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Latest lessons from fixed income market
A REVEILLE has been sounded in markets that are now experiencing feverish activity as half a decade of inertia gives way to volatility. Explanations for the panicked stampede of the Q4 2018 sell-off, subsequent rebound and recent weakness mask the importance of properly calibrated defensive and flexible portfolio strategies in this kind of market environment.
The past two quarters at the turn of the year saw an extremely volatile period for markets, and aside from this I would like to highlight three notable things that stood out to me about the fourth quarter of 2018, the first quarter of 2019 and the last few weeks.
The first is the sheer ferocity of both the downward plunge and the subsequent recovery. The second is the fact that so many people were shocked by this turbulence after such an extended period of dead calm. The last is the remarkable symmetry between the two quarters' rise and fall in spreads and the potential for this latest move to reach the same magnitude.
There is a real sense that market participants (including those in the credit-market) have fully participated - or perhaps even taken a levered exposure - in the market fall that was experienced and have then under-participated in the subsequent rally.
We have certainly observed this in the relative performance of some other investors, which have not had the benefit of either defensive portfolios or a defensive strategy going into the fourth quarter of 2018.
Worryingly, we believe that market participants' memories are getting shorter and shorter: that they fear the cost of hedges and defensive strategies more than they do sell-offs, that the Fear of Missing Out is greater than being too long and wrong.
Our concern is that this is becoming increasingly inconsistent with the desire of end-investors for a more defensive mindset. We are convinced that flexibility and pragmatism will be the watchwords for fixed income markets in the medium term.
Importantly, against this backdrop, investors in Asia and around the world must consider the relative value of assets in fixed income markets and look ahead, creating a portfolio that can manage the growing risks in the system.
But where does this value lie? While we saw greater value in the most liquid parts of the fixed income universe at the end of fourth quarter than at the end of the third quarter, this trend is now reversing. We now see that, once again, our ideal client portfolios show greater allocations to strategies such as direct lending.
Direct lending is one asset class that has shown increased attraction for our investor base around the world. It offers good relative value coupled with low default rates. We also find that hybrids, subordinated financials and emerging market credit spreads continue to offer some of the best value in public credit markets.
However, it's important to note that with spreads generally tightening, they are less attractive than they were at the beginning of the year. Subordinated financials have moved up in our book, reflecting the very attractive relative value that we see in certain pockets of the market, such as UK insurers, Brexit risk notwithstanding.
European CLO mezzanine tranches is another asset class that, given their greater attractiveness on a risk-adjusted basis, shouldn't be overlooked by investors and could provide an interesting means of diversification.
Tranches rated BB and B offer appealing spreads versus the similarly rated European corporates. Their low expected default rates and current good liquidity ensures that they can be readily traded.
While these observations paint a rosy picture of value, there are some areas to be wary of. Government bonds have moved down in our rankings. Yields moved lower following a rally in the asset class attributed to weakening global economic data, the halting of the Fed's tightening cycle and the pricing-in of rate cuts this year. This repricing of US Treasuries caused an inverted yield curve, which many believe signals a recession within two years.
While many view the inverted yield curve as a warning signal, others are convinced that "this time, it is different". Given the uncertainty as to when this credit cycle will end, we aim to maximise returns while reducing downside risk: We continue to select areas of credit risk we like while adding convexity to our multi-asset credit portfolios.
What can investors take away from all this? Our view is there are lessons to be learnt from looking back on the past nine months. Importantly, avoid silos and consider the wider risk outlook.
There's a lot of tail-risk from protectionism and this shouldn't be ruled out but investors should take a long-view. In fact, apart from climate change, we see this as the major medium-term risk for markets.
Ultimately, things won't be different this time around, which is why experience triumphs over hope. Investors in Asia should remain flexible and consistent but think about the long-term and be ready to stand strong and capitalise when others run.
- The writer is Head of Fixed Income at Hermes Investment Management