Portfolio manager explains bond firm's perspective on duration risks, pro-cyclical outlook, and trends in new issuances
Traditionally, the fixed-income market should be a source of reassurance for investors. But as coronavirus-hit economies hit rough patches on the road to recovery, that’s been far from the reality.
The year so far hasn’t exactly been smooth sailing for fixed income investors. Yields on U.S. Treasuries have climbed by nearly 78 basis points and ended up in the neighbourhood of 1.7%, making them unappealing in terms of income as well as increased exposure to capital losses.
“The biggest questions that we get asked is what are our views on current rates in the U.S.,” said David Norris, head of U.S. Credit and portfolio manager at TwentyFour Asset Management, a fixed income boutique of Switzerland-based Vontobel Asset Management.
Founded by its CEO Mark Holman in September 2008, the day after the collapse of Lehman Brothers, the firm has established itself as an innovative active asset manager with capabilities that span global fixed income markets.
“There’ve been a lot of concerns about inflation, so we’ve been listening very attentively to the Fed rhetoric and guidance in their minutes and statements,” Norris said.
He said the prevailing view at his firm is that the global economic recovery is on pace to proceed over the course of the year. Based on movements in the shape and steepness of yield curves, they see the U.S. leading the way, followed by the U.K. and European mainland markets.
While the pace of the recovery in the U.S. economy and its government bond market has surprised most, Norris believes that the positive stimulus and economic news to date has already been priced into the marketplace. Moving forward, he believes that risks of a continued upward trend in interest rates will play a more significant role.
“It's like a double-edged sword, if you like. On the one hand, you're seeing improvements in the economy and fundamentals, which of course, would be very good for credit,” Norris said. “On the other hand, you also need to be cautious of higher rates and, consequently, longer-duration assets.”
As those risks dominate the U.S. Treasury market, Norris said there’s been a spillover in credit markets in terms of the duration of investments that are being made. Against that backdrop, his firm is taking a cautious view on Treasuries as well as the higher-quality credit segments, choosing instead to concentrate on the belly of the fixed-income curve.
“We’re feeling a little more confident in high-yield than investment-grade right now, so we still prefer to avoid the longer-dated bonds and like to move a little further down the cap structure,” he said. “Aside from that, we’re taking a constructive view with a more pro-cyclical approach to our investments.”
As COVID cases decline and more people get vaccinated, consumer confidence is set to rise and provide an outsized lift to certain sectors. To reap the benefits of the economic recovery, TwentyFour has been taking on additional pro-cyclical risk exposure to those areas, which he said also provides an added spread buffer against potential negative rate moves.
“We've tended to focus on industries such as airlines, aerospace, automotives, leisure and hospitality,” he said. “And I think with the infrastructure bill expected in the U.S., we would also be looking at those types of sectors that would benefit from an increase in infrastructure spending and see good opportunities with home builders and providers of building materials.”
The financial sector has been one of the biggest beneficiaries, Norris argued. As central banks have demonstrated a willingness to provide liquidity, banks have shown a readiness to facilitate economic growth by lending. That activity has redounded positively in bank earnings not just in the U.S., but also in the European banking sector.
“We've been increasing our exposure to the European bank sectors not just because of their pro-cyclicality, but also because we currently prefer risk that is priced off the European yield curves,” he said. “If you look at the U.S. yield curve, there is potential for further steepening. But because the recovery in Europe hasn't been quite as pronounced, there’s still room for further growth to catch up with what we are experiencing in the U.S.”
Within the European banking space, Norris said his firm is concentrating on the AT-1 subordinated bond market, particularly those issued by investment-grade and top-tier institutions. They also place an emphasis on BB bonds found within the European CLO market, which also offers very moderate duration given it’s LIBOR-based.
“We believe the structure of the European CLOs provides some very good protection if you stay within the belly of the cap structure, ” he said. “Default rates in Europe are generally lower, and have been lower than in the U.S. Currently, European default rates are around 3.5%, compared to U.S. rates of close to 5.5% at the moment, though both are trending lower.”
New issues are another factor to watch. According to Norris, the new issue market in U.S. high yield this year has seen approximately $188 billion in issuance for high-yield bonds, representing about an 80% increase from where we were at the same time in 2020. In comparison, new issuances in investment grade bonds are roughly 20% lower than where they were at this time last year.
“Based on the percentage trends, you can see that investors are looking more for yield and borrowers are taking advantage of the current lower yields that we've seen,” he said.