Is Credit the Saviour of Fixed Income… and if Not, What Is?

To view this article in digital magazine format, click here.

Let’s face it: Interest rates aren’t skyrocketing any time soon.

Last month, the European Central Bank (ECB) lowered its nominal rate to the lowest point in history, a move meant to fall in line with other major influencing economies.

Most sophisticated investors have already discarded government- and sovereign-backed debt, and are struggling to keep faith with poorly performing investment-grade fixed income.

For more stories like this, sign up for the CIO Alert newsletter. 

In fact, November’s Bank of America Merrill Lynch fund manager survey found investors had allocated the lowest level of assets to fixed income since the report began. For pension funds that have to keep a fairly substantial allocation to fixed income due to its liability-matching properties, the current monetary policy could be used to their advantage.

The current artificially low interest rates have produced historically low default rates in the corporate bond sector. At the end of October, global high-yield default rates had fallen to 2.8% from 3.2% a year ago, figures from rating agency Moody’s show. In the US, default rates fell to 2.5% from 3.6% last year, and in Europe, a 3.2% rate was down a touch from 3.3% at the same point in 2012. This demonstrates how the term “risky” does not have the same dramatic meaning as five years ago—but investors are still rewarded for holding the lower-rated debt.

“Credit might not be the saviour of fixed income,” says Alex Gracian, CIO of the London Pensions Fund Authority (LPFA), “but it could be a centurion in its army.”

Indeed, the sector may not have achieved double-digit returns in 2013, but it has ground out an uplift of two percentage points or more over higher-quality fixed income, which just about made it over the line.

Danish national pension ATP has been reaping the benefits of these more assured corporates in its risk-factor approach to investing. “Absolute spreads are back to where they were in 2007,” says Anders Hjælmsø Svennesen, co-CIO of ATP. “There is very little available on the risk-free side of things, and we hedge out all of the interest rate risk so we are just left with the credit risk premia.”

But is the low-default environment sustainable—and will investors continue to be rewarded? At Deutsche Bank, leading bond strategist Jim Reid predicts low defaults will hang around—or be forced by central bank policy to stay—for a couple more years, but it does not automatically follow that returns will be sustained if more people crowd into the trade.

“Credit can still help deliver the outcomes we need if yields drift up,” says Mark Mansley, CIO of the Active Pension Fund at the UK’s Environment Agency. “We are looking quite closely at credit and are monitoring the narrowing of spreads. I don’t believe we are in a bubble yet, but the upside for spreads is getting less.”

Some think blue-chip corporate securities—the names usually bought by shorter-term investors—are already fully valued, and thus several investors are looking more broadly. “It’s difficult to price in rates over and above what has already been priced in,” says Ian McKinlay, investment director at the Aviva Staff Pension Scheme. “The only way to make money is if rates rise higher and faster than the market thinks. We’re looking at the forward curve and thinking it looks OK—if you don’t think that, you’re fighting the central banks. Who would do that? They are conducting the largest financial experiment in history.”

Better to be diversified, then? “We have a barbell approach: On the one side, we have gilts and conventional fixed income, and then we have alternative debt portfolio, which includes aircraft leasing, shipping finance, and ground rents,” says Gracian at the LPFA. “We have to capture the illiquidity premium. There are various options, including moving around the capital structure and looking at private and illiquid debt.”

Illiquid debt has captured the imagination of many a bold investor, but some—including Leandros Kalisperas, credit manager at the Universities Superannuation Scheme (USS)—fear the low-hanging fruit has gone and funds will have to work harder for returns.

Bank deleveraging may hold promise, says Gracian, who is waiting for the ECB’s next round of stress tests in one year’s time. McKinlay warns, however, that only the most sophisticated—or those with very good advice—should get involved in this sector, and they should all have an exit strategy before going in.

“No asset class is wonderful at the moment, so you just have to get stuck in and get the job done,” he says, “then you might have to change the rules a little...”

The rules he refers to have already been changed by equity investors. Now it is time to turn attention to fixed income. “There has been a lot of noise about smart beta, about non-market cap-weighted portfolios—but only in terms of equities, as far as I can tell, not for fixed income,” he says. “Fixed income could benefit from this diversity. At the moment, investors are often lending money to the most heavily indebted companies. Bonds have even more downside risk, so there are certainly benefits to diversification.”

Gracian sees the idea being developed, too. “I would like to see more innovation in alternative indexing outside equities—and fixed income is the most tractable. Obviously, investors have to be selective about the plays they take. Financials and industrials are good, not just looking across all high yield and investment grade, but relative value plays.”

