Looking at fixed income returns over the first half of 2014, you could be forgiven for thinking that fixed income asset allocation no longer matters.
Volatility across financial assets remained remarkably depressed, falling to 12-month lows (as measured by the VIX volatility index) around the end of the second half.
However, from the third quarter onwards, volatility re-emerged and dispersion (often seen as a measure of the degree of investor uncertainty) rose sharply opening the gap between UK inflation linked bonds and US high yield bonds to approximately 8 per cent by mid-November.
The return of higher volatility is welcome, in our view, and is likely to continue.
We are now seeing real evidence of monetary policy divergence around the world with the US Federal Reserve stepping back from additional monetary stimulus and the Bank of Japan re-engaging, relative to the size of its economy in just as big size. This is presenting good opportunities for multi-asset managers set up to take advantage of dislocations.
Starting with developed market government bonds: While they offer a good hedge against deflation, and so continue to justify an allocation within multi-asset portfolios, there really isn’t much else going for them. Their poor value is underlined in the UK where the yield curve shows negative, real (after inflation) yields across its term structure. While the Bank of England’s November inflation report confirmed a weak growth outlook, little inflationary pressure and plenty of spare capacity in the economy, it is arguable that UK bonds have rallied too far.
Turning to credit: In high yield, an area investors have favoured recently to protect against rising interest rates, we continue to think valuations in traditional sub-investment grade bonds look stretched. The problem is that, in statistical jargon, credit spreads auto-correlate. This means that spread widening in one period increases the probability of further spread widening in the subsequent period; in other words there is an inherent momentum in credit markets which is currently negative.
There are additional technical constraints that are adding to the pressures holding back traditional high yield. Our reasoning relates to the ‘call’ features that are embedded in high yield bonds. At their June high, the average price in the US market was 106 per cent of par for an average 7 per cent coupon. Typically, high yield bonds allow issuers, after five years, to call (buy back) their bonds at ‘par plus half the coupon’.
This meant that, on average, investors would lose out in capital terms in a call situation where, using our rule of thumb, companies could call bonds at 103.5. Today, this skew is more favourable but only just: the average price stood at just over 102 at the end of October.
Fortunately, differentiation amongst fixed income assets globally does exist. In developed market government bonds, the US treasury yield curve offers a better option for multi-asset investors who need to retain a deflation hedge in their portfolios.
Our analysis indicates that the five-year point of the curve has already moved to price in much of what the Fed is likely to do to short term interest rates in 2015. This is in contrast to the UK, meaning investors looking for developed market duration could do a lot worse than looking to the US treasury market.
There are some glimmers of value in high yield too: single B credits look relatively cheap and price in a reasonable margin of safety if we were to revert to average levels of historic default rates. This is truer when compared with the more highly rated BB credits and particularly the riskier CCC credits that offer investors little protection. Furthermore, there appears to be greater excess spread compensation in European Bs relative to the US, perhaps because investors shunned the market following the high profile default of Phones 4U in September 2014.
However, the greatest margin of safety and where we are most constructive in fixed income is local currency emerging market debt, an asset class to which we added significantly in 2014 and which pays a considerable premium over both developed world government bonds and credit.
Whilst the consensus has fretted over the implications for emerging market debt following the end of US quantitative easing, ultimately much of this analysis is, we believe, flawed and at odds with a weight of evidence suggesting that the asset class remains one of the most fundamentally attractive and improving areas of the bond market with attractive levels of debt to GDP and significant foreign exchange reserves complimented by generally improving current accounts.
The issue of margin of safety is hardly new and has formed the basis of many celebrated investment approaches: Benjamin Graham, David Dodd and Warren Buffet to name but three. Central to this approach is that investors run higher risks when they follow the herd in chasing ever lower yields; we believe local currency emerging market bonds offer us the antidote to this all too common problem in today’s fixed income markets.
Anthony Gillham, Manager, Old Mutual Voyager Strategic Bond fund