Bonds: The Good, The Bad & The Ugly

ASG Capital

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ASG Capital
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Partner, Executive Board Member & Senior Portfolio Manager

Introduction

The start of 2022 has been marked by a poor performance in the Fixed Income asset class not seen in decades. Starting from a low base a year earlier, any move towards higher interest rates was destined to have negative consequences on this investment space.

Today, the general sentiment remains bearish on Bond instruments. There is good reason for this. Inflation has yet to be controlled. Political pressure on the US monetary authorities to increase interest rates is very high.

The objective of this article is to point to some of the moving parts of the Fixed Income world in order to provide another perspective on this presently ‘unloved’ asset class.

Is the current inflation increase linear?

The present day inflation paradigm and its repercussion on interest rates are shying many investors away from the Fixed Income asset class. Before brushing aside Bond markets, one should look at the current economic conditions as being cyclical. Inflation may be rising very rapidly today. It is still not clear if tomorrow’s dynamics will necessarily prevail to the same extent 12 to 24months down the road.

It takes two to sustain the ‘inflationary tango’. If high input costs (energy and raw materials) are currently driving up supply side inflation, there must be a corresponding demand for it to really stick. As some point in time, there will be a push back from consumers unable to afford or unwilling to pay the higher prices for goods and services. This should then put downward pressure on inflation. We are not quite there yet….

Bonds an investment Solution?

As any other investment, bonds have advantages and disadvantages. The Fixed Income world is a very large asset market. Within it, there are a multitude of investment possibilities. Some bond instruments provide a better relative value than others, especially in the present day environment.

The Good

Somewhere to Hide

The Fixed Income space, specifically the US Treasury market, offers ‘somewhere to hide’. One of the drivers in the appetite for US Treasuries is the preservation of capital. Under these conditions, the return on investment becomes secondary. When faced with unsettled periods such as today, the US Treasury market remains the ‘go to’ investment space not only for Americans, but more importantly for the International investment community as a whole.

A revenue stream

Uncertainty blurs the visibility on the potential performance of an asset. A Fixed Income instrument has the comparative advantage of offering a clearer outlook on its ‘revenue stream’. This sits well for investors who depend on sustainable income returns from their investment capital.

‘All creatures great and small’

As a bondholder, the investor takes on the role of a lender to a corporation or a government. Fixed income instruments provide a multitude of possibilities to position an investment exposure over the short, medium or long term. This positioning can correspond to an investor’s own specific needs. It can also prepare for changing economic or financial conditions such as increasing interest rates. Two examples:

  • A corporation may have a strong business model for the next 3years while indicating less resilience further out. Holding a long-term equity position might not be the best option compared to holding a short dated bond.
  • The investor may seek to benefit from rising interest rates through an exposure to floating rate debt or short-dated debt instruments. As an equity holder, the investor would be unable to position in such a way.

Fixed Income assets provide investment maneuverability, which opens the way to tactical investing: fine tuning in the management of credit and interest rate risk.

Bonds: a boring investment

Bonds are generally boring investments. The investor quietly waits for coupon payments and reimbursement at maturity. As a result, these instruments have been considered part of the more stable part of an investment portfolio, compared to other more volatile assets.

The Bad

A Fixed Income investor can no longer just look at the returns provided by a bond instrument. One needs to balance the performance potential against the risk of holding this kind of asset. The two of the main risks to focus on are Credit risk and Interest rate risk.

1.Credit risk

Traditionally, it was the quality of the balance sheet and its revenue stream, which determined the credit quality of a bond issuer. However today, these factors are no longer sufficient in a credit risk vetting process. 

Big ‘balance sheet’ is beautiful

Over recent years, the financial footprint of the borrower should be taken into account. For systemic ‘too big to fail’ institutions or other large corporations, balance sheet size has become a determining factor in the access to debt capital markets. Mike Howell of Crossborder Capital sums this up in the following way; bond markets have moved from their original financing role to become a refinancing tool to sustain an ever-increasing gigantic debt pool. At the heart of the system, today’s outstanding debt is so substantial it can only be managed/refinanced with the support of large balance sheets. With this backdrop in mind, the access to capital and availability of liquidity favors larger borrowers (large balance sheets) rather than smaller ones.

This liquidity privilege is especially noticeable under distressed market conditions. When debt markets are disrupted, smaller borrowers can have their access to funding impaired regardless of the quality of their accounting fundamentals. Without a refinancing capability, these same borrowers can find themselves in a precarious situation.

New ‘risks’ on the block

Other risks to be considered are new business regulations or official sanctions. On paper a borrower may be a large international corporation, financially powerful, systemic, and economically sound. Yet, it may find access to capital constrained due to its status or geographical location. This has been the case for Oil companies faced with the ESG green agenda and more recently for Russian corporations shut off from ‘western’ capital markets due to sanctions. 

2. Interest rate risk

Elevator or Stairs

Increases in interest rates tend to affect negatively the Fixed Income asset class. The extent of this loss will depend the speed of rate increases as well as the ultimate level interest rates finally reach.

