Fixed Income: negotiating a turning cycle

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Raymond Sagayam (Chief investment officer fixed income – Pictet Asset Management) remains optimistic about fixed income’s prospects in this Q&A session from the turn of the year.

Do you think the global bull market for fixed income that started in the early 1980s is coming to an end?
RS: Is this the end of the bond bull market? I definitely think so. I feel that finally many agents who were acting in concert to ensure that interest rates stayed low – which had served its purpose to end the global financial crisis – really have run out of steam in the past few years and this policy isn’t relevant in the current macroeconomic context. But does that mean the demise of the fixed income asset class? I firmly and strongly have the conviction that isn’t the case.

Pictet fixed income negotiating a turning cycle1
How does a fixed income manager respond?
RS: What I find encouraging is the fact that fixed income usage has become so entrenched in individual and institutional investors’ behaviour and investment decisions. It’s not an asset class that loses its appeal overnight. Sure, investors could see their fixed income investments become more volatile in the near term. But at a very core level fixed income fulfills a very basic need, which is a stable rate of return over the duration of the asset and the expectation you’ll get your principal back.
There’s a view that millennials – that younger cohort of investors – prefer risk and therefore will steer clear of bonds. While it’s impossible to ignore the impact these younger market participants are having, the people with the money to invest now are not the millennials. Most of the people who need to deploy capital are older, and that’s the demographic that’s swelling in the West and in Japan. These are the ones who are quite influential over the near- to medium-term.
This investor base will always require fixed income, chiefly because of the structure of the asset class and how it ties in with retirement objectives. In the near term, a sharp move upwards in interest rates may cause some investors to scale back on fixed income. In the medium term there are very good reasons to think that these investors will actually take encouragement from the backup in interest rates and start investing in bonds again.
At the same time, rising interest rates reduce the present value of long term liabilities, which is good for pension funds.
You can then easily envision a scenario where a lot of these long term investment plans, which have almost thrown in the towel and basically said “we accept the fact that interest rates are going to be low indefinitely,” start to re-calibrate.
Movements upward in interest rates are going to change the economics of a lot of pension schemes and give them a great source of encouragement. Higher rates have two implications for pension funds. They raise the discount rate that’s applied to future liabilities. But, just as importantly, they also positively affect re-investment: as bonds mature, higher interest rates mean the capital can be reinvested at higher yields, helping mitigate any capital losses.
I think there’s a wall of deployable cash that can curtail extended periods of volatility in the market. But I don’t think the adjustment path will necessarily be smooth or indeed easy to predict. What you may see is reallocations between different types of fixed income strategies. Investors who are not able to ride volatility in interest rate movements – and the impact it could have on absolute performance – may choose to re-allocate to duration-limited products, like money markets, absolute return, total return fixed income products or indeed benchmarked short-duration products.
For instance, the recent spike in US dollar Libor rates – which was driven in the first instance, by a regulatory-driven shift away from prime funds – has made an extremely compelling case to invest in products like our dollar money market instruments for those concerned about duration risk over the near term.
However the speed of the interest rate change is quite crucial. A gradual rise upward in interest rates is manageable. It’s the violent and speedy moves that can be destabilising to some sub-asset classes in fixed income as we saw in the initial knee-jerk response to the Trump election.

Not only are macroeconomic factors bringing an end to the bond bull run, but regulatory pressure has sapped liquidity from the market. How much of a problem is this?
RS: Liquidity has been declining since 2008 in the fixed income market in general. The reality is the decline in liquidity is an entrenched aspect of our market now – unless investment banks are suddenly allowed to go back to holding the large bond inventories they used to hold as broker-dealers.
The way I look at it, you need to accept that illiquidity and use it to your advantage where you can. What do I mean by that? Let me give you a tangible example.
Certain credit default swap (CDS) – contracts which offer bond investors insurance against default – is a market that is very illiquid. These securities are not heavily traded. I can think of two which come to mind: US healthcare and real estate investment trusts (REITs) CDSs. Let’s focus on REITs. US REITs carry an average credit rating of mid- to high-BBB and
the average spread on some of these names is 60 basis points. It’s extremely tight. I say tight in the sense that the risk premium is very, very low.
That’s driven by a lack of hedging requirements or lack of demand of REIT CDS. So that’s what’s caused REIT CDS to settle into this very tight trading range.
One way of looking at it is that REIT CDS are a great hedge to a broad credit portfolio against general market volatility. You can buy this protection cheaply and if and when the market does start to sell off in a sustained way, that illiquidity means the CDS is likely to jump wider.
In other words, the price of this insurance is likely to rise sharply.
So one of the features we have with illiquidity is that it leads to gappy moves, big chunky moves in price. Now of course a lot of people moan about this, but that’s often because they’re on the wrong side of these moves. But what happens if you’re on the right side? Then it becomes a blessing and not a curse.

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I use that example but there are many others specifically in credit. You can sometimes use less liquid instruments to hedge your existing positions. Conversely illiquidity can also work on the long side. You can buy an asset, which, as it becomes increasingly scarce in an up market, gets squeezed and it can tighten and perform in an upward trend disproportionately better. So for me, using illiquidity to your advantage if you haven’t already done that in your business approach or your strategy is something you should really be thinking very hard about. At the same time, investors should focus on bonds that offer adequate compensation against a potential deterioration in liquidity, especially when the climate turns volatile. Instead of bemoaning the lack of liquidity, which is a permanent feature of our market, you have to adapt existing strategies to include or expand your flexibility in your remit. Not to change or abandon your investment philosophy, that’s the last thing you should be doing; but to equip yourself with the tools to take advantage of the illiquidity and the gap risk.