Extra Credit: Earning Bonus Points in Fixed Income
Josh Tarnow & Michael Phelps | October 15, 2012 | Topics: Alternatives
Point of View With Josh Tarnow and Michael Phelps
With investors challenged to uncover attractive fixed income solutions that provide return, diversification and stability, we spoke with BlackRock fixed income experts Josh Tarnow and Michael Phelps about the benefits of an allocation to fixed income credit.
- An overwhelming portion of fixed income return over the past decade has come from interest rate risk; investors cannot rely on that going forward.
- Fixed income opportunities involving credit risk continue to expand and should now include global sovereign, corporate and select asset-backed bonds.
- With elevated volatility now the norm, a long/short strategy offers opportunities for returns in both up- and down-markets.
- An allocation to a global long/short credit strategy can enhance fixed income returns, reduce volatility and diversify portfolios from interest rate risk.
Investors have been acutely focused on the direction of interest rates. Are they overvaluing the impact of duration?
Not at all. For decades, interest rates have declined and bond prices have risen (bond yields move inversely to prices), contributing to fixed income investors' solid total returns. In fact, over the past decade, duration (a bond's sensitivity to interest rate movements) has been the main driver of fixed income returns, with approximately 85% of the return in an investor's traditional fixed income portfolio coming from duration. But with rates at historic lows, fixed income investors cannot rely on benefiting from interest rate risk to generate the same total return going forward, and need to look to other ways to create fixed income returns.
How can investors enhance their fixed income returns in today's low interest rate environment?
Good question. What investors should be thinking about is achieving a better balance between their interest rate exposure (investors are overweight), and credit-sensitive strategies, where there are more opportunities. We feel the rewards of additional returns tied to duration are not enough to outweigh the volatility of interest rates and consequent impact on an investor's total return potential. Therefore, a fixed income investor should consider increasing their allocation to credit-sensitive fixed income. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. This sector offers strong opportunities to enhance yield and total returns because of the higher coupon paid to holders, but also strong relative value trading opportunities for a professional manager to enhance returns.
Fixed income credit can also offer diversification. Investors should be aware that diversification does not ensure a profit or protect against a loss. In addition, while a long/short strategy offers opportunities in up- and down markets, long/short investing entails special risks. Short sales in securities that increase in value can cause a loss of principal and any losses may or may not be offset by investing short sale proceeds in other investments. This strategy can offer an investor the ability to benefit in a volatile market, in which rates may go up or down (with associated fall and rise of bond prices).
Where are the opportunities for credit investing within the fixed income universe?
Investment grade, high yield and bank loans continue to be the bulk of the fixed income credit universe. However, the fixed income landscape has changed dramatically over the past several years following the credit crisis, creating a range of new opportunities for investment. In particular, the asset-backed securities sector (bonds backed by collateral such as aircraft, credit card receivables or auto loans) is one of the expanded credit sectors we believe offers good relative value opportunities.
Additionally, sovereign debt has emerged as a new credit sector following the European sovereign debt crisis. Rather than being treated as a risk-free assets, some governments now face credit and default risk, which has created relative value opportunities (taking advantage of price differentials between related bonds) between sovereigns, as well as sovereigns and corporates. These incredible credit market dynamics make us excited about investing in this sector.
Furthermore, the size of non-US credit markets should make global credit sectors worthy of an allocation in an investor's portfolio. While the US market is quite large at over $5 trillion, as you can see in the chart, adding international fixed income credit doubles an investor's opportunity set to just over $11 trillion. In particular, Europe and Asia have significant opportunities in investment grade and sovereign credit. In addition, the European high yield space is actually one of the fastest-growing segments of the global credit market. While the European market, at $200 billion, is quite a bit smaller than the US high yield market of $1 trillion, it's actually catching up quite quickly.
What are the advantages of a long/short approach in fixed income?
Basically, the benefits of a long/short approach are that the investor can potentially profit from both positive and negative views on individual credit securities. So while an alternative fixed income strategy such as long/short presents the opportunity for significant losses including, in some cases, losses which exceed the principal amount invested, investors can benefit from the ability to take a view on market direction. In other words, the manager can position the portfolio to be long, short or neutral to market moves. Furthermore, a manager can take advantage of disparities that occur between two credits that the manager believes are not currently represented in the right spread relationship.
Adding International Credits Doubles Opportunity Set
Size of Global Credit Markets in US Dollars
Source: Barclays Capital. As of September 30, 2012.
What is an example of a long/short trade in action?
Broadly, we look to own (go long) undervalued securities and sell (go short) securities we believe are overvalued. In the midst of the European sovereign debt crisis, there have been many dislocations in credit markets, thus creating opportunities for long, short, and long/short paired trades.
What you see in the chart below, is an example of a long opportunity that arose last fall. German Corporate Credit A was a fundamentally attractive financial issuer due to its diversified revenue stream and ability to take advantage of favorable pricing dynamics in the market. However, heightened volatility negatively impacted many financial issuers, and the market priced too much systemic risk into the sector. As a result, the price of the bond illustrated fell despite being attractive on a fundamental basis, creating a buying opportunity.
