Over the past two years, the search for yield has become the clarion call of the investment community, spawning a new generation of multi-asset class credit and fixed income products. Today the landscape is becoming more complicated with the sceptre of rising interest rates in the US. Different strategies may need to be deployed but institutions will need to remain nimble and open minded in order to generate strong risk-adjusted returns.
“Investors are looking at a different approach to portfolio construction such as unconstrained funds and multi-credit asset class strategies which offer broader opportunity sets.”
Nick Gartside
“Fixed income markets are in transition with a divergence of monetary policy between the US and Europe,” says Bill Street, head of investments, EMEA at State Street Global Advisors. “The result is that investors cannot look at fixed income in regional isolation. They need to adopt a global outlook in order to play the spread duration and get better diversification.”
Jon Jonsson, fund manager at Neuberger Berman adds: “The steepness of the curve tells us a lot about the differences in the economic paths being taken by the US and Europe. The US curve is steeper which means the economy is further along the path of recovery. The country’s banks have de-leveraged with total loan balances relative to bank deposits approaching 70%. “Europe has a long way to go with its loan to bank deposit way above 100% and the banks are still over three times the size of their domestic economies, much larger than the US where banks are smaller than the economy.”
The European Central Bank (ECB) is trying to light a fire under the region’s economies and recently surprised markets with its 0.25 percentage point rate cut to a record low 0.25% rate. One of the main problems is inflation, which slid to 0.7% in October, is well under the ECB’s target of just below 2%. This is strangling growth which is expected to end the year at an anaemic 0.4% while unemployment is at the highest level since the currency bloc was formed in 1999. By contrast, US GDP was a stronger than predicted at 2.8% in the third quarter, up from 2.5% from the previous three months. The job data was also encouraging with employers adding 204,000 new jobs to their payrolls in October, while 60,000 more jobs were created in September and August than previously reported. This has put the prospect of tapering firmly back on the table although few are willing to nail down a definite time as to when the Federal Reserve will begin to reduce its hefty monthly $85bn bond buying programme.
This is partly due to the nervousness over the government’s inability to reach an agreement over the debt ceiling next February, plus the Fed does not want to repeat the mistakes made in the spring when just the hint of the end of quantitative easing sparked a sell off in virtually all fixed income sectors. It also led to a shift into the shorter end of the curve especially on the high yield front which is now looking both crowded and expensive.
As Roubesh Adaya, a senior associate on the fixed income research team at advisory firmbfinance, notes: “Today the focus is more on short duration plays in high yield, corporate and government bonds due to concerns over rising rates in the US. However, everyone has moved into these assets and now people are waiting for the right entry point to either invest or move back in.”
Taking the plunge
Not surprisingly this backdrop only reinforces the more multi-faceted approach adopted by institutions over the past year to 18 months. “There is definitely an increasing trend for diversification but there is no one formula that will suit every investor,” says Bernard Abrahamsen, head of institutional distribution at M&G Investments. “It will depend on funding levels, sponsors’ covenant, appetite for risk, and governance. Also, although everyone is looking for higher returns, that doesn’t necessarily necessitate a move out of their comfort zone. Investors need to think about whether they are being rewarded for the risks they are taking.”
In general, pension schemes that are fully funded are less likely to be as adventurous as their struggling counterparts who are looking for growth assets to fill any gaps. To date, the most popular vehicles are absolute return funds which aim to make a profit irrespective of the market environment and total return strategies which are typically measured but not necessarily managed to an index. Both share the same types of assets but the blend may be different. For example, a total return fund may add more high yield bonds and emerging market debt into the mix while an absolute return fund perhaps would allocate more to investment grade instruments or employ derivatives, including credit default swaps, to hedge market directional risks.
Stand alone, multi-asset credit or MAC funds have also come back into vogue and they too include high yield bonds and emerging market debt but also leveraged loans, mortgage and asset-backed debt securities (ABS) and distressed debt.
“Low interest rates and QE drove down yields which made traditional fixed income somewhat uninspiring,” says Nick Gartside, international CIO of fixed income at JP Morgan Asset Management. “Investors are looking at a different approach to portfolio construction such as unconstrained funds and multi-credit asset class strategies which offer broader opportunity sets. Also, they allow managers to rotate to better segments of the market because they are not investing against a benchmark.”
Henrietta Pacquement, lead portfolio manager at ECM Asset Management adds: “We are seeing a variety of themes, but there is definitely greater interest in absolute return funds where managers are able to play across the credit and rate spectrum and aim to generate returns regardless of market conditions. This can involve multi-asset credit, including corporate bonds, high yield, loans, emerging market debt and ABS. Clients are looking for flexibility and the ability for a manager to recalibrate their exposure as market conditions change.”
Rich Smith, portfolio manager at Aberdeen Asset Management, also stresses the importance of having a wide geographical reach. “There is much more choice in a global mandate because it introduces different economic cycles and government curves and stimulus. Our global fixed income funds, for example, select from a universe of over 18,000 bonds. This is in stark contrast to UK-only funds, which face an opportunity set that is 90% smaller.”
Floating rate
While these multi-asset class funds have appealed to a wide institutional audience, some investors are happier to add different single asset classes to their fixed income portfolios. This is particularly the case with leveraged loans which are made to non-investment grade corporations for a range of purposes such as financing acquisitions, refinancing existing debt and supporting business expansion. As floating rate notes, they sit between high yield and investment grade. Issuance has boomed in Europe with volumes up 40% to €67bn through 88 deals for the year to the end of September, compared with €48bn from 56 deals in the same period last year, according to Debtwire Analytics.
The main attraction, according to research from BlueBay Asset Management, is they have a strong track record, generating an average annualised return of 6.8% over the past 21 years, with only one year – 2008 – showing a negative return. The drop was deep at 29%, but it was immediately offset by a positive 52% hike in 2009. As to the fears over bankruptcy, the fund management group notes that loan recovery rates are around 70%, which is significantly higher than the historical 40% figure for high yield bonds. Over the longer term, loans have had lower default rates of 2.47% compared to the 3.63% of high yield bonds and rating agencies expect default rates to remain low.
There is also a positive buzz about illiquid bank loans in the private debt market because they deliver high yields and the chance of equity-like performance with greater downside protection, according to Sanjay Mistry, head of private debt at Mercer. “The majority are floating rate notes and investors are more than compensated for the illiquidity risks. We are also seeing interest in commercial real estate debt although the funds are relatively small. The question is how much illiquidity can a pension fund tolerate?”
James Tarry, fund manager at Aviva Investors, believes investors can generate above average returns through commercial real estate and benefit from a fund that invests in a diversified pool across the mainstream sectors of office, retail and industrial. Aviva Investors recently launched a UK commercial real estate senior debt fund with a fundraising target of £500m. The fund which aims to return 2.5-3.5% above equivalent maturity UK government bonds a year, will invest in loans with a five to 10-year maturity and an LTV of up to 65% on core and core-plus buildings. “We are not going into anything esoteric but focusing on the mainstream sectors of office, retail and industrial. One of the keys is to have exposure to high quality tenants with strong covenants.”
Infrastructure debt is also on the radar but it is still a relatively new asset class in Europe and investors, which prefer equity in this space, are treading carefully. “This is slowly changing because institutions want assets that can better match their liabilities and act as a diversifier,” says Deborah Zurkow, CIO infrastructure debt at Allianz Global Investors. “These are the advantages of infrastructure debt because it offers long-term stable cash flows and good risk return profiles. However, there needs to be more education and there are constraints on supply.”
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