Active Management Will Enhance Fixed Income Flexibility For 2019
Q&A with Robert Abad, Product Specialist at Western Asset Management
Why will active management be increasingly important to global fixed—income investors?
Markets now hostage to shifting global macro conditions and different sources of risk (e.g., U.S.-China trade tensions, Brexit, Italy, etc.) only reemphasize the value of active fixed-income management. The resurgence of broad market volatility and pullback in passively-managed flows this year underscore our view that active management in fixed—income is here to stay.
These developments also serve as a timely reminder that unconstrained investing is a viable and attractive complement to traditional benchmarked strategies, or as an alternative investing option in all market environments. The coming year will likely see more bouts of volatility stemming from a number of flashpoints in both emerging markets (EM) and developed markets (DM).
We encourage investors to embrace active management and unconstrained investing. Each affords greater flexibility to manage risk and harvest value opportunities as they arise.
What do you see as the most undervalued fixed—income asset class?
EM. It would be the biggest beneficiary of any attenuation of global risks.
How do you evaluate global bond markets from the bottom-up?
Corporate fundamentals continue to be strong across the majority of sectors and earnings are supportive of credit investing. Concerns grow in certain segments of the market, particularly BBB rated credit and the downside risks from an escalation in global trade tensions.
For compelling value opportunities within each market, we find “attractive:” EM U.S. dollar and local markets sovereign credit (with focus on Russia, Brazil, Indonesia and India), EM corporate credit, and structured credit. The sectors we consider “fair” by valuations are: U.S. high yield, non-U.S. high yield, bank loans, U.S. investment grade (IG) and Non-U.S. IG.
What looms as the greatest global economic threat?
Without doubt, the greatest threat to the global recovery is the prospect of a trade war. Prices may already reflect some of the downside risks. We may have seen the worst of the tough trade talk between the U.S. and China, but we cannot ignore the possibility that trade tensions may worsen before or after the 90-day “pause” agreed to by the U.S. and China at the G-20 summit.
Why do you advocate so strongly for unconstrained bond investing?
An unconstrained investing approach affords investment managers the necessary flexibility to exploit the most desirable characteristics. Given the still-low levels of interest rates, income generation via global credit in all its forms – corporate debt, structured credit and sovereign debt, to name a few – will become increasingly integral to investors’ portfolios. Active sector rotation will be essential. Credit sectors do not necessarily move in tandem; they have different cycles and do well in different environments. The ability to tactically emphasize and deemphasize sectors to find value and drive alpha in a diversified portfolio will be vital for performance.
The keys to selecting the “right” unconstrained solutions are: clarity and transparency around what investors should expect in terms of portfolio risk; the investment opportunity set; and volatility in returns. Many of the products in our industry are somewhat ad hoc, and investors are not always clear as to the nature of the risks inherent in each or among the different offerings.
Is not being benchmarked or tethered to the low levels of benchmark rates important?
Yes. Strategies that look to beat a benchmark must inherently be conscious of tracking error. As a result, managers may own sectors they have to live with, rather than those for which they have strong conviction.
Surges in U.S. government borrowing over the past decade mean U.S. Treasury bonds (USTs) total about 35%-40% of the Bloomberg Barclays US Aggregate Index – in line with the percentage of USTs issued versus total debt. Passive strategies linked to this benchmark are prone to lower yields, and potentially lower returns, as UST issuances squeeze out higher-yielding securities.
Advocating for unconstrained investing rests on the inherent shortcomings of benchmarks and the greater flexibilities unconstrained strategies enjoy to manage duration risk and harvest value opportunities. The resurgence of market volatility – and expectations it will continue – only strengthen the case for unconstrained strategies. They can exploit the most desirable characteristics of fixed-income: income and return, diversification and risk mitigation.
What market dynamics drive these views?
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. Bond investors are asking which sectors look attractive, what investment solutions might best be suited to exploit those sectors and what market-jolting event may lie around the corner.
