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Is diversification the order of the day or should managers keep their faith in sovereigns? Citywire Global discusses with leading fund selectors which approaches they are adopting.
The risk-free label attached to government bonds was an illusion. This illusion has been reinforced in Europe during the last two decades with the process of convergence which led rates to decrease towards the level applicable to the best-in-class issuers. Suddenly, investors seem to realise that each country presents a specific risk, according to its financial strength and its political situation.
We have been out of government bonds all of 2011 and prefer corporates where investors are well paid to take some risk. We selected active managers who conduct a strict bond picking process focusing on value and risk in order to protect our investment.
We favour HMG Rendement and Tikehau Credit Plus. They both lost some money in 2011 but we are confident they will deliver in the long term. Since the end of 2011 we have seen opportunities in government bonds. We are now looking for funds specialising in short-term Spanish and Italian bonds in order to take advantage of the extreme de-rating which appears overdone.
As we enter 2012, the general consensus of fixed income investment managers, analysts and asset allocators is the ‘wider dispersion in fixed returns will persist’. This environment is best suited to flexible multi-sector fixed income funds. Credit rather than government bond exposure stands out as a preferred asset allocation choice.
Corporate bonds in developed and emerging markets provide the most attractive risk return profile. Funds including PIMCO Global Investment Grade Credit and BlueBay Emerging Markets Corporate Bond are effectively capturing a recognised trend in declining leverage and improving free cash flow across developed and emerging market companies.
Multi-sector short-term bond funds are proving to be an attractive solution for wealth preservation with low volatility. This is particularly relevant in an environment driven by a wide range of possible outcomes both positive and negative.
Janus US Short Term Bond and Carmignac Sécurité provide good examples of short term bond funds that feature classic barbell portfolio structures which are most appropriate for the current risk on/risk off environment.
Both funds feature exposure to US treasuries and German bunds combined with modest exposure to short-duration high yield and high-spread investment grade. In emerging markets, the rapid growth in the size and depth of Asian bond markets cannot be ignored.
Alliance Bernstein RMB Fixed Income provides a great opportunity to capture Renminbi appreciation and also to benefit from improving credit trends in Asian corporate bonds. Global Evolution Frontier Fixed Income is uniquely positioned to capture under-researched opportunities in African and Eastern European sovereign bond markets.
We take a longer-term outlook within our funds and as such are positioned more within the credit space versus government bonds. Superior long-term returns from credit are driven by compounding current income and avoiding capital losses. This in turn is based on thorough fundamental credit analysis and a focus on the bonds of companies with improving credit trends.
We are invested into the AXA US Short Duration High Yield fund. This has a strong focus on consistent current income and mitigation of principal loss risk. The team have only had three defaults since 1992 whereas the US high yield market has had nearly 1,000.
What we also like about the fund is that it gives about 90% of the yield of the US high yield market, but only has 30% of the duration exposure of the high yield index and a third of the volatility. In addition we have money invested in the PIMCO Global Investment Grade Credit fund which focuses on investment grade corporate paper and is very well priced.
We also favour flexible fixed income mandates, allowing the fund manager the freedom to move between the various fixed income classes. Here we use the Old Mutual Global Bond fund managed by Stewart Cowley.
We like the non-consensus thinking and original idea generation of the lead manager plus the fund’s flexibility to perform in different market environments – in particular the wide duration range of +9 years to -9 years.
We don’t think the world has changed much, only investors’ behaviour. Fixed income was and will be credit. At HelvInvest we value the sensitivity of the three main risk sources in fixed income, namely interest rate risk, credit risk and liquidity risk.
That means we analyse the beta of any risk source and check what the market or sector is paying for that risk. There is no risk-free asset. Every bond, including sovereign ones, has its own credit sensitivity, which changes over time.
The question is: do we get properly paid for that risk or not? Currently we are clearly overweight credit risk in the corporate sector and profit slightly from the liquidity premiums paid, but we hardly have any interest rate risk sensitivity. Managing fund-based fixed income portfolios, we decide on the risk allocation ourselves and tend to pick managers focusing on a certain risk factor.
In investment grade corporates we like the JPM Global Corporate Bond fund managed by Lisa Coleman because she’s focusing on corporate investing but not on interest rate duration calls. In short-dated high yield the AXA US Short Duration High Yield Bond fund managed by the team now headed by Pepper Whitbeck perfectly suits our investment needs.
Since 2009 we have diversified clients’ portfolios into EMU corporate investment grade and US high yield paper. At that time we saw this move as a relative value play, nevertheless it served us well amid the sovereign crisis.
Today we should regard sovereign and corporate paper in relative value terms. Yields offered by longer-dated Italian government bonds are nowadays attractive on any metric, given a relatively solid fiscal situation and the efforts to reform the system.
However, this is a demand-driven market and the size of financial needs in 2012 keeps the longer end of the curve in dire straits. In general, within the corporate sector, US high yield is to us the most attractive asset class.
Spreads are generous in comparison to default rates, while the US economy seems to hold up better than its European counterparts. We favour high yield fund managers with strong bottom-up research capabilities, since this is a risky asset class where diversification and cherry picking are key. Favourite managers include Muzinich and Neuberger Berman, with whom we have long-standing relationships.
The old adage that conservative investors should hold their approximate age in government bonds, must surely now be questioned, due to non-existent yields and sovereign debt credit crisis concerns. Government bonds are no longer a safe haven investment, priced horribly wrong and a cautious investor should have nil exposure.
The short-term catalyst for a government bond rout will be an improving US economy and corresponding interest rate rise concerns. In Europe, Germany will end up paying, irrespective of which political scenario unfolds leading to a rising risk premium.
Whilst corporate credit and EM bonds are seen as the easiest place to hide as they offer better value, they will also suffer in a G7 government bond rout, due to rising rates.
We prefer the Thames River Global Bond fund ($) as a core holding which is fully exposed to the dollar and 20% net short government bonds, primarily German bunds. ETFs that are short US 10-year treasuries are attractive, but entry timing is critical.
Other alternative bond trading funds, such as catastrophe bonds with floating rates from GAM or buying EM bond funds, such as Investec and Schroders Asian bond funds, on weakness are good ideas. Otherwise avoid traditional long-only fixed income funds for the next 30 years.
This article originally appeared as part of the Buyers’ Market feature in the February 2012 issue of Citywire Global magazine.
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