This is a sponsored article from Hermes Investment Management.

Andrew Jackson
Head of Fixed Income,
Hermes Investment Management

Fixed Income Quarterly – Crunch time? Not yet..

360° – Hermes Fixed Income Quarterly Report, Q1 2019

As Head of Fixed Income, Andrew leads the strategic development of Hermes’ Credit, Asset-Based Lending and Direct Lending investment teams, and its Multi-Asset Credit offering.

Turbulence, disruption, and uncertainty have always provided opportunity for the savvy fixed income trader. Paradoxically, the main sources of uncertainty — including Brexit, protectionism, political upheaval, and end-of-cycle angst — have become almost constants in the investment universe. This calls for a more nuanced and forensic approach to generating returns.

End-of-bull-market rumours greatly exaggerated
Superficially, much changed in the closing three months of 2018 — parts of the US yield curve inverted (albeit briefly), price-to earnings (PE) multiples collapsed (albeit back to historical norms), and all markets underwent a fairly material sell-off. However, at a more fundamental level, conditions have remained unchanged: We still don’t know what form Brexit will take, the European political backdrop is still far from clear, and the rise of protectionism still hangs like a dead weight around the neck of global GDP growth.

Some more effusive commentators described Q4 2018 as a catastrophe and bloodbath (their responses to January’s bounce-back have been equally hyperbolic). This has left many investors wondering what exactly has changed. The short answer is that nothing has actually changed — we just noticed that the emperor was somewhat under-dressed — but things could be much worse.

At times such as these, it is vital to put what we have seen into context. The chart below shows the relationship between US HY and the S&P 500. In dark blue, we have illustrated the spreads on the ICE BAML US High Yield Index since September 2009. In lighter blue, we have plotted the difference (inverted) between the actual level of the S&P 500 index and best-fit line for the S&P 500 from September 2009 until January 2019.

This shows that, as expected, large drops in the S&P 500 are accompanied by commensurate spread widening in high yield bonds. But if we focus on the Q4 move in equities, we note that although being in the long corporate bond space was unpleasant, the scale of the move was more muted than post-crisis history would suggest. A ballpark estimate suggests the gap could have been another 240 basis points wider.

We should also take account of the fact that, since the end of the financial crisis, central banks have conducted the largest experiment in financial history. The signs we are emerging from an end to quantitative easing (QE) coincide with rising protectionism and uncharted geopolitical territory as US-China tensions increase. Simultaneously, end-of-market-cycle conditions are on the horizon. Accordingly, we should perhaps be relieved that the sell-off in Q4 was so mild and that the recovery has been relatively broad-based and rapid. There is little doubt, however, that some scar tissue has formed and that investors’ positioning will be more cautious for some time.

The quiddity of liquidity
Below the macro surface, a few more nuanced shifts have also occurred. These are reflected in the moves we have seen in our relative-value map. Most notable is that illiquidity premia have shrunk — something that normally occurs in rapid moves of the kind we have seen. Liquid markets depress asset prices (or widen spreads) and these movements are not quickly reflected in private and less liquid parts of the fixed income market. Only the passage of time or a further deterioration in liquid markets triggers a repricing in the illiquid spaces, but this is often a rather violent correction. Mathematicians would observe that the distribution of returns is discontinuous in the illiquid universe.

When considering an approach that combines liquid and illiquid products, these differences in sub-asset class biorhythms are vital considerations — as is, of course, the skew or basis when considering index-based hedging in a more liquid approach. We will be publishing more thoughts on the topic of illiquidity premia over the coming months, with a particular focus on measurement, modelling, historical averages, sub-asset class differences, and the impact of various stages in the cycle.

The second trend that went broadly unreported was the meaningful out-performance of emerging market (EM) credit in the fourth quarter. Clearly, part of this out-performance was due to the fact that the sub-asset class delivered the opposite result in Q3, but even this is further evidence of the benefit of a flexible approach to allocation, all other things being equal. Broadly speaking, our view on EM credit is that it should not be seen through the same lens as EM equities, even though it suffers from many of the same issues in terms of end-client flows.

This means the sub-asset class has the potential to yield nuggets of value for those who have the capability and determination to search for such opportunities during or after periods of stress.

Protect and survive
In the last issue of 360°, we reported that we saw value in fixed income markets but were cautious about the amount of tail risk present. We were keen to emphasise investors should not panic during sell-offs and highlighted how cheap we felt protection was for those capable of using it, particularly through options.

This approach would have served investors well through that period and has certainly borne fruit in the first weeks of 2019 as markets began the year in a relatively bullish mindset. The ability to hold on to positions during sell-offs, when bid/offer costs grow and panic sets in, can be very helpful for long-term returns. Given the strength of the early-2019 rally, participating in the beta of the market and, in particular, holding some of the positions that were most hurt in Q4, would have been hugely advantageous, particularly if it were possible to ‘trade’ some of those positions through the volatility.

On several days during Q4, fund flows, trading volumes and the inability to find reasonable bids had a very sobering effect. But even during the darker days there were bright spells. One particularly surprising observation during Q4 was several extreme BWICs (bids wanted in competition) for European asset-backed securities. In each instance, the auctions were smooth, displayed remarkable levels of liquidity, and traded at levels that were by no means ‘stressed’.

Risks worth considering
Looking forward, we do not see a huge reduction in tail risk despite the easing in some of the rather over-stretched technical indicators. The long-term fundamental issues in the world remain unchanged, and the headwinds of protectionism continue to influence our thinking. We also think it is vital to caution that this sell-off was not the big one.

At no time during the sell-off did we feel it represented anything more significant than a slight correction in the huge bull run that has endured far too long. Our equity colleagues experienced much worse than we did, but with utmost respect, we feel there were a few very obvious bubbles out there that needed to deflate slightly. They have deflated now, and we feel markets are more balanced as a result.

So, in the current climate, where do we think investors could look for value and how aggressive can they consider being in their positioning? Our core views are as follows:

● We continue to see value in credit markets and as a result would hold a meaningful net long position.

● The reduction in illiquidity premia means that value is easier to find in liquid spaces, and particularly in the more defensive parts of the markets.

● Residual scar tissue from the Q4 sell-off means that we continue to be tactically underweight UK assets which offer a ‘Brexit premium’ versus our long-run average holdings, but we do see longer-term value in UK ABS.

● An analysis of the constituent parts of the EM, European, and US high -yield markets inclines us to rank them in that order of preference, but we see this aggregation as too blunt an instrument. Now, more than at any other time over the last few years, we believe caution and discipline in terms of individual name and security selection will be essentialvaluable.

● Higher all-in yields make credit a more attractive long-term investment at these levels and, given that global growth is likely to be sluggish, we see the medium-term picture for fund flows into credit as positive.

However, we would sound a few notes of caution:

● The weight of low-rated investment grade credit that could transition to high yield is a major worry in terms of technical assessment (GE being by far the most worrisome name in this regard). It is not inconceivable that the high yield market could be bigger than its investment grade counterpart in a few years.

● Tail risk remains elevated and while recent talk from the US Federal Reserve verges on dovish, we don’t think we have seen the end of QE.

● The repricing of equity markets is positive for forward-looking sentiment but the speed of the retracement in January is slightly less healthy.

● Having been battered once in Q4 2018, market participants in less liquid areas may be less willing to sit on their hands if their resolve is tested again in the near term.

Finally, we believe the most pressing long-term concern for credit markets is climate change. We will examine this in more detail in future bulletins.

Click here to view the full report.

This is a sponsored article from Hermes Investment Management.