It is a difficult time to be a fixed income portfolio manager. An investment strategy that has always been synonymous with safety and income-generation is now being forced, because of extremely low rates, to take on additional risk to produce even the most marginal of income streams.
With no end in sight for the massive government liquidity injection and with rates expected to stay at record lows through 2021, how are fixed income managers adapting and continuing to meet their portfolio goals? Below, we ask Aurélien Michaud, CFA, FRM, for his take.
Michaud is a senior portfolio manager at Banque Cantonale du Jura (BCJ), the state-owned Swiss bank serving the canton of Jura. Michaud holds 10+ years of experience in fixed income investments, beginning his career as a fixed income trader at Valcourt SA, the bond specialist based in Geneva. He then spent time at Lombard Odier Group as a senior fixed income advisor before joining BCJ as a portfolio manager.
In an ultra-low rate environment like the one we are currently facing, how do you find opportunities that can meet your portfolio goals?
Government debt in many parts of the world has essentially become a yield-free investment. The income offered on European or Swiss government bond is significantly less than 0% for nearly all maturities. This fact alone presents a number of challenges. Many fixed-income investors are, naturally, safety and income seeking; portfolios that are geared toward producing even modest streams of income must now take additional incremental risk, by investing in less liquid securities or bonds that bear greater credit risks, or both. In some ways, the challenge of low yields is not new (it has been a reality for CHF investors since 2015), but the severity of the problem has increased dramatically as now USD based investors are also hurt by the near zero yield environment.
As bonds segment of portfolio provides less or no income and does not deliver any downside protection, security and revenues need to be found somewhere else. The idea of a simple 60/40 asset allocation seems now completely outdated in the current yield environment. Protection in a portfolio could be reached using gold, as its opportunity cost of holding it is now negative (real rates are now close to -1% in USD). Regarding income, we will have to look in the equity space, investing in strong company paying constant dividends could be a solution. The Swiss equity market is a good example of an income strategy with companies such as Nestlé or Zurich.
With the extensive fiscal stimulus we are seeing deployed by central banks in the face of the pandemic-caused recession, the potential for widespread inflation becomes more relevant. Do you believe we are heading that direction, and if so how will that affect your fixed income investment strategy?
A rigid dependence on orthodox inflation indicators such as CPI measure has made the economics community partly blind to the elephant in the room, which is the point that inflation has been overly concentrated in asset prices rather than consumer price. Such a situation based on the conjuncture of coupling monetary with fiscal policy should most probably continue in the future.
So far and with the current environment, the prospect of hyperinflation hitting the economy is more a tail risk scenario to me, as the structural weight on consumer price will still be valid in the near future (technological progress and demographic transition). Although in order to maintain a protection against increase in the consumer price, investing in inflation-linked (ILS) bonds could be an adequate solution. ILS are a reliable way of combating consumer price increase within client’s portfolio.
Although if inflation should accelerate more than expected, it would probably force central banks to turn hawkish, spelling difficult time for financial markets dependant on stimulus. That said, I think this is unlikely to materialise in the short term, although, given the discrepancy between valuation and fundamentals, here at the BCJ we rather stay cautious and maintain a defensive position on duration and credit exposure.
Besides the risk of widespread inflation, how do you see the fixed income strategy evolving over the next 6 months? And the next year?
The extreme market turbulence in February and March 2020 drove credit spreads to levels not seen since 2008-2009, creating attractive opportunities, especially in companies with solid financial fundamentals. Unfortunately, the opportunity window disappeared based on the unprecedented support measures revealed by central banks and governments. Credit spreads are now back on their historical averages. While the technical tailwind will likely keep a lid on spread, further tightening may seem difficult to reach.
Given the current indebtedness of most governments in the world, the level and shape of the yield curve in the main currencies should stay the same. We could see some ramp-up of the right tail based on the evolution of the health situation. Conversely, the short-end will stay stuck on the zero/negative bound for the next 12 to 24 months. It will be interesting to see if the Fed will likely wrap up its policy review by September, which could perhaps lead to explicit yield curve control (as a reminder the US already use such measure in the 1940s during WWII).
With these facts in mind, investors should not expect to earn much more than the stated yield to maturity on a bond on the medium term (carry strategy). A difficult reality in a zero yield environment.
What are some particular markets/sectors/industries that you believe will outperform as the global economy looks to survive and recover from the pandemic?
Predicting longer-term thematic shifts is always a difficult game and I personally think that the market already has the answer to that question. Just by taking a look at the year to date return of the NASDAQ should pinpoint tomorrow winners. Pandemic impact on markets or sectors proved Darwin was right with its famous quote: “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.”
Innovation and flexibility will be the key in the digital world that we are living in.
There is a lot of discussion about, and investor demand on incorporating ESG factors into the investment decision making process. Where do you and Banque Cantonale du Jura stand on this matter?
We are confident that the sustainable approach will deliver more resilient risk-return profile for our investors. Since September of this year, either in the advisory or in the discretionary mandates we will be able to fully cover investor needs in terms of sustainable investments. Regarding the advisory service, we have a range of products integrating ESG factors or sustainable topics (based on the UN SDGs). Based on clients sensibilities and values portfolios can be built from scratch.
For our discretionary mandates, we decided to keep only one product range, being responsible investing. The main challenge was to adapt our existing allocation and selection processes to incorporate a new constraint meeting sustainable criteria in a multi-asset portfolio.