Some bonds will fare better then others under these conditions, either due to their coupon structure or to the maturity of the instrument. Mr Gunlach of DoubleLine, sums this up in the following terms: bonds tend to go down sharply just like taking an elevator (capital loss from an interest rate increase for example), and will come back up more progressively like taking the stairs (the cumulative gain from the earned interest takes time to materialize).

Appetite for Higher Yielding Bonds

Another element to account for is the yield level on benchmark bonds (ie US Treasuries). The lower this level is the greater the potential the appetite for other higher yielding bonds away from Treasuries. The reverse is also true. Treasuries can have a crowding out effect if ever their yields were to rise to high levels.

Ultimate destination

Monetary policy in the US has yet to be settled. Certain guidelines have been given on where rates are likely to go. Financial Markets have integrated this already. However, no one (including monetary authorities) is absolutely sure if this will or will not be the ultimate destination for interest rates. The best way to approach such an uncertain paradigm is to keep one’s option open to different scenarios moving forward. 

The Ugly

The main worry for the Fixed Income world is a liquidity or Credit Crunch. As we mentioned before, the world debt system has become a refinancing mechanism. If liquidity is not readily available, certain borrowers could be unable to refinance their debt, exposing them to a risk of default. In the front line to a potential liquidity crunch are the ‘periphery’ Emerging and Junk bond markets.

As most of the world’s debt is denominated in US Dollars, this implies a permanent need for Dollar credit both inside and outside of the United States. Only one institution can provide sufficient and readily available liquidity if necessary, the Federal Reserve. Will it do so this while it is trying to control inflation at home? We will wait and see….

Conclusion

‘The Noise’

Unfortunately, there is too much noise around inflation and interest rate expectations. The world in 2022 is in a very different place from the 1970s. Wage bargaining power, open international financial systems, significant private and public debt, just in time supply chains, ageing demographics, technology, Central Bank interventionist policies, to name but a few, make any comparison with other moments in history somewhat irrelevant. Forget the noise.

Investors should really focus on their own needs and their appetite for risk. As mentioned before, the present and future financial conditions point to many shades of grey. Which part of the risk spectrum does one want to sit on and why? …

In uncertain times, keep your options open

When driving through fog, one needs to keep one’s options open to slow down or accelerate if conditions were to change. This analogy is invariably the same for investors. Keeping one’s options open means allocating in a very diversified way. This can mean overweighting to cash in times of uncertainty. It can also mean allocating to defensive or less volatile assets, such as Fixed Income.  

Negative real rates are here to stay?

Regardless of the inflation dynamics, the present debt pool has reached proportions making it potentially unmanageable over the long run. If ever ‘real’ interest rates were to turn positive (Real Interest Rates = Nominal Interest Rates – Inflation) this destabilizing process would just be accelerated. Negative real rates are likely to continue, as they are part of the solution to maintain our current debt based monetary system functional. One has to account for this when allocating to Fixed Income assets.

Turning Japanese

The Japanese authorities have chosen to support their bond market, regardless of inflationary considerations or of a negative impact on their currency. Over the years, the demographics of this country’s ageing population have been coupled with an overhang of legacy debt. This backdrop makes any return to past interest rate market conditions difficult to envisage. In other terms, the Bank of Japan is too far down the ‘intervention’ road for it to step away without leading to disorderly Japanese asset markets.

The European Central Bank has also gone down the same ‘rabbit hole’ as their Japanese colleagues, in an effort to hold the Euro together. For its part, the Federal Reserve is looking to manage its way out of such interventionist policies.

One can see the potential for policy divergence between major Central Banks. In this context, the attractiveness of an international Fixed Income market would need to be looked at through the lens of its underlying currency. Capital will generally flow to seek the highest returns but also where it feels the ‘safest’. The Federal Reserve’s comparative discipline could end up favoring US Dollar debt assets amongst international investors.

Other Markers to follow

Low Coupon, Low Yield, Long Duration: a place not to go to?

The -40% collapse in the price of the 100year Euro denominated Austrian Government bond shows clearly the vulnerability of holding a low coupon, low yielding and long duration instrument. Investors have had to stomach a dramatic draw down, while being compensated by a meager 0.85% annualized coupon. One should remind holders of this instrument, its value could be worth half its current price if its yield was to rise from its present level to 3%. Over such a long investment period, the downside risk of holding such a bond is too high for comfort.

Rising interest rates: Reinvestment option and Floating rate bonds

The Reinvestment option is a way to hedge against an environment of rising interest rates. Through an allocation to short dated bonds, an investor can redeploy the coupons and the investment proceeds at the maturity of the instrument, thereby benefiting from any interest rate increase over the coming months or years.   

Floating rate bonds, as their name indicate, will adjust the coupon payment upwards in the case of an interest rate increase. These instruments offer another way to protect against rising interest rates.

The Fixed Income asset class can offer tactical investment solutions to address changing economic and financial conditions if one knows how and where to look and what to look for.

Originally Posted on April 7, 2022 – Bonds: The Good, The Bad & The Ugly

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