market, if you're doing that work, you can look to exploit.

And there's some interesting countries listed there as well on the right-hand side that it's worth a very good look at at the moment.

Then the second misperception I often come across is, well, that somehow now is a good or a not good time to invest in fixed income, and it's all about market timing.

So let's have a look at that one.

Well, I think the first thing to say is whether it's a good time to invest, first of all, depends on your perspective.

Examples of what I mean by that are shown here.

On the left-hand side, if you're just looking at credit spreads versus history, and you're trying to make an allocation out of, say, government bonds into credit bonds, then you might form a view that that's perhaps less attractive.

But on the other hand, if you're looking to just make a new allocation into fixed income, so you're more concerned about overall yields, for example, out of cash or other assets, then actually the chart on the right-hand side where you're looking at the overall yields are still very high relative to where they've been since the financial crisis, then you might form a different conclusion.

So that perspective really matters.

What are you allocating out of?

And then on market timing, that's another one.

So the reality is any market indication of when is a good time to invest, what is going to happen to short-term interest rates, those market pricings are generally notoriously poor.

Chart here illustrates that.

The dark line shows the actual outcome for the federal funds rate, and those light green lines show at any particular different points in time what the market had been expecting for that path of bank base rates.

And of course, you can see lots ofCases across here more often than not, where that light green line shows a very different trajectory to the actual reality of the dark green line.

So trying to look at that and bet on when is a good time probably also is a bit of a fool's errand.

In fact, what people should be doing, we would argue, is very much this sort of analysis on the page.

Looking at what is your break even, what is your likely positive return given where yields are and where risks can be.

So an example of that, if you look at the top row here, you've got the current yield on a number of strategies, number of markets.

One of them as an example, global investment grade corporates.

There's the yield, the current duration on the next column, which is then obviously the sensitivity to yield moves in terms of price.

So then you say, well, okay, if yields fall by 1%, not surprisingly, you would get not only a good carry return, but you get very good gains from capital gains as well.

And so you're getting north of 10%.

But of course, that's not by any means a certainty.

So on the other hand, if you look at the other way round, if yields rise by 1%, multiplying that by the duration and offsetting it versus the entry yield means you actually get a net loss.

So in effect then, that right-hand, far right-hand column of break even yield rise is what you should be looking at.

So in this case, at the moment, you've got a break even if you're protected, if you like, against yield rises of around about 0.8% before you would start making a negative return.

And actually then if you look at other asset classes within fixed income and a couple of examples here, you may well find there are even more attractive break evens going on.

So that's the sort of thing we would say is more important and relevant to look at than trying to bet or guess the market.

The third misperception that I often hear a lot about is, well, okay, if you want a nice, safe, steady return and a low-cost return, why not just buy a tracker?

And that's, on the face of it, a compelling argument, and one can see in the equity market how that might make some sense when you're trying to buy more and more of a company that has grown.

But it very much doesn't make a lot of sense in fixed income.

And look, this is something that's relatively straightforward to do.

We have looked at this in the past on a number of occasions and reached the conclusions that really it's not a sensible thing to be doing for an optimum outcome for clients, even though it's easy to deliver.

Why not? Well, first of all, left-hand side box there, unlike equities, bonds have a very asymmetric risk profile.

In other words, if you get the investment right, it makes a return, not a huge return, but a return of some percent low single digit, typically percentage.

On the other hand, if you get it wrong, if you buy an issuer that gets into distress or potentially default, the negative price moves far outweigh any positive from spotting the winners.

So that's not a great start because you have an enormous outsized impact of any downgrades or defaults in your portfolio.

And if you are a tracker fund, you're going to own all of those.

And moreover, you're going to be trying to sell them to other investors when all the other tracker funds are.

So the price you get is not going to be great.

And we saw a lot of that in the financial crisis as being a problem.

The other thing, of course, is as well as doing that forced bad timing of downgrade sales, the reality is fundamentally what are you doing in a tracker fund?

You are buying more and more debt of a company that issues more.

So in other words, as a company becomes more indebted, you take more and more exposure to it because by nature it becomes a bigger part of the index.

Now, I'm not saying that's necessarily a bad thing, but it certainly is not going to be a good thing.

It's at best neutral.

It could be a bad, well, be a bad thing to do.

