There are some major positive aspects and areas of concern that investors are overlooking when it comes to fixed income in the current environment, according to Hermes’ Fraser Lundie.
The fixed income space has come under fire over the last year due to the asset class’s convergence with the performance of equities, causing investors to become sceptical as to whether part of the bond market is still a safe havens.
Performance of sectors over 10yrs
Source: FE Analytics
This correlation in performance is the result of a 30-year bond bull market and central banks’ extraordinary monetary policies, which has led to prices increasing and yields becoming lower. The volatility of bonds over recent months has partially been due to concerns about interest rates in the US, plus there are signs investors are losing faith in central bankers.
In an article published last July, Fidelity’s Eugene Philalithis warned that traditional income-producing assets have lost their appeal for income investors and said that their reputation as ‘safe haven’ assets has also depleted.
“Traditional income assets continue to offer low yields compared to investment grade and high yield credit. They continue to offer an element of capital protection in a multi asset income portfolio but their low yields remain relatively unattractive for income-seeking investors at present,” he explained.
However, Lundie (pictured) believes that many of the concerns that investors have in relation to bonds and credit are misguided, and in the article below, he points out the real headwinds and tailwinds for the asset class that should be focused on. 
Are illiquidity premiums worth taking the risk?
“In general I would say that given what’s going on in the world you need to be paid a huge amount of illiquidity premium to own illiquid assets," he said. “The thing that people forget is that when you buy an illiquid asset what you’re really doing is selling an option, because if you’re buying it you’re locked into it.”
Illiquidity in corporate bond markets has been a point of concern for many investors over recent months, as it has been exacerbated by overarching negative market sentiment towards the asset class.
It is an issue that has also been linked to the fixed income space since the financial crisis of 2008, when post-regulatory reforms allegedly deterred banks from the market area. The absence of money from such large firms, according to many, increased the assets’ liquidity risk.
However, Lundie warns that some fixed income investors are opting for the least liquid assets for their seemingly attractive illiquidity premium, and says that this is unlikely to pay off over the long term.
“If you buy these assets today and then there’s a further big sell-off in the market, there’s nothing you can do about taking advantage of that sell-off,” he explained.
“That’s fine but really you want to try to do that at the lows rather than the highs and I don’t think people have thought about premiums in that way.”
“Most people think, ‘hey I can get a bit of a pick-up so I may as well do that’, rather than saying, ‘how much am I being paid to sell this option?’ That’s what makes me concerned about places like European high yield right now.”
The co-head of credit adds that this thought process is applicable to any asset class with little liquidity at the moment and believes that investors should always question whether they’re being compensated sufficiently for buying into these during a particularly choppy market.
You can’t rely on sector averages in such a broad market
Lundie says that investors need to look at their portfolios and asset allocation in far more depth than they might have done in previous years due to the wider range of products on offer.
An example of this is the increasing popularity of alternatives, which investors have bought into as a means of asset class diversification now that stocks and bonds are behaving similarly.
The manager says that there is also a greater range of sub-assets which investors need to consider before buying into an investment vehicle and points out that sector averages don’t take a fund’s aim or investment process into account.
“The fixed income space is becoming such a grey area – a fund can hold anything from emerging markets to developed markets, government bonds to credit, high yield to investment grade, loans to bonds, the list goes on,” he said.
“Unfortunately the markets try to pigeon-hole people. I spend half of my time trying to make sure that our investors understand what we’re trying to achieve exactly, it becomes very difficult.”
“It used to be that you had a choice of equities and bonds. Now there are equities, bonds, credit, property, and now there are strategies that take care of different parts of each portfolio. You can’t have a peer group of managers who are trying to achieve 80 per cent upside and 20 per cent downside, because their returns are incomparable.”
Bonds have flexibility in down markets
In a volatile world where everybody is hunting for income for protection, an increasing number of investors have been climbing further up the risk spectrum to find attractive yields from dividend-paying mega-caps or ‘bond proxies’.
In an article published last year, Lazard’s Alan Custis told FE Trustnet last year that global-facing large-caps are trading at attractive valuations and offering yields far higher than most assets within the fixed income space.
“We are getting to valuation levels that we think are starting to get quite compelling. If we look at the dividend yields of Rio Tinto at around 5.5 per cent [correct in July 2015], BHP Billiton at 6.3 per cent [correct in July 2015], they’re obviously high-yielding stocks now in the context of the stock market overall,” he said.
While many investors no longer see traditional fixed income assets as offering downside protection in times of market stress, Lundie says that they actually have a greater advantage over equities during falling markets.
“What I like about fixed income right now is the spaces we think are becoming interesting look attractive because companies are choosing to prioritise their debt levels over their shareholders,” he explained.
“Rio Tinto is a recent example, Kinder Morgan is another good example in the US pipeline space as it has basically eliminated its distribution of dividend - the stock gets hammered and credit rallies.”
“This is where I like being a fixed income investor because you can look through the doom and gloom and it doesn’t prevent you from investing in some sectors because in many cases there are layers that are strong enough to be survivors.”
On the opposite end of the spectrum, Lundie says that fixed income funds can also do well in equity-friendly market environments – he is currently holding some short positions in the technology sector because stocks in the market area are trading well.
Over the last three years, Lundie has provided an average total return of 10.48 per cent compared to its peer group composite’s return of 5.76 per cent. He has also achieved a lower maximum drawdown over this time, which measures the most money an investor could have lost if they’d bought and sold at the worst possible times.
Performance of Lundie vs composite
Source: FE Analytics
