Positioning for yield in time for a global restart
As liquidity conditions improved, our portfolio manager shares how we are positioned for income opportunities across asset classes.
Q1. WE HAVE SEEN A RECOVERY IN RISK ASSETS OVER THE PAST FEW WEEKS. IS THE WORST BEHIND US?
When it comes to the risks, while we can be hopeful that strong containment actions across the developed world will limit the further spread of the acute respiratory disease, the true economic impact won’t be known for a few months at the earliest. It’s hard to say that the worst is behind us.
Financial markets tend to be very forward looking. The bottom in the financial markets may not align precisely to economic output or risks to the economy.
The question that we face is whether enough bad news has been priced in. As investors rushed to liquidate positions and de-risk in mid to late March, we saw market dislocation and extreme volatility across all sectors of the global fixed income market. Since then, with the dramatic assistance of the US Federal Reserve (Fed) and accommodative central banks around the world, market conditions have improved dramatically.
Q2. ARE WE STILL FACING CHALLENGES IN LIQUIDITY?
Although bond markets globally experienced significant liquidity challenges in mid-March, this began to ease as the Fed meaningfully stepped up their quantitative easing (QE) programme and introduced a number of highly supportive facilities to aid market functioning and to promote and bolster liquidity.
Q3. HOW ARE YOU POSITIONING THE INCOME STRATEGY?
Active management in this period is critical, including the ability to actively adjust the portfolio in response to rapidly changing market conditions.
At the end of 2019, we had more optimism on the back of positive development of a China-US trade deal, highly supportive central banks and strong fiscal backdrop for consumers. All these pointed to a healthy foundation for consumer-related segments of the US economy. So we carried reasonable consumer risk into the start of 2020. Despite a cautiously optimistic fundamental outlook, we didn’t think that spread levels were fully compensating us for risk-taking. As such, we got more defensive in the strategy towards the end of 2019.
In early 2020, we planned around the “known unknown” risks – such as the outcome of the US presidential election, and its risk of reshaping the US economy. At the same time, we also are able to pivot and respond when “unknown unknown” risks arise, such as the escalation of conflict between the US and Iran, and the pandemic.
We made a number of changes from January 2020 onwards as the disease spreads across continents2.
As we look ahead, it’s important for investors to maintain a keen focus on fundamentals. Although we continue to have selective exposure to HY in the Strategy, we remain cautious on the sector.
While the headline yields in HY are elevated, at approximately 8%4,5, much of that is currently driven by companies that are nominally high-yielding but are being effectively priced for default. By comparison, the more credit worthy issuers are yielding close to 5-6%4,5. As such, we’ve layered some hedges back into our HY exposure, reflecting our caution.
Although the US HY market is deriving a degree of further support from the Fed, its actions to purchase these securities are largely symbolic. As such, we’d expect an average 10% default rate in HY for some time.
Given substantial credit risk in HY, it’s more important than ever for investors to cautiously pick through securities for investment opportunities, particularly in areas such as energy. Therefore, within HY, we’re focused on non-cyclical sectors that are expected to hold up well in this stressed environment – such as media, telecoms, healthcare, consumer goods etc.
Q4. WHAT IS YOUR INCOME STRATEGY'S CURRENT EXPOSURE TO US SECURITISED ASSETS6?
Exposure to a broad mixture of US securitised assets provides important diversification7 to the Strategy. As of end of March, our securitised exposure makes up approximately 40% of the Strategy2.
In the current environment, correlations are higher than we’d expect over a full investment cycle, but they continue to offer some diversification7 benefits given their unique characteristics. We continue to see opportunities in all of those securities.
Q5. HOW ARE YOU HEDGING RISK IN YOUR US SECURITISED EXPOSURE2,6?
We’re broadly diversified7 within the securitised space. We hold everything from auto to home loans, to commercial real estate, to direct consumer loans. We strive not to have a single sub-sector dictate the overall performance of our Strategy. This is particularly important given heightened uncertainty across markets. We manage and hedge the portfolio’s interest rate exposure through Treasury futures. Within each sector, we use instruments that represent a basket of bonds and hedge the exposure via credit default swap indices.
Q6. WHAT SHOULD INVESTORS KEEP IN MIND?
We believe that the combination of appropriate healthcare policy, scientific advancements and a robust fiscal and monetary policy response will help to combat and contain the pandemic over time. As such, we believe there are great opportunities for both returns and long-term income.
The Income Strategy was built around targeting high levels of income at a prudent level of risk and around relying on genuine diversification7 by utilising our resources to identify strong risk-reward ideas. Although markets will remain volatile in the short-term, this provides long-term investors with security selection expertise the opportunity to capitalise on bond market mispricings. As markets normalise, we remain focused on delivering on our long-term value proposition8.
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