So we would say, look, there's two better lower cost, lower risk solutions here if that's what people want.

They don't want the manager risk of active management.

Okay, fine.

That's a choice.

Try two different things.

One would be a more a buy and maintain approach, where for investment grade in particular, it works very well, where you try and overcome those problems by not just buying the biggest issuers, carefully selecting the names, not force selling just because of a credit rating change at usually the worst possible time, for example.

On the other hand, you can take a systematic approach, where you take a very diversified approach to the investments you make.

You also take certain factors and really maximize those in your selection of the securities to get the best returns for the portfolio whilst keeping well-diversified.

And that works particularly well in high yield.

And I'll give you an example of that later on just on the next page.

The reality is, in the high yield universe, as the right-hand chart shows, looking at some of the investment universe returns, when you look at the full high yield universe, including those CCC investments all the way down from single B to CCC, the average manager underperforms over time.

Why? Two reasons.

One, the cost of investing.

Trading in and out of those high yield bonds is expensive.

And two, when I said earlier about asymmetric risk profiles, that's particularly marked for those CCC investments that can suddenly drop significantly in price as a default scenario becomes even more likely.

So managers struggle to get those costs under control and get to where good, sensible, diversified exposure to those CCCs.

Now, I'm not saying there's anything wrong with fundamental investing if you get it right.But that's the manager risk you take.

So you need to be very careful about which manager you go for.

But if you want that lower cost, higher surety return, then actually the systematic approach where you can overcome that with clever trading techniques, you can overcome the triple C problem with that diversification.

And look on the right-hand side, just by doing that, net of fees, you can pretty much deliver the index return.

That puts you, that dark green dot and that light green dot, in either the first or second quartile versus all managers over time consistently.

And by the way, if you can then flex that up as we've started doing more recently with a little bit of a small risk budget for better factor selection, you can really get yourself in that top quartile over time.

Compare that with the orange and red dots, which by the way, are the well-known passive trackers, which do struggle in a lot of environments because of what I talked about earlier.

And then another misperception I hear a lot is about private credit.

Now sometimes you hear people saying, "Well, private credit's great.

You get enormous yields and low volatility." Or otherwise, I also hear for as much of those recently, "Oh, private credit is an accident waiting to happen.

It's all going to go wrong." Of course, the reality is it's neither of those.

It's much more nuanced.

And really to look at private credit carefully, you really need to look at two things we would argue.

On a basic level, on the left-hand side, the first thing to be aware of is, well, what are you getting paid for the illiquidity in private credit?

Is it good or bad?

Fair compensation for what risk you're trying to achieve in your portfolio?

One example of looking at that is on the left-hand side.

Now for sure that has come down over time.

This looks at single B equivalent public and private issuers.

And you can see the blue line, the extra liquidity, illiquidity rather premium you get from private markets versus public, has come down quite materially as that line shows.

Now where we are really it's much more a question of, okay, there is still some premium to pick up, but people need to be structuring their investment portfolio such that you have a good sensible blend of liquid public assets and some good opportunities in private markets that the public market might not give.

That sensible combination can still work.

It's not all or nothing.

And on the right-hand side, another thing to say is, look, the lot of particular highlighting here by the equity market, just look at the green line for the S&P 500 versus the dark green line for the so-called business development companies of that are private credit issuers.

Big difference in return, as I'm sure many of you know.

What does that mean?

Well, actually what that means, we think is, again, not every single private credit manager is going to find themselves in difficulty in the end.

That's not how these things play out, but there will be winners and losers.

And as a result of that, there are two things to be aware of.

Of course, good underwriting by the particular managers is going to be key to sort out the winners and losers, but also as the market punishes everybody with the same brush if you like, then the reality is there are going to be some good opportunities for fixed income investors to potentially buy selected exposure to those business development companies' bonds.

And that's the sort of thing we would be very much looking at as this continues to play out.

So an opportunity as well as a careful selection, winners and losers issue.

And then lastly, the final thing I often hear is, and see is, well, multi-asset fixed income, multi-credit strategies, well, they tend to have a lot of quite static allocations and say those are optimal combinations of whatever it is within the fixed income universe.

Now we would say, look, actually what you need to do is take a much more active approach in multi-sector credit to really exploit the opportunities and the differences there.