USS is already climbing the thought curve, having brought on an investment bank to create such an index in its emerging markets portfolio, which Kalisperas believes is a good fit. “We only want exposure to certain countries, so our benchmark is not market-cap weighted,” he says. “In fixed income, there is a whole universe of factors to consider and build alternative indices—there has been a bit of talk but not much action.”

This could be the next challenge for fixed-income managers who want to woo back investors: clever benchmarking that fits with institutional investors’ needs.

“People are realising that generic fixed income has had somewhat mixed performance in matching liabilities, and are becoming more sophisticated in this aspect of the portfolio, running more explicit liability-hedging programmes. This means the bond portfolio is being freed up to become more focused on return-seeking and open up to a broader set of ideas,” says the Environment Agency’s Mansley.

“Pension funds have to look at fixed income in the same ‘breath’ as equities; we have to be more open to the different options—but not get carried away.”

The most sophisticated investors are interested, so it is up to providers to take the next step. Maybe this will be a means to avoid bubbles for good.

To view this article in digital magazine format, click here.

“The emotional tail wags the rational dog.”

—Jonathan Haidt

In countries where one has to opt in to become an organ donor, there is a shortage of donors. In Germany, for example, the organ donation consent rate is a mere 12%. In dramatic contrast, those countries with opt-out donor legislative systems in place have significantly higher donor rates; in neighbouring Austria, the consent rate is more than 99%¹.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

Why is there such a significant difference between these two concepts, given both effectively offer the same choice framed in different ways? The reason is that we human beings are not always as rational or logical as we might imagine—or traditional economic models might suggest. We are often influenced by biases—in this case, the “status quo” bias—and heuristics. Put another way: We take mental shortcuts.

Behavioural economics shines a light on such shortcuts and the psychology of those who participate in financial markets, both individually and as part of a crowd. In particular, it seeks to understand how markets might be distorted or inefficient due to the influential biases of its participants. (As Warren Buffet once said: “I would be a bum on the street with a tin cup if markets were always efficient.”)

As a historian, I am particularly interested in booms, bubbles, and busts in market cycles. These are often viewed simply in terms of fear and greed, but in reality they reflect many underlying behavioural patterns, such as the ‘herd instinct’, that were just as prevalent in the Tulipmania bubble of 17th-century Holland as they were during the dot-com boom of the 1990s. As Mark Twain is alleged to have said: “History does not repeat itself, but it does rhyme.”

Psychologists estimate that the human brain is potentially subject to more than 120 different biases, including ‘base-rate neglect’ (ignoring the statistical facts and figures, often in favour of an emotionally appealing or attractive story—a real-life example is the popularity of some ‘pseudo-sciences’ despite minimal supporting evidence) and ‘anchoring’ (consciously or subconsciously latching onto a preliminary figure as a reference point for decision-making). A pioneer of behavioural economics, Professor Daniel Kahneman, once conducted an anchoring experiment by asking his subjects what percentage of African nations were members of the United Nations. On average, those who were asked whether it was more or less than 10% guessed the answer was 25%, whilst the answers of those asked if it was more or less than 65% averaged 45% ².

This brings us nicely to observe one area in financial markets that is coming under increasing scrutiny: the inefficiency of market capitalization-weighted equity benchmarks. Almost by definition, such benchmarks will overweight what is overvalued and underweight what is undervalued. It can be enlightening to see how poorly these market-cap benchmarks generally perform in comparison to those constructed using different methodologies. Indices containing low- and medium-volatility stocks, for example, have generally had superior risk-adjusted returns compared to higher-volatility stocks over most meaningful time periods and across most countries and regions.

Human biases can also lead to sub-optimal decision-making around board tables and within committees, so understanding key aspects of social psychology—above all recognising and preferably avoiding mental shortcuts—is an important defence against what is often referred to as “groupthink”. Conformity is another bias to be particularly wary of, and the importance of having someone play devil’s advocate in a decision-making group cannot be underestimated, if only to challenge the consensus.

Kahneman was awarded the Nobel Prize for Economics in 2002—no mean achievement for a psychologist. The message is that behavioural economics is important because it relates to real people in the real world, and challenges the traditional economic models that assume people are always rational decision-makers who fully analyse data and act logically to reach conscious decisions. Indeed, whether in the fields of investment or more general decision-making, behavioural economics demonstrates the importance of challenging our hardwired beliefs and in-built biases, in order to optimise our chances of reaching the correct conclusions.

Paul Craven, former Head of EMEA Institutional business at Goldman Sachs Asset Management, will be leaving GSAM in 2014 to promote behavioural economics in business.