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Letter from our CEO - Q2 2017

Unchartered waters

Since the 2008 financial crisis, central banks have been on the front lines, injecting liquidity massively, buying up securities of all types, and launching bank rescue plans. Their objective has been to keep domestic and global economies from slipping into a new recession. With one eye on Lehmann Brothers, world leaders of all stripes have said in unison: “never again”. 

Eight years of constant rate cuts later, the measures still look the same but have now been taken into overdrive, even though their marginal effects seem weaker and weaker and their collateral effects are raising more and more questions and criticisms. Sadly, we are witnessing the transformation of the bond market, originally meant to be a “free market” driven by independent economic actors, into an increasingly skewed phenomenon that is guided by laws other than supply and demand and perceived risk-return. While the initial objective was undeniably praiseworthy, it has caused collateral damage to savings and pensions. Not to mention the negative incentives for governments to implement fiscal and structural reforms that have long and eagerly been awaited, in vain.

The worst-case scenario has been avoided but the situation is now becoming a big concern for many market participants –savers who no longer know what to do with their savings, which too often are eaten away by zero or negative interest rates; pension funds, whose liabilities are constantly increasing, tracking major demographic trends, but which do not have the resources to match; insurance companies that paid out guaranteed rates to their clients; and banks whose fundamental transformation role is being undermined both by negative rates and a flat yield curve. To make matters worse, growth is soft and equities are overpriced on their actual earnings growth.

Central banks are trying to nudge investors into taking greater risks and into boosting consumer spending to jump-start an economic engine that is running on three cylinders, with governments expected to take over with reforms that will support productivity gains. Some countries have already done this, while others are dragging their feet, especially where that would entail unpopular policy choices during election campaigns.

The Swiss sovereign yield curve is now in negative territory up to 50 years (with the Swiss National Bank’s focusing on keeping the franc from appreciating too much). In Germany, you have to invest beyond 10 years to avoid negative rates. Some of the largest and most solid corporates issuers are also making investors pay for the right to use their savings. 50% of sovereign debt in Europe is trading at negative yields, and 72% of corporate bonds are trading at less than 1%.

What if this state of affairs were to last far longer worldwide than expected, before returning to “normal”? A long economic slump, like Japan experienced and is still experiencing, with the hope of inflation coming back one day? After all, if this soft growth continues, neither pressures on wages or commodities will feed inflation, which will remain wishful thinking. Meanwhile, the major underlying trends, both demographic and technological, do not appear to be in favour of productivity gains of the scale the world once knew.

 

There are opportunities out there

However, savers, pension funds and many other investors cannot completely ignore fixed-income products, even though yields are currently unattractive, to say the least. It is not reasonable to invest 100% of one’s portfolio in equities or real estate, and corporate bonds, while improving, offer only a partial solution due to their lack of liquidity. The same goes for infrastructure investments, whose political risks, incidentally, are too often underestimated. That said, some liquid niches on the bond market still offer opportunities for the taking, as long as they are chosen carefully, thoroughly and with discipline:

The credit market, high yield in particular, still offers carry opportunities and, while default rates have risen slightly, they are still low and make the risk premium attractive. To those who might be concerned that the market is “expensive” right now, the short answer is that the entire bond universe is expensive and could remain so far longer than expected. Some high yield sectors could be hit hard by exogenous events, as occurred late last year with the oil price slump. That’s why active selection of bonds and sectors can help avoid the biggest pitfalls, which will inevitably emerge. 

Emerging debt, when chosen selectively, can also serve as a solution to lower yields, for, as long as the dollar does not enter an uncontrolled rise, emerging economies, on the whole, are not at risk of running off the rails. 

Duration is also a source of returns not to be overlooked and, while interest rates are low, they can go lower still. A fund selector at a major Swiss bank told me this summer that, for several years now, he has put out a monthly newsletter in which he has said each month that rates are low, that there is no longer any value in bonds, and that the risk/reward ratio was unfavourable… While the market has proven him wrong for several years running, the day will come when it proves him right. When that day comes, duration will have to be managed “like milk on the stove”. 

All these uncertainties weighing on the bond market, which are making specialists sail in unchartered waters, suggest a flexible, opportunistic and global approach, in which various drivers of performance can be sought out wherever they are: high yield in the US, duration in Europe, possible rate hike (one day, maybe…), portfolio protection against market stress, hedging of currency risks – in short an active and dynamic approach that is far removed from the chase for coupons of yesteryear.  

The constant increase in supply of flexible bond funds and their AuM shows that an increasing number of investors are alive to this new approach, which in the current environment allows them to keep one foot in the bond universe with an additional dose of reassurance. This trend is just now starting, and the current environment will not become any less complex. Quite the contrary, a few months from major elections in the US and several European countries, political risk could be the icing on the cake for investors.

Since 2013 Mirabaud Asset Management has managed a flexible bond fund that calls on three sources of performances, the breakdown in which shifts with global economic cycles: Credit, Duration and Hedging. Systematic currency hedging and the option of distributing or capitalising make this fund attractive for both institutional and retail clients. As of 31 July 2016, Mirabaud Global Strategic Bond Fund USD A Cap was in the top quartile of Morningstar’s flexible bond funds since its October 2013 launch.