Illustration of that is this very colorful and busy slide, which effectively says each year, just looking at some of the sub-asset classes in fixed income, what have been the winners and losers?

And you can see the different boxes up and down the page vary enormously depending on the year we are talking about.

So what does that tell you?

That tells you that you need to take a very dynamic approach to really deliver multi-sector fixed income returns.

And you can see an illustration of that on the next page, where we've got a multi-sector credit income strategy that we run that, yes, looks at different combinations of overall risk on average over time that investors would like.

We tailor it to whatever particular investor groups want as a center point, but then takes a dynamic approach around that to exploit those different returns I showed you on the previous page.

And look, as you can see on the left-hand side, first of all, the yield it will deliver initially is pretty comparable in between global high yields and investment grade corporates, but it's not about yield, it's about return in the end.

And that's on the right-hand side.

So if you look at the actual realized return from that strategy because of that active management, again, not just saying it's about the yield, I will sit on that yield.

It's about managing around that for total return.

Look at those outcomes on the right-hand side.

You're getting, using the horizontal axisBasically, a slightly higher return than high yield over time and materially less volatility.

So, a much better outcome than either just maximizing yield in high yield or obviously being more conservative in investment grade.

Yes, that has manager risk around it, of course, that's what you're paid for, but if you pick someone who can do that dynamically and well, and you're prepared to take that risk, do that analysis, you could get a better outcome.

So that's all the misperceptions.

What about the uses of fixed income, and what about the current environment then?

Well, as it says at the top, in the absence of a market rally, and we're not believing there will be a significant fixed income market rally at the moment, what can fixed income deliver for your current client base?

Well, short answer is many different things, depending on how you structure them, as I said.

Some examples here where I've got a number of strategies on the left-hand side column.

I've then got, reading across, different attributes that those strategies can deliver over time.

Wherever there is a shaded box, that's an attribute that exists.

And then when I've ticked them, those are particularly strong relative attributes in the current market environment.

So as an example, absolute return, yes, it delivers return, as the name suggests, but where it really shines at the moment is alpha, i.e., return that is not correlated with market moves.

It's about taking long and short positions, not being fixed, relying on credit market spreads or bond markets underlying to rally.

It can go long and short, and importantly then it is very well diversified versus equity and bond returns in people's portfolios, so hence the tick in that column as well.

Yes, it's also low duration, but there are probably some other things you can also look at further down the page that might be even stronger in that category.

And an example of that might be that latter comment is on the next page here.

So reality is in regular investment grade and high yield, whether it's the left-hand side for high yield or the right-hand side for investment grade, the compression of those different lines showing the yields at different maturities just highlight how flat those curves are in jargon speak, or in other words, effectively, how little extra compensation you get for going longer maturity and therefore longer market risk in investment grade and high yield.

So actually, as the title suggests, if you want to get the best risk return at the moment, it's worth looking at shorter duration strategies in both of those asset classes.

Another thing that's interesting at the moment, asset-backed securities.

Now, for many years, particularly since the financial crisis, and it's still the case now, you can get better spreads for the similar credit ratings or indeed the same credit ratings, as shown here, by investing in asset-backed securities instead of regular public market, unsecured securities, corporate bonds.

Example here, for one to five-year European corporate bonds, single A or triple B rated, that dark green line, look at the spread there over government bonds.

That is less than the top-end triple A and double A categories of ABS.

And actually, as you go further down the capital structure, and further down the risk spectrum, that premium between equivalent corporate bonds of the same rating and asset backed gets ever bigger.

Now, I would say what you're paid for, of course, is also the manager being able to not only manage the complexity, but also be aware of areas of caution for asset backed and avoid those.

Because at the moment, there's really what you might call a K-shaped consumer recovery type market, where some sectors are doing well, some sectors are not doing so well at all.

And that's what you need to steer through.

So credit card, as it says here, and subprime auto delinquencies are continuing to rise.

Commercial real estate, of course, has well-known headwinds to be aware of.

And we've talked about already the private credit market was, again, it's not by any stretch all bad.

The reality is there will be some areas of that where people have perhaps overstretched themselves and maybe used rating agencies that are not mainstream ones just to get ratings and therefore perhaps not been as strong on their due diligence for the underlying asset classes.

