Fixed income

Where to buy your risk

We all know people have different approaches to risk. Some of us like to take physical risks in search of an adrenaline high, while others take investment risks chasing hot stocks. The majority of the population, we suspect, stick to the sofa, and there’s nothing inherently wrong with that.

In today’s market though, you could go so far as to say that investors have no safe ‘sofa’ option; if you want a return, you need to take some risk. But you can still choose which risks you want to take. Our piece this month is about where we think the risk/reward balance is most compelling in fixed income at the moment.

In a global, go-anywhere bond strategy, there are two parts to how you take risk. The first is the most obvious – what you invest in and the associated risks. The second comes through having less protection in the portfolio, whether that comes through government bonds or specific portfolio hedges.

Of high yield and hybrids

We’ll tackle portfolio hedges further down, but where we are finding value at the moment is in low-quality investment grade and high-quality high yield. Taking the latter first, US high yield bonds are one of our favoured areas in fixed income today. There is greater diversification to be found in US high yield over its lower leveraged European equivalent, particularly in the CCC-rated space. We think there is value in market at the shorter end of the maturity spectrum, especially when you compare US high yield to high quality investment grade.

As a general rule of thumb, we saw a yield floor of around 5% in US high yield in the pre-COVID cycle. Following on from the monetary response to COVID-19, we think that yield floor has dropped and indeed it did go through the 4% level recently. The spread between US government and high yield bonds still has some way to go before it hits its historic lows so there could be room to generate returns from further price appreciation, as well as the yield pick-up you get over safer assets.

In the investment grade space, we have been adding recently to corporate hybrid bonds. These are generally higher yielding than conventional bonds because the issuer has more optionality around the call date of the bond and the payment of the coupon. As well as the higher yield, we also think there is the potential for some spread tightening as hybrid bonds catch-up with the recent tightening seen across fixed income markets more broadly.

We’ve been adding to hybrids mainly in the telecommunications and utilities sectors, partly by design but also because these companies tend to issue the most hybrid debt. Telecoms and utilities tend to have stable revenues, which helps to give investors’ confidence that they should lend to these good quality companies issuing bonds in a more subordinated structure. Here, as always, fundamental credit analysis is critical to ensure we lend to companies we are comfortable holding in the portfolio.

Taking the handbrake off

The other way to take more risk is to make sure you have less protection. For the past several months, we have been gradually reducing the size of our credit default swap (CDS) position, closing out the position entirely in February. Short-term market signals driven by the momentum around the “reflation trade” indicated it was a good time to take this off, and we can be nimble in putting the position back on if we feel the need. By taking off our CDS position, we have effectively taken our foot off the brake of our spread risk, to allow the portfolio to generate returns faster.

Mindful of risks, but letting the portfolio run

There is lots to talk about when it comes to fixed income at present. While we remain mindful of the risks in markets and how fragile the global economy remains, for the meantime we are happy to take more risk and incrementally pick-up returns.

There is plenty to watch in the next few months, and we dare say we will be writing about our view on government bonds in the near future, particularly with the upcoming Federal Reserve meeting in March. High yield and hybrids are our favoured areas within higher risk fixed income for now as we look to generate returns for 2021.

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