Income and global credit are becoming mainstays of fixed-income investing – an actively managed, unconstrained approach can be a valuable tool to face today's rapidly-changing market conditions.
- With markets now hostage to shifting global macro conditions and different sources of market risk, we are taking this opportunity to re-emphasize the value of active fixed-income management.
- After a multi-year period of low yields and little market volatility, we are finally seeing select value and diversification opportunities arise heading into the new year.
- In our view, income generation via global credit will become an increasingly integral part of investors’ preferences, and active sector rotation will be essential.
- We see EM as the most undervalued asset class and one that would be the biggest beneficiary of any attenuation of global risks.
- An unconstrained investing approach could afford the necessary flexibility to exploit the most desirable characteristics of fixed-income: income and return, diversification and preparation for risk.
Unconstrained Investing: Stay “Active” in These Uncertain Times
Exhibit 1: Year-to-Date Excess Returns
Source: Bloomberg Barclays, J.P. Morgan, S&P Global Market Intelligence, a division of S&P Global Inc, Western Asset. As of 30 Nov 18. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
In a paper we published last year, Global Investing: The Price You Might Pay for Going Passive, we cautioned investors over the misplaced euphoria and growing herd mentality around passive fixed-income products that was fueling a supply boom during an extended period of low volatility. We underscored the product shortcomings: an overweight bias toward the largest debtors, the inability to exploit off-benchmark opportunities, an asymmetric duration risk (i.e., less yield compensation), and the propensity to take on greater tracking error (and to potentially lock in underperformance) due to index replication constraints. We also argued that while a passive approach might make sense for highly liquid and well-researched markets such as US large cap equities or US government bonds, extending this approach to less transparent and less liquid markets such as high-yield or EM meant foregoing opportunities to enhance returns and effectively manage portfolio risk.
Exhibit 2: Passive Fixed-Income ETF flows
Highlighting Risks and Opportunities
Exhibit 3: J.P.Morgan Growth Forecast Revision Indices
Without doubt, the greatest threat to the global recovery is the prospect of a global trade war. As discussed at length in our recent paper, Trade Wars in the 21st Century: Perspectives From the Frontline, market prices may already reflect some of the downside risks and we may have now seen the worst of the tough trade talk between the US and China. However, one cannot ignore the possibility that trade tensions may worsen before or after the 90-day “pause” agreed to by the US and China at the G-20 summit.
With this downside risk on full display, one might question how it is possible to be even modestly constructive in our market outlook. We would argue that there are glimmers of light amidst the gloom. First, the Fed has already begun to walk back its hawkish rhetoric. Second, despite massive market pessimism about the challenges of Brexit and Italy (which we believe are misplaced), European growth has been sturdy; we expect this to continue as the Bank of England and the European Central Bank (ECB) continue to be highly focused on underwriting their respective expansions. Third, while the US-China trade dispute has introduced tremendous uncertainty in the global economy, it has engendered a course correction in Chinese economic policy. Gone is the deleveraging campaign of earlier this year. Interest rate cuts, reserve requirement reductions, targeted fiscal spending increases and a renewed lending to the private sector suggest slowing Chinese economic growth will reverse over the next several quarters.
Last, extreme market pessimism pulled the entire EM asset class downward this year despite important positives in the sector such as remarkably subdued inflation and resilient sovereign and corporate balance sheets. Consider these statistics:
- Yield spreads between EM and DM debt are near 2008 and 2016 wides;
- Currency levels are the lowest in nearly 20 years and are 35% lower than just five years ago;
- The real yield of EM debt is at a 15-year wide versus the real yield of DM debt. Our view is this asset class would be the biggest beneficiary of any attenuation of the global risks highlighted above.
