Fixed Income Opportunities | Insight Investment

So you've heard from Adam and also Harvey that we're not expecting a huge directional move in fixed income. So don't necessarily invest in fixed income expecting that huge capital growth. But despite that, the key theme here we're going to explore is on the left hand side there are a whole different range of purposes of fixed income that you can invest for in the current environment. But crucially, it depends how you structure your fixed income investments to what is best captured on that left hand side. So we'll come onto that in a minute. On the right hand side, sorry, as you look at it, there are though a number of misperceptions that we just want to explore before we get onto that, which helps frame that discussion. So let's crack on with that. So first of all, volatility. So there's a lot of talk about whether volatility is good or bad for fixed income. The truth is, it depends what you are trying to do. So if you are trying to add alpha or excess return over benchmarks, then actually volatility should be a good thing, different story if you're not.

But if you are, you would expect to have an upward sloping curve there. And indeed the average investor at the bottom, the average market player does have a small correlation there. But there are a lot of strategies there that are hidden that are not really alpha strategies that are billed as alpha strategies. Again, important to break out those different strategies and tell them, call them what they are. For any alpha strategy, you should have a very steep upward sloping curve. So for those strategies, more volatility, more uncertainty, dislocations that Adam and Harvey have been talking about to exploit. Another thing to say, we often get asked this by clients as well, is now a good time to invest in fixed income? Should I do it this week, next week? Whatever the short answer is it. That's not really the thing to be worrying about. Why? Because as it says here, any sense of trying to forecast the market or look at where this week or next week is good or bad is generally a fool's game.

Good example of this is looking at the average market forecast for short term interest rates over time, comparing the reality of the dark line with the forecast of the light green line and look at those differences. So don't get caught up in that game of trying to do that. When we talk about forecasts in our process, what we really mean is fair value indicators, not where's it going to be next week or tomorrow. And with that spirit in mind, we generally steer clients towards this sort of analysis and say, well okay, what is the break even here? Rates could go either way. You're worrying about that with your risk perceptions and risk management. For example, the top row here, you've got a current yield as Adam was talking about 4.3% in dollar terms. Well with a just shy of six years duration, if yields go down, that's a pretty healthy return. But we're not saying you should expect that. On the other hand, there is a risk that if yields rise, for example 1%, you start creeping into negative territory.

But the key thing is on the right hand side, then what is the breakeven? Are you comfortable? Are your clients comfortable with that breakeven? Those are the discussions we recommend and have with our clients on a regular basis. And look though on the right hand side, those look relatively attractive in a number of cases at the moment. Another thing we often get talked about is, well, if I want to let, I don't want alpha, I want to low cost, low risk, low manager risk, way to access fixed income just to get the income. Well straight away we get into that debate about passive tracker funds particularly versus a different approach. Now obviously track passive tracker funds are relatively easy to run. There's nothing wrong with them necessarily in the equity space, fixed income space, we could do it. We've looked at this on a number of occasions over the years, but the problem is the fixed income market has a number of differences that make that not necessarily the best approach. Why? First of all, crucially, unlike equities, bonds have asymmetric risk profiles, particularly in credit.

So the cost of owning something versus the gain if it does well, is obviously skewed against you. And in particular you have an outside impact of downgrades. And why? Because the tracker funds are forced sellers by rule, the street, the investment banks that is, know this. And every time you get to towards a month end, things get downgraded. Tracker funds are for sellers. The investment banks say, thank you very much, we'll take a lot of money out of you and bid them at low prices. You saw a lot of that post the financial crisis and you've seen a lot of that whenever you get a volatile market. So why be on the wrong side of that? And finally, effectively the the basic fundamental concept that we've struggled with is well, okay, well it could be a good thing, it might not be, but it could be a good thing to buy more and more of a company's equity because it's growing might have a valuation issue. But if it's growing it could be good, in fixed income, fundamentally, why would you buy more and more of a company's debt?

