Fixed income investors need to take better care in protecting portfolios against ‘breakable’ assets during periods of deleveraging to avoid catastrophic knock-on effects.
That is the view of Citywire A-rated Tad Rivelle, who is co-chief investment officer for fixed income at TCW, overseeing $140 billion in bond funds and assets.
In an investor commentary, Rivelle, who is a named manager on several US-domiciled and Ucits-compliant funds, said efforts by the Federal Reserve to relever the account were faltering and investors need to be conscious of deleveraging.
‘The Fed’s vast re-leveraging project is running smack dab into that “long run” we were supposed to not fret about,’ he said.
‘Excesses and misdirection of capital flows have brought oversupply and deflation to the commodities complex, a sharp slowdown in EM growth rates, a strong dollar and earnings recession to the US, and crowded trades in risk assets everywhere.’
Against this backdrop, he said the fixed income market then aligns itself into three broad buckets: the traditional risk-off assets (such as treasuries and agency MBS), ‘bendable’ assets (such as investment grade corporates and senior non-agency MBS), and ‘breakable’ assets (such as high yield and EMD).
‘The distinction between risk-off and risk-on assets is widely understood. What distinguishes “bendable” assets from “breakable” ones? Bendable assets will experience a “linear” widening in their risk premia while many breakable assets will “gap” to the downside in terms of price,’ he said.
Rivelle said during periods of deleveraging, rightly or wrongly, assets are perceived as having ‘no future’ and will be priced as if they are set to be restructured or liquidated. He said this can often leave ‘breakable’ assets extremely vulnerable.
‘A “breakable” asset is one whose valuation suddenly transitions from “going concern value” to “workout value”. Needless to say, when the market changes its valuation paradigm, the ride down is stomach churning.
‘In contrast, while bendable assets are priced more cheaply as a de-leveraging unfolds, the inherently solvent nature of bendable assets means they cheapen in a “linear” way as opposed to repricing “catastrophically”.
‘Now more than ever is the time to be wary of owning too much that might be “breakable”,’ he said. ‘Alas, the autumn leaves of this cycle have changed colour. Investors need to be prepared for the coming winter of deleveraging.’