Advocating Unconstrained Investing
Exhibit 4: Global Credit Market Views
Not being benchmarked or tethered to the low levels of benchmark rates will be just as important. We emphasize this because strategies that look to beat a benchmark inherently have to be conscious of tracking error and, as a result, managers may own sectors that they have to live with rather than those for which they have a strong conviction. For example, the surge in US government borrowing over the past decade means USTs now total approximately 35%-40% of the Bloomberg Barclays US Aggregate Index—in line with the percentage of USTs issuance versus total debt (see Exhibit 5). Passive strategies linked to this benchmark are prone to lower yields and potentially lower returns as more UST issuance squeezes out higher-yielding securities.
In the papers we’ve published, our case for advocating an unconstrained investing approach rested on the inherent shortcomings of benchmarks and the greater flexibilities unconstrained strategies enjoy to confront duration risk and seek value opportunities. These arguments have not become obsolete. If anything, the resurgence of market volatility and expectations that this will continue only strengthen the case for unconstrained strategies given their ability to exploit the most desirable characteristics of fixed-income: income and return, diversification and risk mitigation.
Exhibit 5: Percentage of Debt Issuance by Category
Source: Securities Industry and Financial Markets Association (SIFMA), as of 30 September 2018. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Exhibit 6: Yield-to-Worst vs. Historical Correlation—Last 10 Years
Source: Bloomberg Barclays, as of 30 November 2018. Yield and volatility statistics reflect US dollar-hedged data. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
We would also highlight the negative correlation that global government bonds have with equities (using the S&P 500 as a market proxy). We have long argued the value of holding government bonds, with a particular emphasis on USTs, mainly for their ability to act as ballast against spread risk in a broad investment portfolio, especially during turbulent market periods. Recent divergent price action of US equities and USTs continues to support this view.
The keys to selecting the “right” unconstrained solution(s) are clarity and transparency around expectations and tolerance of portfolio risk, the investment opportunity set and volatility in returns. Some of the investment approaches can be somewhat ad hoc and are not always clear as to the nature of the risks involved.
That’s the reason we believe it is essential to consider three key parameters when thinking about an unconstrained approach:
- Volatility tolerance: low, moderate or high?
- Opportunity set: what type of assets will the portfolio hold?
- Sources of alpha: will it be credit spread focused, macro focused or a combination of the two?
Other investors have demonstrated a preference for more global or macro-oriented unconstrained strategies. These typically exhibit the same level of volatility as traditional global indices such as the FTSE World Government Bond Index or the Bloomberg Barclays Global Aggregate, yet avoid exposure to low and negative yielding markets such as Europe and Japan to improve their risk and return profile. The opportunity set for these strategies is more biased toward investment-grade and the sources of alpha come from rates and currencies. Higher volatility macro strategies, which incorporate a wider opportunity set and have looser sector and credit-quality constraints, have also increased in popularity as they are less correlated with traditional beta and sit outside the traditional growth and defensive allocation framework.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
The Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Group of Ten (G-10 or G10) refers to the group of countries that agreed to participate in the General Arrangements to Borrow (GAB), an agreement to provide the International Monetary Fund (IMF) with additional funds to increase its lending ability.
Exchange Traded Funds (ETF) are a type of investment company which are bought and sold on a securities exchange. ETFs generally represent a fixed portfolio of securities, derivative instruments, currencies or commodities. The risks of owning an ETF generally reflect the risks of owning the underlying securities or commodities they are designed to track. ETFs also have management fees and operating expenses that increase their costs.
Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change of 100 basis points. It is calculated as the weighted average of the present values for all cash flows.
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The Group of Twenty (also known as the G-20 or G20) is an international forum for the governments and central bank governors from 20 major economies, respectively. The G-20 members include 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States—along with the European Union (EU). The EU is represented by the European Commission and by the European Central Bank.
The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.
A spread is the difference in yield between two different types of fixed income securities with similar maturities.
Government-sponsored enterprise (GSE) includes Freddie Mac, Fannie Mae and Ginnie Mae. GSEs were chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
Alpha is a measure of portfolio performance vs. a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.
Global Expansion: What's Going Right
The Credit Cycle: Key Signals
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