Just because a company's becoming more indebted doesn't really make a lot of sense. So we suggest and have lots of dialogue with clients. Two potentially alternative approaches. One in a more traditional way buy and maintain, manage that risk asymmetry, keep the cost low with diversified, carefully selected portfolios or potentially go even further than that in a different way. A systematic approach. Now this works particularly well we would suggest in high yield, not just in high yield, but that's the key genesis of that area and we'll come onto that in a second. And then as Adam's touched on of already, there's the private versus public issue. Look, I mean I won't say too much more on this, he's covered it well. But just to reiterate, the current environment with all that money chasing not potentially enough investments, you've seen that compression in spreads on the right hand side relative to the public markets. So whilst there was a premium of that light orange line of roughly 200 basis points or 50% of a spread give or take a few years ago, now that premium is halved and relative to in a relative sense, of course it's gone down even more.

So again, not to say that private credit is a bad thing, absolutely not. It just reiterates that point. That now is the market where you need to be much more careful about what you invest in, who you pick to lead your investments. And also there is potential benefit from looking at the asset allocation opportunities and how they will now wax and wane between public and private markets. That's the key takeaway for us. It's not just a simple buy the yield environment anymore. 'cause there isn't enough of it to do that without thinking. Okay, so Adrian's already showed this chart so no need to explain this, but the key thing is, okay, all of these dislocations and all these differences that he talked about, what do you do with them? Answer we would say is look at this sort of thing left hand side, multi-sector credit income. If you can take a dynamic approach to moving around between those different areas of the fixed income market as they do well or less well, you can create something on the right hand side potentially where you can deliver with that dynamic approach the best of both worlds.

You can get yourself something that gives you pretty much the similar yields, similar certainly returns as high yield but with less volatility, more investment grade like volatility. So that's again what you need to be thinking about. We'd suggest when you are looking at multi-sector strategies, a lot of them we'd observe are quite static, we would say given as again Adrian showed earlier, things move around, you need to play that. So then we get onto the other question, okay, what about now then what are the particular strategies that look attractive? Well, answer is there are various different things you can do. I'm sure you're familiar with all of these types of strategies on the left hand side, point is here, they all have different qualities they can fill in all of those different needs you want. But the ticks show where these strategies are relatively particularly attractive right now. So for example, absolute return, yes, return it delivers, but ultimately where it really shines is exploiting that volatility. Where it really shines is a lack of diversification with other risk assets and indeed with fixed income.

And of course yes it is low duration, but there are some other low duration options one could consider at the moment as well. And then just picking up on those, I mean first of all, Adam's talked about investment grade, it's pretty flat, the curve. These are looking at the yields here again, but also in high yield, same story. So again, we would recommend short maturity, investment grade and high yield strategies of something that gives you a good trade off at the moment. Moving forwards, We'd also, and Shahir is going to explain this in much better way than I could about asset-backed securities. The basic high level observation is shown here that you've got effectively an opportunity in asset backed to get your higher spreads, higher returns, but with lower credit risk. You can see that with the dark line being the corporate market, low spread, lower rating relative to all of those asset backed opportunities. Again, more on that later from Shahir. I talked about the systematic approach. So busy slide here. But the key messages are, look, the high yield market has a number of challenges with it.

If you look carefully, you folks probably know some of this already. Most traditional high yield managers have a BB, single B benchmark against which they invest. Why is that? Because it is actually quite difficult for most of them to outperform the whole high yield universe. So let's outperform something that's a bit lower return and easier to outperform. Nothing wrong with that if you want lower return and a bit lower risk. But if you want to capture the full return on average, 40 basis points, 0.4% per annum extra, what can you do? Well, if you look on the right hand side, there are a number of things you can do. Ultimately you can buy an ETF. Problem is with the ETFs, given the cost of the market and some of the issues I talked about, they do, okay in a bull market, there's the orange and yellow dots. They struggle in other markets for all, for all the reasons I just talked about. Hence those longer term returns are lower. And by the way, this chart just to be clear, is showing the percentile peer group rankings of the whole high yield universe in the US 'cause that's the biggest part of the market.

Where do all the managers deliver versus that high yield index, that biggest part of the high yield universe. So straight away, that's probably a questionable strategy. And then of course, hopefully you can see from the the dark green dot being the index and the, and one of our strategies where we're just trying to replicate the beta of that market, but selectively the beta not the composition. If you can get pretty close to that delivery net of fees, guess what? You're above average all the time, one way or another. So because of the cost of the market, because of the asymmetry being extreme with the CCCs, there's an opportunity. Now if you add to that, we have an alpha version of this strategy, which we've launched more recently in the last year or two. You can get a little bit of extra return on top of that by applying the same principles you're write up in that top quartile consistently. So worth thinking about that one. Then another one is, well it absolute return. Now again, in the interest of time, I won't go through all of this, but look, if you focus on the left hand side, we look at when we have dialogues with, with ourselves, nevermind our clients is well, if we're comparing absolute return with market exposure or total return strategies, what are the key factors to look at to compare those?

