Panel debate: Fixed income investing in a crowded world - how to build a portfolio of high quality, low risk assets that meet growth and cashflow challenges.

1. What challenges have arisen for fixed income investors from the changes to market structure and increase in trading participants?

Changes to market structure can pose liquidity challenges in two ways:

There are less trading participants as the banks are stepping back from holding large trading inventory due to higher regulatory charges and the need to build/maintain capital. That means they cannot make markets in the way they used to. Without this “safety valve” markets appear to be more volatile in risk-off environments as we saw recently in December 2018 and again in early 2019.

The rise of daily liquidity, retail oriented ETFs – most notably in the high-yield and loan space (about 10% of the market) has introduced a new type of volatility into the loan / bond market. Everyone is heading for the door at same time. This herd behaviour exacerbates risk-off.

2. How will fixed income investors need to adapt and change the way their portfolios are built to reflect growing liquidity and cashflow needs?

Liquidity needs can most obviously be met by switching from accumulating to distributing mandates. Beyond this a move away from longer dated lockup vehicles (e.g. private debt) to more liquid broadly syndicated loan/ bond markets (liquid alternative credit) can meet these needs as well as using a gilt repo facility within LDI portfolios.

Cashflow needs at the long end – in GBP – can be met with high-grade Buy and Maintain type portfolios. Note that the long-dated GBP market (about £350bn in size) does not have sufficient size or diversity for the amount of appetite for long-dated GBP paper. Hence B&M mandates typically look to US exposure to increase diversity and capacity. (US credit is around 30% of a typical B&M portfolio).

Given capacity constraints in the long-term sterling credit market, a “creeping barrage” of shorter dated credit portfolios could compliment longer dated B&M portfolios. This can also help with liquidity as schemes mature. By virtue of being short-dated, liquidity is naturally generated as the portfolio rolls off.

3. Is there such a thing as assets in today’s economic and market climate, that are ultra-low risk that can in anyway meet return needs [thinking particularly about the fixed income space here]?

With growing leverage in the corporate sector and a turn in the cycle in the offing, ultra-low risk assets are harder to come by.

More positively, the recent bout of volatility has cheapened all assets, including higher quality segments of the investment grade, high yield and structured finance markets. While there has been a retracement from December’s spread widening in January and February (the change in tone at the Federal Reserve is helping) low risk assets are still (just) cheaper than they were for much of 2017 and ‘18.

Securitised credit is often suggested as a way of accessing higher returns without necessarily taking more credit risk. There is some merit to this as securitised credit:

• Offers a respite from overcrowded corporate credit (Other than agency mortgage backed securities, which sit outside of major benchmarks and are typically not a holding found within ETFs)
• Comes in alphabet soup of flavours: residential mortgage backed securities, commercial mortgage backed securities, credit card and auto loan asset-backed securities, etc.
• Allows investors to pick the risk return profile – moving higher in capital stack to AAA and AA tranches for example.
• Can make sense, with he warning that they give rise to more complexity and not all AAAs are created equal (downgrade volatility)

4. Which kinds of products and exposures should investors choose in order to maintain quality and mitigate risk?

Sticking to larger more liquid corners of the credit markets is the obvious way to maintain quality and mitigate risk. Otherwise, investors have several tools at their disposal to mitigate risk as the credit cycle matures. Among them:

• Move up in ratings quality
• Hold dry powder in form of cash or treasuries
• Stay in higher quality segments of the high yield, investment grade and securitised markets
• Shorten credit duration

Interview End.