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Towards a new order in fixed income

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Not that long ago, investing in anything beyond government bonds, or quasi-state asset backeds and issuers with the very highest of credit ratings was a practise not indulged in by the majority of mainstream fixed income managers across the UK and Europe. By 2004, however, investor portfolios are vastly more diversified acrtoss a bigger range of asset classes and types of instruments.
“Over the last couple of years the approach to managing credit in general has become much more developed, and credit is clearly here to stay” says Heinz-Wilhelm Fesser, Director of Fixed Income at DWS. “With the added attraction of being able to use various hedging instruments, such as credit default swaps (CDS) which have themselves improved greatly in terms of liquidity and standardisation, credit is now a meaningful part of our investment universe. With such low yields, and little prospect of significantly higher interest rates for a while, the additional yield pick-up from credit is particularly appealing. Couple that with the growing budget deficits of governments and their deteriorating credit-worthiness, to have the ability to diversify out of government bonds is also very appealing.”
Laurence Mutkin, director of fixed income strategy at Threadneedle Asset Management, wholly agrees, pointing out: “There has been a significant broadening and deepening of credit markets within Europe and even high yield is a market with real breadth, no longer confined to telecoms and banks. We would be most unlikely to see a new bond mandate that does not have combined credit and government bonds.”
Mutkin goes on, “Long term savings plans should own debt and they ought to have credit risk, as they don’t need the liquidity of government bonds. If we couple this with the strong trend for funds to closely match their assets more closely to their liabilities, then it is pretty clear that the demand for bonds will stay.”
Asset/liability matching has been carried out for years, reminds Nick Horsfall, senior investment consultant at Watson Wyatt. “It may be talked about more now,” he continues, “because the investment environment is different. Throughout the 1990s markets were generally going up, so it was viewed as less important what assets were held or what managers did.”
Many factors influence demand/ supply dynamics but, says Bruno Crastes, head of global fixed income at Credit Agricole Asset Management/Credit Lyonnais Asset Management, the two main ones are antagonistic to each other. He explains: “On the one side we have more and more pension funds buying fixed income because they have to, being pushed by strong secular forces like ageing populations and moves towards better asset/liability matching. However, a very strong force against the move into bonds is coming from the macro-economic environment we find ourselves in right now. While I admit that there is more subjectivity behind this analysis, we believe that our world is moving away from the disinflationary period and going to a new era of reflation with more inflation and higher yields.”
Crastes agrees that central banks will fight against inflationary forces, flattening or inverting yield curves, as demand at the long end stays strong. “On a longer term view, real yields will stay lower and long term rates will become more and more expensive as yield curves stay flat. We have seen this in the 1990s and what we have learnt is that this flatter yield curve means higher volatility in bond markets. And what that argues for,” says Crastes, “is more active management going for absolute returns. We have had 20-years of falling rates and so are skewed towards positive performance in our individual asset classes. Now we need to consider the new order: equities should outperform bonds on a risk-adjusted basis so let’s look at asset classes together and why not be long equities and short bonds?”
Emeric Challier, euro fixed income CIO at Fortis Investments, argues a similar though rather less radical tack. “As rates have come down a lot and indeed are approaching zero the risks are clearly asymmetric – high risk /small gain. We are bearish on bonds and are strongly recommending underweighting the fixed income part off any portfolio. Of course the extreme case is the Japanese bond market where interest rates are already at zero. Theoretically, if you are fully underweight (ie, 100% in money market) you’re deemed to be taking a strong risk against your benchmark. We ask ourselves: Is not holding a bond when interest rates are at zero really a risk?”
“Where can I get good returns without too much risk? The perennial question, but especially today in this new environment of potentially increasing yields and tight credit spreads,” says DWS’s Fesser. “It’s more difficult for investors to decide in which sector to invest: Government, credit or high yield. Rather they are seeking products which actively combine chances of attractive returns in a risk and volatility managed portfolio, targeting stable returns which may even be uncorrelated to traditional markets.
“We are not suggesting that we are ready to see the end of traditional high quality bond and equity funds just yet,” continues Fesser, “but the market is ready to accept a new type of product: the absolute, total return hedge fund, which gives a better choice of risk/return profile to the investor.”
In fact the regulatory environment in Germany is being opened up in favour of hedge funds and hedge fund of funds. These investment vehicles are now permitted under official investment law, rather than the jurisdiction of some offshore domain so they become transparent and thus open to institutional and retail investors.
For Threadneedle’s Mutkin the moves toward more flexible investing are well underway. “Benchmarking will change. Historically we have all been concerned with the shape of the market itself, but we need to be focussing more on the matching of our liabilities which shouldn’t wholly depend on what the market is doing.
“This does require a change in mindset. For the client the search is not to find which manager can get over the line first, but is that manager adding alpha? And there will be room for hedge funds primarily because of their abilities to produce uncorrelated returns, but they do not meet every need.”
Watson Wyatt’s Horsfall cites the example of the pension fund which needs inflation-linked assets and which to date has owned index-linked gilts. “There assets are sub-LIBOR levels of return, and there are only 10 issues outstanding. How can an active manager give you a return of Index+1%? Why not get the inflation-linked exposure through the derivatives market and then use the freed up capital to play asset markets which can generate more alpha: the credit markets or even the FTSE100? This is the way forward – we do not doubt that managers can add value if given the scope to do so.”
If anyone needs confirmation of changing investor attitudes, a look at where today’s ‘new’ money is going reveals a lot. Credit Agricole AM/Credit Lyonnais AM have seen 90% of new money heading towards their absolute return portfolios. “In this environment where everything is unstable, what you do defines your risk not your asset class,” says Bruno Crastes. “So across all the asset classes group them according to risk/volatility and choose your level. This way you have a much wider universe and higher alpha. It is much more optimal.”

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