Again, not all of them, some of them.

So you need to steer through that.

So as it says on the right-hand side, the bottom-up underwriting very much is key.

And a couple of examples here, both in private and public.

One example here, private short-dated business loans.

The reality is here you can find a pretty attractive, as the detail shows, asset class in the private markets which has been underexploited and is actually quite well protected versus any credit risks.

You get a single A rating, and this is an example of looking for high quality illiquidity, where the quality of the premium has got worse thanks to the holdings of capital raised, the amount of capital raised.

The second slide, another example from the public market, data centers.

Well, again, a lot of talk about AI financing, and we can get into that maybe another time, and that also is a new opportunity in the public markets.

But look, one example here, if you pick very high-rated tenants, they are there.

There's plenty of opportunities for very strong, solid tenants in very good projects with attractive loans to values, offering pretty decent returns for relatively low credit risk.

And alsoTicking the right boxes in terms of ESG investment as well, which again isn't always the case.

So that's one example there.

Straightaway financing those is a good opportunity in the asset-backed area.

The sort of thing we would look at for some of our clients who are interested in that area.

Also, then finally, another area, we touched on it earlier, absolute return, relatively attractive at the moment.

Why?

And again, this is relative.

Looking at the different factors on the left-hand side as to what makes absolute return potentially more attractive than fixed income markets that are effectively exposed to market moves at the moment.

Well, first of all, if cash rates are relatively high compared to history, then your starting point is cash.

So that obviously straightaway gives you help.

Secondly, if the yield curve, as we talked about earlier, is relatively flat, so less of a premium for getting longer duration risk, that also helps.

If volatility is higher, as given the current environment, unfortunately that's clearly going to continue for the foreseeable future, then again, a strategy that is very much focused, in fact, purely focused on exploiting long and short market inefficiencies is going to have a relatively attractive environment.

And then finally, if credit spreads are tight, just buying outright exposure to credit bonds is relatively, I'm not saying it's unattractive, but is relatively less attractive to being able to go long and short and exploit inefficiencies than it would be in different market environments with wider spreads where it may just make more sense to lock those in and potentially see them rally.

We've done some work historically where you look at all of those different factors as the right-hand side shows, comparing the current orange with the averages in blue.

Over time, where are we on that scale between relatively unattractive on the left and relatively attractive on the right?

And then we combine all of those to just see in aggregate, where are we in terms of relative, and I keep emphasizing relative attractiveness of absolute return right now.

And there we are in a chart form, probably easier to read, showing today.

And you can see if you read across from here, till the financial crisis, lots of things to do, relatively attractive on those metrics in particular.

Then because of the post-financial crisis compression in yields and spreads and so on by the central banks and that big era of market beta, market exposure being relatively more attractive.

Yes, it waxed and waned as you can see, but generally more attractive to do.

That's changed again.

Since 2022, that was the real test of just being blindly long everything.

If you were doing that, you would have struggled.

If you had a proper absolute return strategy and that yields higher environment, you would have shined.

And ever since then, we've really been in a different environment where those four factors I took you through are looking relatively attractive.

So worth looking at an absolute return if on that box chart I showed you earlier, those factors are things you're looking to-- those attributes rather, are things you are looking to exploit.

So finally then, just pulling it all together.

In the current environment, when you take all of those fixed income capabilities, fixed income attributes into account, you think about what you're trying to achieve and you look at those misperceptions in the current market environment as well, we would suggest, look, four categories here of what's potentially interesting.

One, if you're trying to find a more attractive credit market, again, look at short maturity investment grade and short maturity high yield or asset-backed.

Lots of relatively attractive opportunity there.

If you're trying to get out of directional bias or risk, then as I've just shown, absolute return looking relatively attractive.

On the other hand, if you're looking to dynamically exploit dislocations across different sub-sectors of the fixed income market and lock in some sort of income and yield, multi-sector credit, and particularly multi-sector credit income looks good.

And then finally, if you're trying to get small to relatively low cost, relatively low manager risk ways of getting market exposure, instead of trackers, look at things like systematic exposure, particularly in high yield or buy and maintain, particularly in an investment grade.

Not exclusively for either, but those would be the relative focuses I would suggest.

So hopefully that was useful.

Thanks for checking in and hopefully we'll speak again soon.