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Peter de Coensel, DPAM’s Chief Investment Officer Fixed Income and Manager of the Global Unconstrained strategy, explains his view at the onset of a second quarter that will likely be fraught with volatility spikes, declining central bank support, fresh Trump tantrums and renewed uncertainty on the geopolitical front.
As early as the end of 2016, you forecast a change of volatility and monetary policy regimes in key markets and began to prepare your own global bond portfolio, by gradually raising the weight of government bonds.
Now that the markets have started to integrate such a view and that your strategy has begun to pay off, does it mean that the only way to go is ‘Defense’?
Indeed, excessive expectations (and related bets) of low volatility, incessant turnover of key staff at the White House and a budding trade war between the US and China caused significant turmoil in the markets in the first quarter, which ended on a notable move in favor of safe-haven assets.
In the chart below, we notice that the small spike in the MOVE index (which gives an estimate of bond rate volatility in the US) in early 2018 was followed by higher term premia across G4 (US, UK, EU and Japan) government bond markets. The purple line shows the difference between 10- and 2-year rates for the G4 government bonds; the measure is GDP-weighted. Over the past decades, periods of low bond rate volatility coincided with a smaller rate differential and thus a flatter curve in developed markets. As central banks gradually exit their non-conventional easing policies, the number of high volatility episodes should increase and we prepared for steepening curve conditions.
Higher volatility = Steeper curves
Source: Bloomberg, DPAM, 13.04.2018
Starting in late 2016, we began to modify the balance between government and corporate bonds. While government bonds made up slightly less than 30% of the fund back then, their weight has steadily increased to well over 60% today.
At the same time, we have gradually migrated upwards on the ratings scale. We have an allocation of less than 10% to high yield bonds (exclusively in government bonds from Brazil, South Africa and Portugal) and also to lower rated (BBB-) investment grade corporate bonds. Close to 40% of our holdings belong to the AAA to A- rating category.
Finally, since we run a high conviction relative value strategy, we maintain a high level of protection via credit and rate derivatives.
We intend to keep or even reinforce all three levels of defenses going forward.
Are there still opportunities though? If everyone is ‘de-risking’, will one be ‘late to the party’ if they only start now?
Of course not. One must tread carefully though, but armed with the right analysis tools, we have identified some areas of interest for the short, medium and long term. We can start with Europe and the rate convergence of periphery countries —Spain, Italy and Portugal— with core countries such as France and Germany. This is a theme we have had in the portfolio for some time and its potential remains intact. Periphery bonds offer value, as these countries’ finances are firming, while at the same time, key regional leaders such as Merkel and Macron seem to be on the same ‘pro-Europe’ page. The rating status of these countries has already improved and will continue to do so, which should lead to narrower spreads. We feel that markets are currently underestimating this potential.
Outside the continent, we also like emerging market government debt in local currency, but due to its typically higher volatility, exposure to this asset class must remain modest. We are interested in Brazil, South Africa and since the end of this quarter, Mexico, mostly due to their economic recovery prospects under disinflationary conditions.
What about credit? What are the prospects there?
In that sphere, we do tend to stick to sector blue chips rather than small-cap issuers for example. In the US, we expect the Fed to continue normalize policy. Therefore, in non-financials, which can be adversely affected by higher rates, we focus on bonds with an intermediate (3 to 7 years) maturity. At the long end, we stick to senior bank debt, as over time, banks traditionally benefit from higher rates.
In the second quarter, we expect sustained corporate issuance in Europe and thus, issuers will have to offer higher premia to attract investors. Amid rising supply, credit will become cheaper, putting upside pressure on spreads. Based on our analysis, there are some value opportunities among insurers.
Still in Europe, we are adding financial floating-rate notes (FRNs) to the portfolio and expect to continue doing so. The goal is to best protect investors’ capital and also profit from tightening rates. Indeed, demand for FRNs (and their value) should increase through 2019 and beyond.
So your expectations of gradual monetary policy normalization and rising inflation remain unchanged?
Short-term, we are sitting on the fence a bit. But over the next two years, US inflation should increase and upside surprises are highly likely, but this is not yet priced in. One often hears: ‘Don’t fight the Fed!’ and we don’t intend to. We anticipate three hikes in total in the US for 2018—one behind us, two to go—, while in Europe, the end of quantitative easing this fall means indirect tightening. Hence, our exposure of around 25% to inflation-linked bonds, with 15% in US TIPS and 10% in Spanish and Italian linkers. Their potential will be released once inflation expectations catch up.
To summarize, you must build up a defensive wall, but do not simply retrench behind it—there are opportunities to be captured. The current regime transition simply means that the type of opportunities that one can seize is changing. Flexible strategies such as our Global Unconstrained or Global High Yield as well as investments that benefit from rising rates such as Floating Rates Notes, are recommended.