David Lloyd, head of institutional portfolio management at M&G Investments, questions the credibility of 'view-based' bond strategies.
The human face of this Greek tragedy is all too apparent, with deeply unsettling scenes of rioting and civil disturbance on the streets of Athens. The financial face is equally stark. Although the recently announced second bailout and debt restructuring removes the immediate threat of a calamitous default, the road ahead in terms of economic growth, debt sustainability and market confidence is littered with unknowns. And much of this doubt applies right across Europe.
Of course, one can never have absolute certainty in bond markets, but I cannot recall a time when markets were this uncertain. What's the outlook for inflation and growth? In all honestly, I haven't an earthly clue. Nor, frankly, do the government, the opposition, the Bank of England, the OBR, the IMF, the OECD or any other institution that feels inclined to hazard a guess. And it is against this wildly uncertain and unstable background that investors are trying to formulate strategies that will both protect and benefit their clients.
So how to proceed? I have a strong conviction that institutions that adopt a couple of simple maxims should be able to pilot their bond portfolios through the financial flotsam.
The first is to eschew 'view-based' investment strategies. These involve predicting future outcomes based on information available today, and allocating money on that basis. It's something a surprising amount of money managers try to do. Investing on the basis of predicting how politicians and central bankers will react to as yet unknown (and unreliably forecast) economic circumstances strikes me as tenuous at the best of times. In current markets, you're on a hiding to nothing - markets are so volatile that an incorrect view can prove extremely costly.
Instead, a long-term bond investor should rely on the most useful metric available: value. To do this well, you need to be equipped to quantify it, have the patience to wait for it and the fleetness of foot (and the cash) to exploit it once it materialises.
What's good value in public debt markets right now? Credit has failed to keep pace with core sovereign debt, opening up a significant yield gap that is now worth capturing. Where strong management and sensible balance sheets exist, there is value to be unearthed in the corporate bonds of both investment grade and high-yield companies.
Within core sovereign markets, perhaps the most compelling opportunity is the striking value on offer in the active management of index-linked gilts. Too many institutions manage inflation risk on a passive basis. Fine when markets were becalmed in 2003-06, less easy to justify now that we have enough volatility to make yield curves oscillate. These oscillations present some of the most exceptional opportunities to buy and sell relative value that I can recall in well over 20 years. And these strategies are entirely non-view based. Good active managers are consistently generating returns that are significantly above those of passive mandates, on a net of fees basis.
A second rule of thumb (and this is, no doubt, a very big ask) is to consider investments purely on their merits, rather than on the basis of how well they fit in to 'buckets'. Last year, inflation linked gilts - a 'matching' asset - returned more than 20% - while UK equities - a 'return' asset - actually lost 1.5%. Are these buckets really doing what we want them to?
Investors appear to have ascribed characteristics to assets based on how they would like them to perform, rather than assessing their inherent characteristics and their valuation. This is restrictive at best and very dangerous at worst.
I have had many conversations of late where interesting and risk-efficient investment ideas (such as buying supermarkets and leasing them back to their operating companies) were discussed. These deals are offering real yields of 4.5% secured against prime real estate, highly attractive compared with the negative real yield on government linkers. But always comes the question: "Is this a matching or a growth asset?"
Markets are efficient in the long run. If they sense investors are behaving mechanistically, they will price assets accordingly. By investing more flexibly, schemes can find assets that offer compelling return potential whilst maintaining a sensible link to liabilities. The inflexible pursuit of (unnecessarily) precise matching almost guarantees that schemes will hold overpriced assets.
So, in answer to the question "Which bucket do assets such as these sit in?", I would answer, "Does it really matter, provided they can do the job?".
David Lloyd is head of institutional portfolio management at M&G Investments