The manager of the $10.2bn JPM Income Opportunity fund has been selling bonds and building up almost 60 per cent of his fund in cash, warning that investors have become complacent. Within fixed income he has been taking an increasingly defensive position and says there are five specific signs that trouble is brewing.
“Signs of complacency seem to be abundant in bonds but the long-awaited inflection point in the bull market may be closer than investors expect,” Eigen said.
“Limited pockets of opportunity within credit exist, but now is the time to start exiting them, while the doors are still wide.”
“There is a popular notion that simply seeking yield is a surefire strategy in a world backstopped by a great central bank put.”
“That may have been true of the very recent past, but there are reasons to believe that extraordinary set of circumstances cannot and will not continue.”
The manager, who runs an absolute return strategy, says a stretched market is making managing the downside increasingly important to generate returns.
One reason for concern the manager highlights is that investors in credit markets are expensive.
“Nearly every part of the global credit markets looks pricey,” he said. “This includes US and European high yield debt, investment grade credit, agency mortgage-backed securities, emerging market debt and convertible bonds amongst others.”
“These securities’ valuations are effectively pricing in near perfect fundamentals, as well as the optimistic forecasts for further growth. At the same time those very fundamentals are eroding as credit underpinnings deteriorate.”
High yield has been popular for investors in UK, US and European debt over the past three years, but Eigen says this area is at risk having done particularly well.
Data from FE Analytics shows that the US and EU indices have increased more than 25 per cent over three years whilst UK high yield has risen 43.89 per cent over the same period.
Performance of indices over 3yrs
Source: FE Analytics
Eigen says high yield is one area of the market that has historically shown resilience in rising rate environments but is currently compromised given tightening spreads.
“Sectors like high yield debt are vulnerable to a range of potential factors as opposed to just one or two possible detractors,” he warned.
“For example, rising interest rates, even if caused by better than expected economic growth, may cause losses in areas of the market that have historically benefited from such trends.”
He says these tightening spreads have recently been beneficial to credit markets but with the prospect of the Fed’s tapering of its stimulus program and a likely rate rise, it is reversing from a tailwind to a headwind.
“For years, credit has reaped the benefit of rapidly tightening spreads combined with rates falling to lows artificially induced by ultra-accommodative central bank policies. These powerful drivers are in the process of reversing.”
“US central bank actions have moved to tapering and therefore a step closer to tightening, for example.”
“Reversal is also seen in economic growth rates finally gaining above trend traction, forward inflation indicators in the US pointing higher, and poor fixed income technicals after an extended period of record flows.”
He says liquidity is a fourth concern. While there continues to be demands for fixed income assets, liquidity is relatively low posing a threat in the event of a sell-off, he explains.
“Liquidity is already somewhat of a mirage in the credit markets, is another barometer to be watched.
“It remains as transient as ever, due in part to a more challenging regulatory regime market makers are grappling with. Dampened dealer activity and record low inventory levels have reduced the supply trading on the markets on any given day.”
“The situation may appear deceptively calm while investors are still buying in fixed income, but there is a significant potential for price destruction in the event of a sell-off precisely because liquidity is so thin. Technicals can – and very likely will – change on a moment’s notice.”
“They are susceptible to the possibility of a sell-off, given currently stretched valuations, or to the risk of a rise in interest rates damaging price returns.”
Eigen also warns that the increasing correlation between areas of the fixed income market exacerbates the risks of a sell-off.
“The ability for diversification within credit to provide downside protection is significantly more limited than it has been in the past when it was fueled by declining interest rates,” he said.
“This leaves cash as the only true form of “long only” insurance for investors.”
Eigen currently has a high cash weighting in the JPM Income Opportunity fund with 57 per cent held in cash due to his belief that there is a current lack of value in credit markets.
The biggest fallacy in fixed income is the myth that you need to be fully invested at all times, he says.
“Reengage with credit only when it starts compensating you for the risks,” he said.
The fund has made a loss for investors over three years of 0.46 per cent, falling short of its FO Absolute Return sector average, which returned 1.89 per cent, but stayed ahead of its benchmark – the EBF Eonia Average – which fell 5.97percent, over the same period.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
In contrast to Eigen, Richard Woolnough, manager of the £18bn M&G Optimal Income fund recently told FE Trustnet bonds were becoming attractively priced again and that he was increasing credit risk as default rates fall.
