Fixed income outlook


Jonathan Platt, Head of Fixed Income

1 June 2017

Q: Fixed income investors have enjoyed a 30-year bull market, but with interest rates beginning to rise in the US and some significant losses last year, what’s the outlook for fixed income?

A: I have been very lucky in that my experience of fixed income investing has all been during the 30 year bull market, and this is the context in which you have to view performance in 2016. Losses in 2016 were only incurred towards the latter part of the year and, overall, it can still be regarded as a fairly decent year for fixed income. Although they may trend slightly higher, our view is that interest rates are going to stay low for a long period of time. While we may have seen the best of the returns, we don’t think there will be a return to the interest rate levels we saw prior to the financial crisis.

Q: What parts of market are you most cautious about?

A: We believe there are many opportunities within fixed income markets provided you dig down and understand the credit fundamentals of the individual bonds you invest in. The areas that I would be most cautious about currently are those caught up in momentum trades, such as the high yield market’s exposure to the energy sector in the US. I would question whether they are generating enough cash to service their debt.

Q: How do you deal with the issue of liquidity in bond markets?

A: There is a lot of focus on liquidity in bond markets but, from our point of view, illiquidity actually offers some opportunities. For example, we often invest in unrated, complex, or asset backed securities or issues that are smaller than the size needed for inclusion in a benchmark. These bonds are less liquid and are often overlooked but if you embed them into your portfolio and take those cashflows over the longer term, this can help to generate the excess return over the benchmark that our clients are looking for.

Q: How do you balance risk with return?

A: Our holding in Co-op Bank covered bond is a great example of this. Looking at the headlines you would think it obvious that this is a credit to avoid. However, you can buy exposure to different parts of the capital structure of a bank and the part we have in our portfolios is right at the top end: senior obligations to the bank, collateralised by mortgage assets. We tested this protection through our credit research and our stress testing showed that there would need to be massive falls in house prices before those assets are not covered.

Q: What is the best way to generate alpha from a corporate bond fund in the current environment?

A: Global real yields are phenomenally low, and the UK is no exception. We think real yields are too low, but, equally, we do not expect that to change in the medium term. Increasingly, active managers are going to have to justify their existence by adding value above a benchmark index and, to do this, they will have to look at areas of the market that are under-researched. We continue to be amazed by the number of inefficiencies that exist within credit markets and active investors can take advantage of these. The key is not to look at credit overall, but to concentrate on individual opportunities. Our focus is on exploring new areas, finding new cashflows and different sources of income that do not simply replicate the returns of a large benchmark, which investors can do with a passive strategy. We do this in our funds through stock picking, by looking at under-valued or under-researched areas and using our experience of the market to identify those areas where we can add value and offer a differentiated product.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.

 

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