A time to be flexible (Archived)
Adam Mossakowski, fixed income manager at Insight Investment, says despite market uncertainties dampening enthusiasm for bonds, 2014 could be a good year for fixed income. He believes bond markets are much more likely to be range bound over the year, which means it will be worth earning additional yield from being invested in the market, while at the same time flexible mandates will be able to exploit market volatility by timing their exposure.
Meriten’s head of high yield, Alexis Renault echoes the sentiment there are many reasons to be positive about fixed interest for the year ahead and agrees the key to returns could be flexibility and risk management. To this end investors need to be acutely aware of how bond funds are being managed to ensure they are not overly vulnerable to liquidity shocks. Until 2007, high yield credit funds were predominantly driven by bottom-up, credit analysis, he notes, whereas in 2014 macroeconomic views in positioning portfolios will be invaluable.
“Today it is more difficult than it has been to be a credit manager. The new world we live in is one of low absolute yields.” In this environment Renault contends duration exposure will be an important differentiator of risk and returns.
The risks ahead
Renault notes one of the biggest unknowns for fixed interest investments in 2014 is the impact of tapering in the US. Indeed it could spark large outflows from corporate credit markets, creating a funnel effect on liquidity, he says. Mossakowski agrees liquidity will remain a concern this year and could be a catalyst for underperformance in the asset class. “The exit doors for fixed income are very small these days.”
As Mossakowski and Renault both point out, investors got a taste of this risk last summer when Ben Bernanke merely hinted at the possibility of tapering, leading to a sharp sell-off in emerging market debt and a wave of volatility through markets.
Although tapering poses a threat to fixed income markets, it should not dampen the appeal of bond investments, the managers say.
The positive side
In light of some of these risks, and the lack of visibility in the market, both managers favour the short end of the corporate bond market, particularly European high yield.
Short duration exposure not only helps to reduce volatility, it can ease liquidity concerns, Renault says. He favours issues that will mature in the next 15 months as they are easier to sell than longer dated bonds. In addition a holding cannot be sold, there is only a short time to maturity and redemption anyway.
Although Mossakowski is less keen on sub-investment grade for 2014, believing it to look expensive, he does like very short dated high yield bonds, noting the yields on offer make it a good place to ride out any sudden economic dips. He also likes the short end of the asset backed securities (ABS) market. Mossakowski says European 12-18 month floating rate ABS’s offer decent spreads and trade cheaply compared to a commensurate level of risk in investment grade corporate bonds. Issues in this space feature decent asset cover and so can absorb a huge amount of write downs before losses would be incurred, he notes.
Positive on select financials, Mossakowski is also exploring some newer bond alternatives, such as contingent capital (cocos), which are designed to convert into shares if or when a pre-set trigger is breached. Considering regulators’ interest in shoring up bank capital, new hybrid assets like cocos could be increasingly important, he says.
At a macroeconomic level, Mossakowski points out interest rates across Western markets are unlikely to rise in 2014 while inflation looks to be largely under control. One risk Renault believes has lessened and will not pose quite so much difficulty for investors in 2014 is Europe. “Today we can see economic improvement in Europe so the chances of a big blow up in that region over the next 12 months are limited.” He adds default rates for corporate credit in general are likely to remain low over the coming year.