Global Aggregate Bond: The Inside Story

 

I'd like to start by talking to you a little bit about what's been happening in bond markets. As you may be aware, we've had a very significant sell off over the last few months.

Latest bond sell off in historical context

As you can see on the chart, the gold line there shows what we've experienced since yields collapsed to all-time lows in the summer of last year. The market has been supported by enormous central bank buying and also by very low levels of interest rates.

But it's fair to say that, around the start of this year, investors started to look through the Covid crisis, became a lot more optimistic about global growth prospects and realized they were sitting on an asset class that was still pricing a very dull and severe outlook. 

The consequence of that, and a concern that, as things improved on the global growth outlook that central banks would start to take back some of the support for bond markets, led to are very abrupt and severe sell off in the first quarter

You can see a phase of consolidation over the last few weeks, but we anticipate that yields will continue to rise as the year unfolds.

Despite the selloff, valuations remain stretched

Despite yields having risen sharply over the last three or four months, that hasn't really dented the stock of fixed income assets which are negative yielding. Of course, in this topsy turvy world there are lots of reasons for negative yields. But that sell off, as I say, has only done a little bit to dent that stock of negative yielding bonds and still suggests that underlying value in fixed income is stretched

The opportunity set

Turning to the benchmark that I manage my strategy against—the global aggregate benchmark—it has a number of positive features for investors. It offers a high degree of liquidity and diversification, you can see in excess of 26,000 individual securities, round about 70 countries, 24 currencies as well, and it has a high intrinsic credit rating of just under double AA. Managing around this strategy, allowing us to manage between government bonds and corporate bonds and also the securitized fixed income element, is something that gives us a lot of opportunity and allows us to think about defending value, defending capital, as well as looking for incremental income return over time.

Active exposures today

In terms of our approach at the moment I'd like to take you through three areas that define the active positions that we take in relation to that high-quality benchmark. The first is duration, the second will be currency and the third are sector and security. As you'll see, they’re unified by certain themes.

Theme 1: Growth normalization

The first theme we've identified is growth normalization. As we come out of the Covid crisis, as the vaccination strategy continues to broaden out, we would hope that that generally increases business confidence and will allow a significant pool of savings that have been accumulated to be spent by consumers. This growth normalization phase tends to be more of a headwind for duration strategies so whilst we moderated duration over the last few weeks, we're very prepared actually to go further underweight the benchmark again as we look for the next phase of higher interest rates.

In terms of growth normalization, it also means looking at currencies that are going to maybe benefit from the early stages of a broader global recovery. We identify currencies like the Australian dollar and the Canadian dollar to help us do that.

As we look at the growth normalisation theme and we look at what we call sector and security opportunities, there are countries that saw their bonds deteriorate in value quite significantly as the Covid crisis took hold. Yet, in comparison with the fundamentals, they seemed to become undervalued. We've been particularly keen on the Bahamas, where our perception is that as the vaccine policy gets rolled out international travel will be set to resume and that will improve tourism.

We also like Qatar in the Middle East, of course a significant gas producer and, as you think about things like carbon emissions, actually investors distinguish more carefully between oil production and gas production, and we think Qatar is well placed in that environment, again also to pick up on higher global growth trends 

The Philippines sits as a great substitute in the global production chain, especially when there have been some concerns about the degree of  developed market corporate exposure to manufacturing in China. We think that the Philippines is a country that is likely to benefit from that change in the location of production.

Theme 2: Low-beta duration

Now as as yields rise and we manage our interest rate sensitivity (or duration risk) around the benchmark, another thing that we can do is to think about countries that actually might be less responsive to this general increase in interest rates. An example of that is Sweden, where the inflation outlook continues to be very muted indeed, and we think the central bank there will continue to buy government bonds for a long time. 

Another country is China, which has been running a monetary policy stance which is actually out of step with the accommodation seen in a lot of other economies around the world. They started to withdraw support and liquidity much earlier. That has meant that Chinese government bond yields have been offering as much as three, three and a half percent, and to us that's an attractive holding period return to help diversify and improve the yield in the strategy. 

The low beta duration concept also applies in credit markets where the continuing support of the European Central Bank makes (albeit low yielding) European credit look attractive in terms of reducing what we call the asymmetric risk, that is to say, we think that corporates in euro land as the recovery comes through, will hold up for fundamental reasons and also for technical reasons, because the European Central Bank continues to provide so much support to that market.

Within the European investment grade credit sector we're particularly interested in companies that will benefit from an improved a global rate of growth, remembering, of course, the eurozone’s capability as a as a global manufacturing base.