Price of Hypothetical German Corporate Bond
What you see in the chart below, is an example of a short opportunity that arose in early 2011. As a sovereign, Spain was facing many headwinds, including a large and unwieldy fiscal deficit, unsustainable employment levels, and an undercapitalized banking system. Given these factors, the price of these sovereign bonds should have traded lower, but they rallied following the implementation of the ECB's LTRO bond-buying program. These artificially higher prices created an attractive short opportunity as the effects of the LTRO faded and bond prices fell.
Trade example: Shorting Spanish Bond
Price of Spanish Sovereign Bond
Has recent market volatility caused you to change your view of fixed income market opportunities?
Absolutely. Since 2008, volatility has been at historic highs (see chart below) and it is changing global fixed income markets. In turn, we have evolved our approach to take advantage of new opportunities. While corporate balance sheets are dramatically stronger than they were only several years ago, and default rates extremely low, credit spread securities continue to trade with elevated volatility. Generally, the more volatility there is, the more action there will be in price movements and the greater dislocation there will be between how credit securities are trading compared to their fundamental value, as well as to the fundamental value of other credit securities. This is where a manager's approach, be it long-only, or long/short, can play a critical role in performance.
Long/Short Credit Strategy Can Mitigate Volatility
Source: Barclays Live, BAML, Bloomberg. Periods of rising interest rates represented by the 10-year US Treasury.
How do you go about balancing current income, total return and risk in a portfolio?
We think of portfolio management in a holistic way focused on total returns, not only for current income (which is a component of total return). We are taking an innovative approach to total return generation by not only expanding the opportunity set to be global, but taking advantage of both the up-market as well as the down-market opportunities. We believe in addition to traditional strategies, conditions are ripe for a long/short approach to the market.
From a portfolio perspective, while the majority of the time we believe a net long credit exposure positioning within the portfolio is best, there is the potential for the team to have more negative views than positive, and we would position our long and short holdings to reflect that. It is unlikely that the portfolio will be positioned with a market- neutral position where we wouldn't be exposed to credit risk.
Where are you finding the greatest opportunities in the market today? Do you have industry, country or regional preferences?
The greatest opportunities we see right now are effectively split between the US and Europe. There are opportunities in Asia, but it is a considerably smaller fixed income market, and we feel liquidity is paramount. Part of the reason there are so many opportunities globally, however, goes back to our discussion of volatility and the fact that interest rates have been unstable. Typically, in a stable rate environment, credit spread securities might trade very tightly to the risk-free rate, without much differentiation. Since 2008, however, individual securities as well as entire sectors are greatly dislocated from their fundamental as well as relative values, presenting numerous opportunities.
Can you explain your investment process?
We apply a fundamental, bottom-up approach to identify relative value opportunities across fixed income sectors and geographic borders. Our team structure is one in which credit research analysts retain responsibility for a particular sector or universe, and the process begins by searching for a signal across the credit universe. When a compelling signal appears, the team then does a deep dive to investigate the opportunity, select securities and recommend a long or short strategy. The managers then organize the opportunities based on relative values across issuers and sectors, reviewing the entire portfolio from a risk and market exposure perspective.
Investment Process and Portfolio Construction IN ACTION
Tell me about your team?
The team we have put together to manage our investment process is truly global in nature. With lead portfolio managers in New York and London, and traders in Asia, the sun does not set on global credit opportunities. Overall, the team relies on 58 investment professionals as well as a cadre of 25 traders that can help us maximize opportunities in terms of idea generation, as well as find more interesting opportunities in the United States, Europe and Asia. To ensure the deepest understanding of each market in which we trade, local team members speak the languages of many of the countries we are investing in, allowing the managers to understand where there's relative value across regions, credit quality and sectors.
How should an investor incorporate a credit strategy into their portfolio?
Investors can utilize a long/short credit strategy in several ways. For those who wish to reduce interest rate risk, a zero duration credit strategy offers diversification potential. Additionally, employing a long/short strategy offers a way to pare back risk from a long-only credit allocation. Finally, for investors who were driven into cash by fears of equity or interest risk, a long/short credit strategy is a way to re-invest without taking on these risks.
Broadly speaking, making these allocations can help provide attractive absolute returns, moderate to low volatility, and exposure solely to credit markets with zero interest rate risk. At the same time, investors should be aware that fixed income credit investing introduces the risk that the issuer of the bond may not be able to make principal or interest payments. Given the challenges of managing market, credit, interest rate and other risks, we recommend that investors rely on a proven professional manager to oversee each of their investments across the fixed income universe.
About the Author
Managing Director, Portfolio Manager on the Leveraged Finance Portfolio Team
Managing Director, Head of European Credit Investments within BlackRock Fundamental Fixed Income
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Investment involves risks. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Investments in non-investment-grade debt securities (high yield or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. Asset allocation strategies do not assure profit and do not protect against loss.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of December 8, 2011, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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