Passive investors drawn in by the relatively smooth ride of the past ten years are in danger of sleepwalking into a world of riskier assets, volatility and illiquidity.
Rohan Thiru, portfolio manager, fixed income, at Canoe Financial, an active independent investment management firm, believes people overlook index risks at this stage of the cycle at their peril.
He said December’s sell-off should have raised alarm bells among investors and that people have become so excited about stimulus from US President Donald Trump and the US Federal Reserve that they’ve become “super complacent about risk”.
He added: “As money comes into ETFs and other passive instruments, they don’t think twice about buying credit and they’ll indiscriminately buy anything. When liquidity dries up, you are stuck – and that’s when you start seeing capital erosion.”
In the first of two articles with WP, Thiru, who is a portfolio manager on the Canoe Bond Advantage Fund and the Canoe Bond Advantage Portfolio Class, highlighted three areas of risk in the market that he believes are not on people’s radar. The time to be concerned is now, he stressed.
The first major problem he highlighted is that indices hold riskier assets than 10 years ago. Now, the index contains a lot of triple B’s, REITs, pipeline companies, and energy names, which have all been big issuers of debt.
Thiru said the fact that a lot of debt has been used for buying back shares, high valuation M&As and paying dividends rather than increasing productivity is of concern. The consequence is that a lot of these low-quality issuers are on the cusp of going into high yield.
When global growth slows, revenues decline and cashflow starts deteriorating, which is when some companies may have difficulties paying down debt. Ratings agencies could step in and tell these companies to start paying down their debt or risk being downgraded. With the investment grade market at about $475 billion and the high yield index at only $13 billion, the high yield market has a smaller amount of buyers who are willing to take on this type of lower-rated debt.
He added: “Then you get massive forselling where $13 billion of the high-yield market is not going to be able to take all this on. So, you get massive dislocation in prices. A lot of the time the market sees the downgrade coming and starts selling. There is about 90 days of lead time the index gives before a name gets rolled over into high yield. So you’ve got 90 days to sell otherwise you are holding on to a high-yield name in an investment grade index.”
A lot of the time bad news comes all at once, said Thiru, creating panic. Therefore, he has no triple-B exposure in his funds and has concentrated on A and double-A rated issuers, as well as financials, which trade better in a risk-off environment with better fundamentals and better liquidity.
The second major risk is that new capital instruments mean index investors have more exposure to stock market moves. Examples of these equity-like investments include non-financial hybrid securities and bank non-viability contingent capital (NVCC).
In theory, if a Canadian institution for some reason is in financial distress, the non-financial hybrid security is converted into equity overnight, despite being in the index and being treated like fixed income. While an unlikely scenario, Thiru’s point is that when there is a market sell-off, these instruments are the first to go.
He explained: “They are high beta securities and sell off a lot more compared to a lot of other defensive fixed-income products. We have decided to avoid these types of securities as we enter the late part of the cycle, and we have been proven right because these sold off meaningfully more in December – they were the first ones to be kicked out of the index. There is a time and a place for these but not now.”
His final major concern reflects the shift in how the dealer brokers manage their inventory, leading to potentially low liquidity. According to Thiru, new regulations have prompted the US dealer inventory to shrink from $500 billion to less than $100 billion, while at the same time the amount of credit in the country has tripled from $2 trillion to $6 trillion.
The intermediary who is supposed to be providing the liquidity has decided to scale back the risk.
He said: “When you have ETFs and other passive investments that need daily liquidity and the liquidity has dried out, you get this dislocation. In December, people were trying to sell ETFs, which are hugely liquid instruments but the securities underneath them are not as liquid.
“They are trying to sell for all kinds of reasons – de-risking, redemptions – and there is no dealer liquidity. At the same time, money managers are going the same way and trying to sell into the market.
“We haven’t really seen this play out for a long time but we saw a glimpse in December where, for a couple of days, the bond market completely froze. I couldn’t even sell high-quality names because the dealer inventory was full and no one else on the other side wanted to buy.
“At that point, index ETFs become price-takers. The dealers just put any price on it and the spreads are going to back up significantly causing more erosion, or there may be no liquidity and you are stuck with it.
“If that stress is prolonged, it could be meaningful in terms of capital erosion. When people are looking at fees, the point they may be missing is that capital drawdown could be a lot more meaningful than the couple of basis points in fees they are so concerned about.”