The central bank story is not going away. As inflation begins to creep into every conversation, fund buyers such as Fidelity’s Charles McKenzie are taking a careful overview of the bond sector.
‘As we move into 2018, many investors believe the interest-rate sensitivity of their bond portfolio is the dominant risk. Yet I would argue that late-cycle risks are most pressing for credit.
'Yes, inflation is likely to creep higher in 2018, but we do not expect it to derail central banks’ gradual approach to policy normalisation. ’
Rather than fixating on one issue, McKenzie says it is better to embed comprehensive protection into portfolios for the new year.
‘For those portfolios with a wide remit, being smarter with asset allocation is key. Wide diversification to dampen overall volatility should be balanced alongside active rotation across the credit market as conditions change.
‘Some of our portfolios supplement this with sophisticated techniques to add downside protection, such as using credit options to buy protection against spreads widening beyond a specified level, or dynamically hedging a portfolio based on timely model signals that gauge shifts in market sentiment.’
McKenzie says a large element of downside risk is still bubbling under the surface for corporate bonds. ‘Most important for protecting against downside risks however, is credit selection.
‘Markets are quite indiscriminate in pricing between good and bad credits at the moment, so now is a good time to trade up in quality without incurring much of a yield drag. A t this point in the cycle, when volatility is low and market conditions are stable, credit research really counts for underpinning portfolio positioning,’ he says.
Walking a similar line when it comes to a ‘protection first’ playbook is Spyros Agrianitis (pictured) of Greek investment firm Alpha Bank. Describing bonds as a ‘conundrum’ for fund selectors at present, Agrianitis says the best thing portfolio managers and asset allocators can do is consider their worst-case scenarios.
‘If you look at the asset class as a hedge against potential market downsides within portfolios, then developed government bonds, for example, are the proven asset to meet that need, but that choice will not generate returns.
This year, investors will have to strike a balance between an acceptable level of returns, while maintaining the hedge the asset class offers in case of market corrections.
‘For that reason we have raised our exposure in selected alternative fixed income products, to give active fund managers some flexibility to deal with this problem.
'Within portfolios in discretionary and advisory mandates we can apply strategic and tactical allocation decisions, but it is impossible to reallocate risk on a systematic daily or weekly basis. That is where successful active management makes a difference.’
For the year ahead, Isabelle Tillier of FundQuest believes one theme will be consistently important: diversification. ‘If we see anything like a correction, it could be damaging as there is increased crowding in areas such as high yield. Diversification and idiosyncratic performance drivers therefore make a lot of sense. Security selection remains key,’ she says.
One way to ensure diversification, she says, is to track down managers with wide remits and flexible approaches. She cannot name any specific fund managers, but Tillier’s (pictured) attention has been drawn to unconstrained bond funds, as these have a broader scope of investment opportunities.
‘Unconstrained strategies are attractive, particularly given the difficulty of forecasting market developments and the higher transaction costs of credit. Flexibility alone in asset allocation will not be enough.
‘As a result, diversification and bond picking is likely to be a key driver in portfolios and managers will need to reduce the risks of concentration. Also, given the low dispersion among the various credit markets, it is a good time to go up the credit quality keeping a high return.
‘For example, the yield differential between BBB and BB-rated corporate bonds is close to its historically low level. Managers must therefore question themselves each time they increase their risk-taking in their quest for returns. The current environment will help distinguish winners from losers.’
Having highlighted that the French group is finding credit expensive, Tillier believes opportunities will emerge but these may be in areas where historic analysis makes the difference. ‘In credit, you have to pick conservative managers with a long track record of avoiding bad names, as well as flexible players who can reduce their beta exposure and pick either the good asset classes or the good names,’ she says.
Menno Meekel of Rabobank, agrees that inflation is not the only concern for bond investors, but says it needs to be given the right level of priority and viewed at a regional level.
‘After we sold our remaining global high yield position in 2017, we bought EM debt. This is not an overarching theme but the spread over US treasuries in select investment grade countries is around 1-1.5% higher than in developed markets.
‘We think local currency is especially attractive, as inflation risks are muted and there is a lot of economic reform taking place in different countries. EMD comprises many regions so a good active manager should be able to add value here. Because we don’t want to miss out on opportunities in the hard currency segments of the market, we invest in EMD via blend funds,’ he says.
So, where will Meekel be putting his efforts to the test this year? ‘Subordinated debt remains one of our favourite investments and we prefer the deep subordinated Additional Tier 1 debt of banks.
‘We are aware of the potential risks so we keep the allocation at around 5%. But the current spread versus senior bank debt is still around 250-300 basis points, and there is a large amount of regulatory oversight. We are still well compensated for the risk we take versus high yield, for example.’
One thing is certain: government bonds require a major shift in fortunes to regain the favour they once had among fund selectors. Francisco Amorim of Millennium BCP is not alone in positioning with a view that sovereigns will continue to suffer in 2018.
‘Yields in government bonds are likely to maintain their slow upward trend in the US and Europe but we expect low returns to persist,’ he says. ‘This will be a challenging year for fixed income managers, even for those who achieved solid returns over 2017.’
Wary on winners
For Anders Bertramsen, head of external products at Nordea Asset Management, last year’s winners need to be reappraised carefully moving forward.
‘There has been a surge in hot money and marketing-led ideas, as we have seen a growth in AI and disruption-focused funds or robotics, most notably in equities. In some cases, it seems as if the marketing department has been involved and that is not an encouraging sign as investors need to consider the fundamentals at play.
‘We want to avoid hot money as much as possible. EMD has seen inflows but that is underpinned by solid reasons, so we are more comfortable. Looking ahead, we could see some potential for municipal bond funds as well but we need to assess each asset class as we go,’ he says.
These comments were part of the Bonds & Beyond supplement published at the start of February 2018.