Outlook demands flexible approach

Weak market sentiment offers managers the chance to turn negative prospects for a company into returns for clients and, despite the uncertainty, portfolio flexibility is key to survival.

As far back as the autumn of 2006, it appeared that cash returns would outperform the returns to be made from bonds. Holding cash proved to be a smart decision in 2007.

However, this year, after America’s Federal Reserve announced a three-quarter point interest cut – the biggest single cut in more than two decades – the outlook is looking more positive for fixed income as an asset class.

Last year came in two distinct halves: the first half was characterised by strong equity markets, tight credit spreads and rising bond yields.

The latter half was the opposite: weak and volatile equities, credit implosion and a major flight to quality. Although the credit boom was living on borrowed time, nobody expected the severity or duration of the credit crunch that followed.

Nor the way negative sentiment would travel between previously unrelated asset classes: from asset backed securities to loans through to high yield, investment grade and equities, and now on to monoline bond insurers.

Making money in this sort of environment has been tough because fund managers have little choice but to operate within the confines of the market.

Liquidity dried up in all asset classes, making asset allocation difficult and implementation tricky. Ironically, almost all fixed income asset classes were poor over the year, languishing in a range of plus or minus 2%.

So it was not really a big asset allocation year, which is unusual given the large historical deviations between different types of fixed interest assets.

Cash won out against all, including equity and property. But investors should remember that it is called an economic cycle for a reason; if cash did not dominate occasionally monetary policy would not function correctly.

Last September was a turning point. The shake-up and repricing of risk to more rational and even cheap levels represented a good buying opportunity for bond investors. A general rule of thumb is that investors should buy bond funds just before interest rates peak. Well, rates have peaked.

Secondly, corporate bond spreads have blown out to five-year highs and the market is trading at levels discounting a recession. In fact BBB-rated companies are trading at levels discounting five-year cumulative default rates of 10%. The worst ever five-year period since 1970 is 5.4%, and the average is 1.9%.

Financials are trading at levels implying 14% default rates over a five-year cumulative period. This is cheap on any risk-adjusted basis.

Everybody thinks investment grade financials are cheap but few are brave enough to buy them now, as most expect them to get cheaper as new supply hits the market over the rest of the quarter. However, most strategists believe that on a 12-month view this is the trade of the decade.

The financial crisis is being contained by equity support by sovereign wealth funds, from players such as UBS, Citigroup and of course significant central bank action from the European Central Bank, and most recently, America’s Federal Reserve.

The crisis is – in large part – of the banks’ own creation and is not dissimilar to the one the incumbent telecoms companies found themselves in post the 3G licence misadventure in 2002.

To put it simply, banks need to de-lever, recapitalise and hunker down. Running banks for creditors is good for bond holders, but does not make a good equity story. Bond managers will not be too troubled by this.

So in times like these, how can a bond fund manager add value? By using a strategic approach that allows for greater flexibility than traditional bond portfolios.

For example, during Christmas and the new year we implemented a hedging strategy by using credit default swaps to short several investment grade industrials, airlines, cyclicals, and consumer names (such as BA, Clariant, Dixons and Tomkins), given the market’s concerns over recession.

This type of trade is vital when market sentiment is weak, as it presents opportunities to turn a negative outlook on a company into returns for clients.

There is much to be concerned about with such an uncertain economic outlook, but portfolio flexibility will be key to steering through the murky waters. Bonds are cheap and should outperform cash in 2008.