Designing a fixed income strategy for both resilience and recovery

Key points

• In crisis phases, investors expect their bond allocation to provide a degree of portfolio protection, but there’s more to fixed income than that
• An unconstrained approach can access a broad spectrum of opportunities with the potential to deliver outcomes ranging from capital preservation to income and capital growth
• Investors should seek unconstrained fixed income strategies which are designed to navigate the whole market cycle. That means participating in recovery phases is as important as resilience against volatility.

The right opportunities, at the right time

It is at the height of crisis periods such as the one experienced earlier this year that investors expect fixed income to prove its worth by providing the resilience needed to weather the storm. However, that is not all today’s diverse global fixed income universe has to offer.

In our view, unconstrained total return-focused fixed income strategies should be designed to use their flexibility to navigate the changing macro and market environment. That is not to say they will always be in positive territory, but the broad idea is a strategy which has the potential to deliver attractive risk-adjusted returns through an economic cycle.

Striking the right balance of different risk factors and potential opportunities is key to ensuring that the portfolio has enough ammunition, both to provide a degree of resilience when required, but also to participate as much as possible in recovery markets that inevitably follow market downturns.

Rotating from resilience to recovery

We believe a good foundation for an unconstrained fixed income strategy is a simple, transparent framework which breaks down the fixed income universe into three categories: Defensive, Intermediate and Aggressive. An unconstrained portfolio should have the flexibility to shift the balance between these three categories, as markets move and change through the cycle.

For much of 2019 and 2020, we were observing that markets were approaching the end of the cycle and, therefore, it seemed prudent to adopt a relatively defensive tilt in portfolio positioning. Specifically, our main convictions were based around three main themes: own duration, being selectively long credit and maintain portfolio hedges. As markets now evolve from crisis period to recovery, the relative emphasis that we place on each of these themes may be shifting, but our convictions remain steadfast.

After the peak of the crisis in March, we believed it was appropriate to begin shifting emphasis somewhat away from a defensive bias in favour of the intermediate and aggressive assets which have been benefiting from the recovery in the months since.

The shift in relative emphasis of our three key themes is explained below:

• Carrying quality duration: Coming into 2020, mainstream government bonds yields were low, but we believed they could go even lower with the end of the cycle approaching. Although we have brought our exposure down quite a bit since March, we still think that always maintaining some portion of the portfolio at the more defensive end of the spectrum to offset some of the more ‘exciting’ assets provides the best means of delivering the potential profile that investors expect from their core fixed income allocation.
• Selectively long credit: With that said, an unconstrained total return strategy attracts investors seeking to use fixed income as a growth asset; so, while capital preservation is key, it is equally vital to have exposure to a diverse pool of return-seeking assets. We had been cautious on spread risk for much of 2019 and the early part of 2020, preferring to own smaller pockets of value. Post crisis, we are now starting to turn more opportunistic on cheaper valuations in developed market credit and emerging markets. Since March, we have also participated in some new issuance in investment grade credit at attractive spreads.
• Portfolio hedges: We believe having elevated levels of cash is important in periods of uncertainty. While there is no yield, there is also no risk. However, cash levels could be somewhat lower during the recovery to allow rotation of the portfolio towards higher beta opportunities. We continue to believe credit default swaps are a useful tool for tactically dialling risk up and down in high yield, as we do not expect the recovery to occur in a straight line.

More defensive positioning at the height of a crisis period should offer some potential to mitigate the worst of the market drawdown. However, it is worth re-emphasising that, generally speaking, investors in total return strategies have some appetite for drawdown, in the knowledge that risk assets are typically the first to recover following a crisis and any recovery has the potential to be highly profitable. In other words, it is helpful to consider not only the potential for resilience in crisis, but the potential to participate in the recovery over the period that follows.

A focus on flexibly rotating the portfolio to position as appropriate for resilience or recovery should be, in our view, at the heart of an unconstrained fixed income strategy.

Looking ahead

COVID-19 has been a huge shock to the world and a huge amount uncertainty remains around the virus itself and the ongoing economic and market impact. For us, it will be as important as ever to stick to positioning the portfolio with the potential to deliver the sort of outcomes our investors expect.

In terms of what we can observe today, we see an ongoing battle between fundamentals and technicals. We expect a weak fundamental macroeconomic backdrop for some time, but this is so far being outweighed by strong technicals supported by policy around the world. Against this background, sentiment and valuations are mixed.

Parts of high yield credit and emerging markets are attractively-priced, but we expect defaults to rise. So, we see opportunities to go yield-hunting, but we would not be maximum bullish on credit in this environment and still see merit in balancing the risks with mainstream government bonds which, even at low levels of yield, offer potential defensive properties - especially considering what profile we believe an unconstrained fixed income strategy should offer investors.

Importantly, we do not believe the recovery will come in a straight line and volatility will persist. We intend to play that by employing our strategy’s flexibility to pick up assets which become priced to offer potentially good returns over the next 12 months. However, we will still use cash and portfolio hedges to do so cautiously.

Overall, we believe a low yield, high volatility environment calls for unconstrained, flexible strategies. It will be important to maintain focus on transparency and risk management as global fixed income is a broad spectrum. In our view, the key to navigating whatever comes next is actively managed diversification of asset allocation combined with high-conviction security selection, with the aim of delivering solid risk-adjusted returns.