Investors have been blindsided by bouts of sudden, sharp volatility across equity, fixed-income, commodity and currency markets. Market angst has been amplified by fears of slowing global growth, the inability of central banks to inspire confidence around policy normalization, tighter financial conditions, and a dizzying array of idiosyncratic risks coming out of DM and EM.
Yet spread sectors held up well in the first half of 2018?
True, but since then, market sentiment weakened and depressed valuations across the bulk of the credit spectrum. UST bonds also succumbed to the market’s gravitational pull as U.S. growth optimism and glib comments by U.S. Federal Reserve (Fed) Chair Jerome Powell propelled U.S. rates to a multi-decade wide versus most other G-10 countries.
Recent U.S. mutual fund and exchange-trade fund (ETF) flow activity reflects this heightened state of market anxiety. After a sizable build-up of assets under management in the passive taxable bond segment, following the oil price collapse of 2015, demand fell off considerably in 2018, with the bulk of the decline observed over the past few weeks. Most notable is the sharp reversal in corporate, high-yield and bank loan flows, and the surge into the combined short-term and ultrashort bond segment. This dynamic should not be surprising.
Why is it not surprising?
In a paper we published in 2017, 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 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 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 U.S. large cap equities or U.S. 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.
What is your top-down view of fixed—income opportunities for 2019?
Expectations for continued synchronized 2018 global growth were upended by acceleration of U.S. growth beyond consensus estimates, slower global growth and idiosyncratic EM risks. Revisions to U.S. and non-U.S. growth diverged as the year progressed, resulting in broad-based U.S. dollar strength, higher U.S. interest rates and higher risk premia across global spread sectors. We expect 2019 U.S. growth to slow slightly as the impact of fiscal stimulus wanes and the pernicious effects of tariffs weigh on key pillars of the economy (e.g., housing and autos).
Absent an acceleration in nominal GDP, and without any real signs of sustained wage pressure, we also view any upticks in inflation in the near-term as merely transitory. We expect the Fed to continue to move cautiously and adjust policy as needed, based on market realities and not on static models. Our hope is for clear communication and minimal uncertainty as unexpected monetary policy moves will undoubtedly lead to even greater volatility.
Even with downside risks on full display, are there glimmers of light amidst the gloom?
Yes. First, the Fed has already begun to walk back its hawkish rhetoric. Second, despite massive 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 remain highly focused on underwriting their respective expansions.
Third, while the U.S.-China trade dispute has introduced tremendous uncertainty into the global economy, it has engendered a course correction in Chinese economic policy. Gone is the deleveraging campaign of early 2018. Interest rate cuts, reserve requirement reductions, targeted fiscal spending increases and renewed lending to the private sector suggest slowing Chinese economic growth will reverse over the next several quarters.
Lastly, extreme 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 that: yield spreads between EM and DM debt are near 2008 and 2016 wide; currency levels are the lowest in nearly 20 years and 35% lower than just five years ago; and the real yield of EM debt is at a 15-year wide versus the real yield of DM debt.
So, investors in unconstrained bonds would be wise to consider diverse products?
Since there is no “one-size-fits-all” approach to unconstrained investing, it is essential to have a range of strategies from which investors can choose to meet their risk and return objectives.
For example, over the past few years, a growing number of investors have chosen to invest in multi-asset credit (MAC) strategies, rather than trying to figure out which credit sectors to invest in at any given time. MAC strategies generally have a volatility range that reflects their underlying credit opportunity set, which can include but is not limited to corporate bonds, EM debt and structured securities. Given their credit-heavy orientation, the major sources of alpha in a MAC strategy over time will come from spread sectors.
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 they avoid exposure to low- and negative-yielding markets such as Europe and Japan. This improves their risk and return profile. The opportunity set for these strategies is more biased toward IG, 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. They are less correlated with traditional beta and sit outside the traditional growth and defensive allocation framework.
Robert Abad is a Product Specialist at Western Asset Management, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
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