Is the cash rate rate good or bad? Therefore it could be good or less good for market for absolute return. Is the yield curve flat? A steeper yield curve is better for market exposures carry and roll down. It's quite flat at the moment. Volatility. The more volatility you're gonna get, the better it is for absolute return, genuine absolute return, not to carry strategies. Credit spreads again, if they're tight, less attractive for market beta strategies because you're just not capturing as much carry. And then we blend all of those together and say, well, okay, through history relative to history, where are we? And that's what this chart shows. We're currently in the 82nd percentile as it says at the top. So whilst we had a long period post-financial crisis of absolute return being relatively less attractive compared to market exposure, total return, as you know, yields were compressed by monetary authorities and so on. For all the reasons, you know, the reality isn't how that has changed, that relative game has changed. So that's worth thinking about.

So then in conclusion, really what we're saying is look, if you pick out the environment as it is today, the key areas that we would say are particularly relatively interesting at the moment, starting on the left hand side, we've talked about short maturity both in investment grade and high yield asset -backed more on that in a second from Shahir. 'cause it's crucial as to what do you buy in asset backed and how do you approach it. On the other hand, if you don't want directional bias or risk, absolute return is now looking relatively attractive. Equally, if you say I'm happy with that, but I want to capture bigger, I want to capture potentially slightly larger total return. But albeit taking market risk, then be dynamic. 'cause multi-sector credit with all those in a volatile world is particularly appealing. And then lastly, if you say yes, that's all very interesting, but really what I want to do is just capture that income of current incomes, roughly speaking of that are available. And I want low market, low manager risks, sorry, and low fees.

Have a think about systematic or buy maintain rather than passive. So with that, I'll hand over to Shahir to show you what we should be doing in asset backed. Thanks. Thank you. Thank you Peter. good morning everyone. So, as you've heard a couple of times today, the ABS market is a market that we continue to find quite attractive. There are a few reasons for it. return is one of them and not only in terms of in absolute terms, but in terms of relative terms to other markets. So what we do over here is show the premium that each of these sectors can give over and above corporate bonds holding the rating and maturity constant. And there is quite a wide range. So at the more the sort towards the left hand side, when you're pulling far fewer of the levers available to you in the asset class on a UK prime, RMBS AAA bond, 10 to 25 basis points. The typical premium that's observable when you move towards the middle, say, you know, 70 to 80 for a broady syndicated loan, CLO at the AA level, and those numbers go to a hundred and, and far beyond, if you really are, pulling all the levers available with you to you in the asset class, what are those levers or in other words, you know, why are the returns where they are?

We think there are three major reasons for that. The first is capital charges post a great financial crisis. the way a ABS, securitized instrument is treated versus say a corporate bond, a government bond, a covered bond is, is much more punitive if you're a bank and insurance company than if you are a non-bank or non-insurance company. That technical differential between the ABS market and others allows that premium to be higher, particularly as you move down the capital structure complexity, as Adam alluded to, the securitization market is viewed as a whole, as relatively complex to other things. But even within the securitization market, there are different shades of complexity tied in quite well to the previous slide. Actually, a UK prime high street originated pool of mortgages is quite a different animal to an aircraft ABS or a music royalty, ABS. and finally liquidity. there is a private ABS market over the last two years or so. It's, it's now being increasingly called the asset-backed financing markets. we've always called it the secured finance markets. and that's, it offers you an illiquidity premium, but even within the public ABS market, there are different shades of illiquidity.

Generally speaking, your average, fund structure out there is a daily dealing fund structure. The relatively short notice period as you move down the capital charts bre spectrum up the complexity spectrum, your liquidity drops and a more patient approach, you know, a different fund structure may allow you to take advantage of more of the levers than otherwise would be the case. So I think a good question to ask would be, well, is some of the premium there available because of fundamental concerns? and I will come onto where there are, there is potentially some cause for concern, although whether we at the tipping point of Francesca's analogy earlier, I would argue not, not yet, but if I were to take the, some of the major, synchronization markets that exist globally and compare their arrears level, so arrears are typically speaking your leading indicator of problems. Someone who goes into arrears or a company that goes into arrears, moves into default with a and then potentially into loss with a much higher grade, frequency than, than someone who's not in arrear.

