A number of bond managers, such as Kames’ Stephen Snowden, have expressed concern about the lack of liquidity in the bond market, which he believes will see multi-billion pound funds find it increasingly difficult to shift their assets in a sell-off. Lundie (pictured) agrees, and points to the recent rise in yields as a big stumbling block for larger bond funds, which he says are quickly running out of areas to invest in.
Yesterday, real yields – above the rate of inflation – on 10-year US Treasuries became positive for the first time in nearly two years, which has had a widespread impact across the fixed income market.
To counteract the risk, he says he is using his flexibility to find opportunities outside of the mainstream market.
"The problem with liquidity is panning out as we speak," he said.
"In a more challenging world for fixed income, long-only investors must look beyond physical bonds and outside European markets to earn strong, risk-adjusted returns in 2013. They may find it useful to use derivatives alongside bonds in global markets."
Performance of indices over 1 month
Source: FE Analytics
"The way we are trying to manage through the lack of liquidity is by actively using CDSs [credit default swaps] in conjunction with bonds to provide a broader opportunity set."
"Selling CDSs provides exposure to underlying bonds without their call options. The derivatives, which collect premium payments for insuring against the default of a bond, are also more liquid, less expensive and are not sensitive to rising interest rates."
"Careful issuer and security selection mitigates the risk of becoming exposed to defaulting bonds," he added.
As well as being the company’s co-head of credit, Lundie also runs the offshore Hermes Global High Yield Bond fund.
He has managed the fund since its launch in May 2010, during which time it has outperformed its FO Fixed Interest Global High Yield sector. Over the past year the fund is up 20.71 per cent, beating its sector average by around 7 percentage points.
Performance of fund versus sector over 1yr
Source: FE Analytics
Lundie says he is using a number of different strategies within his portfolio to outperform the market.
For example, he is investing throughout the capital structure of companies worldwide, the first of which are single-name swaps.
"Callable bonds from the same issuer can have different risk-return profiles. Selecting those that are trading further below their call prices – and therefore have greater upside if the market rallies on falling interest rates – can deliver capital growth in addition to income," he explained.
"Investors wanting only to collect coupons do not pursue such relative-value trades. This complacency provides opportunities to those who understand how volatility affects prices."
He also says he is using a "ratings barbell" approach within his fund: "We calculate that 82 per cent of B-rated bonds trade very close to their call prices. In contrast, only 44 per cent of BB-rated bonds are callable."
"While 76 per cent of CCC-rated bonds can be redeemed by issuers, the average security still trades at a meaningful discount to its call price."
"This means that a portfolio of CCC- and BB-rated bonds is more likely to outperform one consisting of B-rated bonds during a market rally."
Lundie says that bond investors are becoming inward thinking and are not diversifying properly.
"Investors should also remember to look outside their home markets for superior returns. The European market consists of 336 bonds. But worldwide the investable universe comprises some 3,219 issues," he said.
"Last year was an exceptional year for bonds and no-one should be expecting a repeat of it in 2013."
"However, provided bond investors are equipped with the right tools and skills, there is no reason that strong returns from high yield bonds are only something to be remembered," he added.
Although he says investors should be looking across the globe for credit, Lundie says he is finding a lot of opportunities in Europe.
"We do like Europe, both in the mainland and pockets of the periphery," he said.
"That is the key difference between equities and credit as we like the more murky environments, where company management teams aren’t overly shareholder friendly."
"For instance, the US is performing well so management teams are going out and buying companies and paying out dividends," Lundie added.
Hermes Global High Yield Bond has an ongoing charges figure (OCF) of 1.4 per cent and requires a minimum of €1,000.
