In an age of technology-driven investments, big data, and high-frequency trading, many would anticipate that fixed income markets are efficient and that there is little room for active management, but this simply isn’t true. 
In reality, there remain systemic inefficiencies created by investment rules, regulatory frameworks, market constructs and investor bias’. These create irrational and inefficient behaviour and when combined, may lead to considerable mispricing and investment opportunities.
Against such a backdrop there are a number of inefficencies investors can exploit to find value.
The hidden risk in debt benchmarks
Bond indices were never intended to form a basis for investment, but merely reflect a market. As a consequence, they expose investors to the most indebted issuers and potentially ignore or underweight the best opportunities, hardly a rational investment strategy.
Avoiding risk in debtor nations; debunking the emerging market myth
The outdated view of a binary world of ‘emerging’ and ‘developed’ markets has resulted in mispricing of risk leading to considerable opportunities for the well-informed investor. Many EMs have grown up over the last 20 years and sound economic profiles and more stable political backdrops are labelled “more risky”. The profiles of many developed countries now encapsulate many of the weak economic traits and policy constraints faced by emerging markets in previous decades. In a world of potentially tightening liquidity, countries reliant on debt to fund will become more vulnerable to financial risks.
Credit investing is about avoiding downside risks and outperformance can be generated by avoiding vulnerable countries and seeking out financially sound countries regardless of their “labels”.
Finding value in Asia
Asia’s economic size and potential for growth is structurally underappreciated by fixed income markets, yet sound fundamentals and supportive market development make this region rich with opportunity.
Investors often think about equity allocations at a regional or even a country level, not only in developed but also in emerging markets. Asian representation in global fixed income benchmarks reflect a fraction of the region’s economic power, whilst for emerging market managers there is less incentive to invest in the defensive end of the spectrum. As a result we believe this leaves an attractive risk premia for Asian debt relative to equivalently rated debt elsewhere.
Pay attention to capital returns in a low-yield world
In today’s low-yield market, reduced coupon cash flows mean bond returns are more sensitive to price changes, so a systematic approach to capitalising on price volatility is more essential than ever.
Navigating credit risk for better gains
Avoid chasing yield and focus on value when credit markets are rich. Portfolios should be positioned for prospective returns from their credit risk exposure. There is a temptation to focus on yield, and move down the credit quality spectrum, however, buying riskier overvalued credits which are more susceptible to a downturn in the credit cycle, could result in greater downside risk. A focused approach to identifying undervalued bonds can help maintain exposure to higher quality assets whilst softening the blow of lower yield and offering potential for capital returns if the undervaluation is recognised.
Exploiting the rules-based investor
The proliferation of ETFs [exchange-traded funds] and development smart beta in equity, leads to the question of how this trend might translate into fixed income. Sizeable core fixed income ETFs, now exert substantial influence on market flows arguably amplifying stampedes and crowding effects as a result of their structure. Smart strategies can exploit some of the technical conditions created by the mismatch in liquidity profiles between the exchange-traded instrument and underlying market. Complexity in the execution of smart beta strategies make running rules-based ETFs challenging, but smart strategies with a degree of flexibility and an active component can potentially exploit these anomalies.
Long haul or short stay? Duration uncovered
Understanding the dynamics of duration is essential, it is more complex a concept than an expression of interest rate risk. Not all bonds with the same duration behave in the same way. Consideration of the shape of yield curve and the correlation of credit risks influence volatility of a bond investment. Credit spreads can move in greater magnitude than interest rates, so shorter duration, lower quality assets may mean more risk. Long duration asset can have diversification benefits, as well as the potential to generate capital returns from mispriced securities. Picking the balance of credit and interest rate risk, can help to manage volatility and enhance capital and income returns.
Michael Leithead is head of fixed income at EFG Asset Management. The views expressed above are his own and should not be taken as investment advice.