Modern Bond Investing for the Modern World
Execution Matters in Opportunistic Fixed Income Strategies
By David Young, CEO of Anfield Capital and John Harline, Co-Founder/Managing Partner of Elysian Capital Holdings
Every investor is waiting. Every financial advisor is waiting. Seemingly, the entire world is waiting. The waiting is the hardest thing to endure. As the world waits, the Federal Reserve remains elusive and uncommitted. It is this lack of clarity that has the world, and most importantly, investors increasingly aware that traditional fixed income strategies might be even riskier than previously assumed.
While many investors flocked to the perceived safe haven of U.S. Treasuries during the financial crisis as a source of “risk-free return,” the prospect of higher interest rates may make them seem more like a source of “return-free risk.” But it’s not just higher rates that are forcing a major rethink of traditional bond investing. New banking regulations, aging populations, and growing markets outside the U.S. are fundamentally changing the fixed income landscape as we once knew it. So it’s not surprising investment managers have been suggesting that bond investors consider moving away from traditional benchmark-bound strategies to more flexible, opportunistic fixed income approaches, many of which target a positive return across all market cycles. These strategies are better equipped to seek return across a far larger universe of global fixed income and credit markets and can use a wider range of tools to nimbly rotate in and out of sectors, entire debt markets, and typically enjoy the capability of taking large concentrated bets, pursuing complex derivatives based strategies, and shorting markets, as opportunities and risks change.
But as investor interest grows in ‘non-traditional’ fixed income, we think it’s important to understand exactly how these strategies work so that investors avoid trading one kind of risk for another without a full understanding of what’s involved. Some of the fixed income approaches that have performed well over the last five years (when credit spreads were wide and market liquidity abundant) might face greater challenges in this new period of tighter spreads, less liquidity, limited inventory, and higher volatility.
In this uncertain environment, we believe individual security selection, and consequently access to increasingly hard to find bond inventory, will be even more important than macro decisions, like duration or relative value based sector allocations.
This begs the question, Are you asking the right questions of your portfolio manager (i.e. Competence Matters)?
As the sources of unpredictability facing fixed income portfolio managers increase in this current environment, the questions from investors continue to grow as well. The real concern for investors should be how their portfolio managers are navigating the unpredictability to mitigate the risks associated. This makes it even more important for investors and advisors alike to ask portfolio managers the right questions, in order to determine whether or not they are on the right course. Not surprisingly, some the answers are creating even more complex questions.
Can my current manager truly navigate all corners of this new fixed income landscape in the face of historical change (i.e. Execution Matters)?
We have determined that there is a growing concern among investors and financial advisors with the advent of rising interest rates. Additionally, this environment has become more unpredictable than ever before. All of it colliding to form this new fixed income landscape, which looks far different than it has historically.
The real question for portfolio managers is not whether they will recognize this new landscape, but whether they will be able to navigate their way through the mire of the unfamiliar, while avoiding potential pitfalls.
There are approaches that attempt to navigate different fixed income strategies in hopes of avoiding troublesome areas. Although, many of these unconstrained and strategic income strategies end up chasing higher risk areas, within the fixed income universe, for higher returns and yields. Depending on the portfolio manager, some of these risks can be beyond the competency of the manager and/or greater than an investor realizes.
The graph below illustrates how over the last three years, the average return in the unconstrained universe has exhibited an extremely high correlation to high yield credit spreads.
Not surprisingly, the last three years have been a favorable period for strategies to have a high correlation to riskier fixed income spread sectors. As such, the most recent period was characterized by fund managers being able to generate return from a fairly straightforward sector selection among areas like high yield.
Looking ahead, there are at least five major changes that might make such a blunt sector selection approach less effective:
1. As the Fed brings its Quantitative Easing policy to a close, the result will be less market liquidity and potentially higher interest rates;
2. The process of rolling back unprecedented Fed liquidity is likely to increase market volatility;
3. Spreads have currently become much tighter in many fixed income sectors;
4. As Basel III banking regulations and the Volcker Rule begin to roll out, sharply reduced dealer inventories may impact retail bond market liquidity; and
5. Retiring baby boomers are likely to increase competition for scarce fixed income assets.
Why is the increased competition for more scarce fixed income assets so important? Well, size is only becoming a bigger problem, as liquidity and actual cash bond inventories, including trading, are a fraction of their pre-crisis levels. Yet, investors expect an opportunistic fixed income fund to be invested exclusively in bonds.
In this uncertain environment, we believe individual security selection will be even more important than macro decisions, such as duration and relative value based sector allocation. As a result, we maintain that thoroughly understanding a manager’s ability to capture opportunities at the security level, and the factors that affect that ability, will be an essential consideration for investors over the next few years.
How big can an opportunistic fund be and still be opportunistic (i.e. Size Matters)?
Mega funds may be more challenged by their large size to capture individual security-level opportunities in the more obscure corners of certain sectors and regions. This is an important constraint when it comes to high yield bonds or subprime asset-backed securities, where a new issue, for example, might be as small as $300-500 million, and the allocation to any one manager even smaller at $20-50 million.
As the following tables illustrate, a smaller asset base could allow for capturing more meaningful, high conviction exposures that will compare favorably to a very large fixed income mutual fund.
Confounding the dilemma is persistent and compelling evidence that smaller bond issuances show a strong tendency towards higher return, with far less price volatility than their larger liquid issue peers. The data below from a Guggenheim study shows the “small issue” premium quite clearly for the high yield market.
Fund size also dictates how managers can transact in global fixed income and credit markets, to an extent. Beyond a certain size threshold, it becomes more difficult to transact in cash bond markets. Larger funds may need to gain exposure to certain parts of the market through derivative contracts, introducing special counterparty and liquidity risks that must be managed. While derivatives can be useful tools for managing interest rate changes and other kinds of portfolio risk, we think it is important for investors to understand: 1) the full extent of derivatives in the portfolio; and 2) whether derivatives are driving the pursuit of income, or if they are being used primarily to manage risk; and 3) that many derivatives are fundamentally systemic risk and opportunity plays (and not the same as idiosynchratic individual security risk) and are therefore, exposed to broader macroeconomic and market forces and volatility.
Are fund holdings and risk exposures transparent and clear (i.e. Transparency Matters)?
A recent study of nearly 80 high net worth investors in the U.S. revealed that more than half of them were not at all familiar with derivatives. As more investors consider making opportunistic fixed income strategies a meaningful part of their core fixed income allocation, we believe it is important that they not only understand the investments their managers are making, but how certain exposures are being achieved. For strategies that make significant use of derivatives, investors need to increase their knowledge of the role of derivatives in the portfolio and how the potential for additional risk is managed. As Cyrille Conseil, Director of Research and Trading at Anfield Capital and the lead portfolio manager of the Universal Fixed Income fund, says: “Investors expect an opportunistic fixed income fund to be invested in bonds. We believe that our bond-by-bond implementation of Anfield’s ‘best ideas’ from all sectors and regions of the fixed income market is probably easier to understand than a portfolio that makes heavy use of derivatives to gain exposure to certain markets and shows dozens of line items of swap contracts in the portfolio holdings.”
The fixed income environment is changing, and as a result, we believe opportunistic fixed income strategies with the flexibility to go anywhere are better suited to today’s market realities than traditional, duration-heavy core holdings. But because these strategies come in different shapes and sizes, we think it is important for investors to drill down into what they’re actually investing in and to understand both the “what” and the “how” of investing in this new fixed income landscape.
If investors are prudent in their discovery, they stand a much higher probability of identifying the pitfalls and recognizing their options in order to avoid the depths of potential loss that will accompany the next transition in the fixed income universe.