Expert: Fraser Lundie, Federated Hermes Facilitator: Andrew Mills, Insight Financial Research
Headlines:
- Bonds are back
- Fixed Income has grown more sophisticated in recent years
- Diversification and intelligent risk management are key
Discussion points:
One major impact of the last year’s momentous events has been a revival of interest in fixed income among many investors. The rebound in yields from the low levels of recent years is tempting investors to dip their toes back into the market, but many are simply buying a basket of Gilts or UK Investment Grade (IG) corporate bonds.
Investors could and should give themselves a better spread of risks and returns. That view is underscored by events such as November 2022’s LDI debacle, which provides a wake-up call about the risks of putting all your fixed income eggs into one, relatively small, domestic UK basket.
One key thing for investors returning to fixed income to understand is just how far and how fast markets have evolved in recent years. The High Yield (HY) market provides a great illustration. The global HY universe now spans 85 countries, and the average EBITDA of HY issuers has gone from ~$250m to ~$1bn over the past decade or so. In short, HY has grown up.
Another example comes from the emergence of a global market in corporate hybrids. This is a form of perpetual debt that doesn’t always pay a coupon, but which must be paid before issuers can distribute any dividends to equity investors. That makes hybrids issued by companies with high or consistent pay-out policies particularly attractive.
Returning fixed income investors should appreciate the importance of effective diversification, which is far easier to achieve today than in the past thanks to the increasing choice of markets, sectors, risk tiers and durations available to fixed income investors.
In addition, it is increasingly feasible to for intelligent risk management to help investors avoid possible areas of weakness or potential pricing shocks, and to capture relative value opportunities.
This is becoming increasingly important as rising interest rates create greater opportunities for alpha into fixed income markets.
Key takeaways:
There are a number of risk indicators to look out for:
- Factors that can be indicators of repricing risk in fixed income markets – especially when several overlap – include excessive leverage, complex financial engineering, opaque issuer fundamentals and high valuations relative to sector peers or to issuers’ own equity
- The rapid growth of private credit markets in recent years, especially among issuers that previously favoured HY markets, could also mean that this asset class is harbouring hidden mark-to-market risks - which might conceivably spread to other asset classes via collateral call risks in the event of market dislocation
- Variations in risks and returns between countries, sectors, ratings layers and durations are increasingly apparent across IG, HY and other global fixed income markets
- A flexible mandate and the ability to access alpha via smart credit selection are important components of success
- Investors can also use options – at a typical approximate cost of 50 basis points a year – to provide partial protection against downside risks
- Active engagement and stewardship, based on specialist insights, can also be valuable