If I were to compare the latest arrears numbers to the three and 10 year averages, there really isn't a great deal of difference. Um, and if you, and if you take into account that over the last 10 years we've seen quite a lot, most importantly a rise in interest rates, which were now the other side of admittedly, you know, people's mortgages were doubling people's unsecured lending rates were rising quite significantly. And yet over that period, the strong collateral performance of you know, reflecting the, underwriting practices that exist out there ha has born fruit. That being said, we are quite late in cycle. We have, as you've heard, an unstable equilibrium, you know, in major currencies. And that's even before adding all the geopolitics, et cetera. so it's always worthwhile looking for areas of caution. And really there are three that that come to mind within the asset-backed securities markets. The first is, there is certainly evidence of a decline in the United States. credit card receive, delinquencies are, are, are rising, subprime auto delinquencies are at cycle highs. and these numbers aren't consistent with what you'd expect statistically when you compare to, to the current GDP rate and the current unemployment rate.

There are people being left behind and they are some of the people that make their way into collateral pools. commercial real estate headwinds, nothing new here. I would argue the losses are still to make their way through the system. You, you can amend and extend a commercial real estate loan quite significantly over time to try and and hope that things get better. the office market, for example, is still seeing, struggles, out there. And finally, as mentioned a couple of times today, growth in private credit, there has been a significant growth of, of private private credit within the asset-backed securities markets. you've heard Adam talk about the rise of the insurance balance sheet in the United States with respect to investing in private instruments that has come with what, what we call the credit rating agency drift. Not only have we seen agencies become a little bit more positive in their credit assessments, we've seen the, the, this stunning growth of your non-major rating agencies rating collateral pools, which range from being a little young to be statistically rateable to.

I'm not sure how you managed to rate this. So certainly, you know, we have a very strong top-down picture, from a return perspective, a a really solid top-down fundamental picture as well. But bottom up underwriting is key because there are some areas of caution beginning, you know, beginning to appear. So with that, I got a couple of case studies of things that are in our, in investment universe that we've, that we're looking at or have or have invested in. the first example from the private markets, so this is, this is an example from the business loan market. So, much like the consumer markets, businesses are increasingly buying from each other now on an online basis. unlike the consumer markets, you know, there's a lack of credit card availability. Buy now, pay later, you will in your, in your favorite marketplace of choice, you'll see all the buy now pay later options available to you that hasn't really permeated itself within the business to business e-commerce market. So roughly about 10% of, of merchants offer instant on instant online credits.

So that gives an opportunity, there's a funding gap there. What sort of instruments do you acquire? a highly granular pool of business loans. And we think really interestingly, considering the points made around shortening your spread duration, not looking too far out into the future, these loans are 30 days in maturity. So it, it is one way of extracting a 250 to 300 basis point return. So a significant illiquidity premium, but not putting your money out to work for very, very long for a pool of assets which are insured against credit losses, giving you an investment rate credit quality from the public markets. AI is being mentioned today. absolutely we expect the AI super cycle to see every conventional market being tapped for financing, be it secured, unsecured, public or private equity or debt loan or bond. Whether we are in that results ultimately in, in a, in a credit credit cycle bust with winners and losers. Time will tell, but one way to express yourself in the AI theme and remain fairly close to home from a risk perspective is on a secured basis lending against the data centers themselves.

Where you can target, you can be very particular on the type of risks you want to take. You can target your, your best of breed sponsors, lease profiles where you have a hundred percent investment grade rated tenants on long leases. That's quite unique in the real estate market. Your typical leases are three to five years and you certainly don't have a AA minus rated average tenant lease. Lease profile LTVs are reasonable in the low sixties spreads are, are attractive in the mid two hundreds. and interestingly, these are very power hungry things. So from an ESG, from an engagement, from an impact perspective, you can actually positively select for those originators that have clear net-zero targets, and indeed those that operate data centers that have extremely high effectiveness for the power that they generates.