Theme 3: Yield

The third theme is seeking attractive yield, and there are countries out there where yields had risen significantly as core yields rose in the first quarter and actually begin to offer what we would regard as fundamental value.  For example, the local Mexican government bond market, the long end of the curve yielding well above 7%. And also Russian debt which, of course, had a shadow over it with recent sanctions concerns and seems to be turning a corner as President Biden seems intent on having a better relationship with Russia. And of course we’ve got a summit hopefully to look forward to in June, so we see certainly tactical value in owning Russian debt at this point.

That attractive yield theme also comes through in terms of EM hard currency credit or corporate bonds and there are a number of companies out there, again, that will benefit from an improved global growth setting and we see a lot of those companies, of course, in the emerging world where yields can be a little bit higher. But this is still investment-grade credit and it actually works very well with our investment process to be able to look at those individual companies very carefully and discern whether there is value.

Theme 4: Exploiting inflation expectations

Another theme which, of course a lot of people have been writing about and thinking about, is inflation expectations. And although inflation linked securities aren't a direct part of the benchmark, we have flexibility so we can go off benchmark.  We have added inflation exposure in Mexican government bonds and also actually in Italian government bonds where the so-called breakeven inflation rate appears to us to be optically very low. And if the ECB is successful in both getting higher growth and higher inflation over time then we think there is natural value in these securities.

We're very conscious of monitoring commodity market trends and we see a significant upward pressure in, for example, the copper price at the moment. The oil price, of course, has bounced considerably from its very low level of around about a year ago, and if these sort of elements feed into a generalized increase in business confidence as the Covid crisis comes under control, then there is also the possibility of a higher level of inflation expectations permeating investors’ thought pattern. We have the ability to take advantage of that using these types of securities.

Theme 5: Global protectionism

Maybe something connected with inflation expectations is a fifth theme that we've noted here: global protectionism. The unwinding of trading relationships between the US and Europe and potentially China also introduces challenges to supply chains, how these things fit together. And there could well be some friction appearing in terms of pricing power especially during a phase of global recovery. The one way that we think it's worth trying to exploit this is actually being underweight the Chinese renminbi as a way of taking advantage of that potential friction in trading relationships.

Theme 6: Hedging risk

And then last but not least: hedging. Active fixed income investing is all about bearing in mind that you can't predict everything. You need to have a well-constructed, balanced portfolio. Securities like the Japanese yen provide that theme, because if risk aversion starts to increase again the Japanese yen tends to appreciate. We can also provide a degree of insurance for our credit strategy so owning what we call long protection on certain types of credit derivatives, especially where that protection seems to be undervalued and relatively cheap to own, is a very nice way of balancing of the portfolio, as we take on those specific security ideas that I mentioned earlier.

Historical over-and underweights. Where are we now?

We are indeed active managers and I wanted to show you three charts that prove that. Duration, if you like, is the fixed income fund manager’s first tool in the toolkit.

We’re prepared to run the strategy with an active interest rate sensitivity that at points in time can be considerably different from the benchmark. And you can see there over that history has been both underweight the benchmark and long of the benchmark.

The other big topic, of course, is the US dollar. US fiscal stimulus, very low interest rates, a lot of investors have been looking for the dollar to start to depreciate against other currencies globally. That would be actually very bullish for risk appetite and we are prepared to manage the strategy, again, actively in relation to the dollar position which, on a normal day, accounts for around about 45%. That's the neutral level in the benchmark. So again there you can see that we've been been pressing into a more defensive posture on the dollar, precisely because of this global growth optimism that we do believe can carry economies through for the rest of the year. And we also know that the Federal Reserve is determined not to raise interest rates during that period of time, which again provides less support for the US dollar.

And then last but not least, credit. And credit has been a very exciting journey, for us, we correctly identified how expensive the corporate bond market was in 2019, and whilst we were a little bit early to that in terms of our asset allocation, when spreads expanded significantly as the Covid crisis took hold in March and April of 2020, we were very prepared to take advantage of the value that very quickly appeared in the corporate bond market as spreads in some cases doubled or trebled for the same types of corporate bond. Fundamental research gave us the confidence that those issuers were not going to suffer a significant deterioration in their creditworthiness, and so we could take advantage of the financial stress in the market to buy those types of securities and, as you can see, we ran the portfolio from a defensive position to a significant overweight position in credit. Of course, as value changes, we are going to respond to that. And, as credit spreads tightened very significantly with the support of central banks, we saw that value itself in that sector also started to diminish so we've taken down our significant overweight, to a much more sort of normalized position.

In conclusion…

So thank you for listening and watching. I'll leave you just with three soundbites. Hopefully you've got a flavor here for our active proprietary research in action, helping us construct these types of strategies, I hope you can also see that we are flexible and dynamic in our approach. We are active investors and then last but not least, I hope you can also see that the qualities of the benchmark in this strategy are significant. And we display empathy with that benchmark we don't want to turn our strategy into something that investors don't expect it to be, thank you for listening.