For quite some time now, bond bears have stated that the investment grade bond market should brace itself for higher rates and an upsurge in volatility. Three factors commonly cited as potential catalysts for weakness in the market are reduced liquidity, persistent low rates, and changing index dynamics. At IR+M, we are keenly aware of these challenges and view them as opportunities to provide unique solutions for our clients.
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Challenges
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- Fixed income trading volumes are stagnant despite overall market growth
- Increased financial regulation has rendered banks less willing to hold bonds and provide liquidity
- Larger managers may have difficulty
- Building meaningful bond positions and be forced to source exposures using derivatives and the primary market
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- Treasury rates continue to hover at recent lows and corporate spreads have tightened to pre-crisis levels
- Investors are receiving less compensation for credit risk as the basis between Aa and Baa credits narrows
- Forward curves suggest that rates will rise; however, timing can be difficult to predict as evidenced by the year-to-date rate rally
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- Interest rate risk has increased as Treasury and Agency allocations have ticked up in many broad benchmarks
- Index allocations to Agency MBS may cause their durations to extend in a rising rate environment as prepayments slow
- Unconstrained bond mandates offer a greater opportunity set, but also have an increased risk profile, and typically have a higher correlation with equity markets
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Opportunities
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- Our size and focus on the cash bond market allow us to seek out attractive relative value trades in the secondary market when dislocations occur
- We are able to maintain our credit discipline, sourcing bonds we like and avoiding forced transactions to gain market exposure
- Despite reduced liquidity, the market is adapting as improvements in post-trade data transparency have helped tighten bid/ask spreads
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- We employ a diligent security selection process, rather than rely on rating agencies, to find credits with strong fundamentals and stable cash flows
- As spreads compress, lower-rated companies have reduced borrowing costs, while higher-rated companies have increased leverage
- BBB credits in non-cyclical sectors have limited downside and offer attractive spread pickup versus higher-rated credits
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- Our high-quality, transparent, multi-sector strategies and security selection capabilities can provide strong risk-adjusted returns
- We work closely with clients to create customized portfolios that meet specific needs, while not losing sight of the purpose of fixed income in their overall asset allocation strategies
- As an active manager, we can underweight sectors that we feel may underperform if rates rise, the economy rolls over, or M&A intensifies
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Expansionary monetary policy and financial reform stemming from the financial crisis have triggered several changes to the traditional fixed income landscape. Stricter bank regulation reduced market liquidity, the accommodative Fed drove rates lower, and heavier Treasury issuance triggered benchmark changes. While navigating these changes, we maintain a long-term focus and remain mindful of the role fixed income plays in our clients’ overall allocation of assets. We avoid unwanted risk and lean on our proven ability to add value through bottom-up security selection.
Source: Barclays
As of 5/27/14. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.
