Sizing Up The Fixed Income Market by Colin J. Lundgren, CFA, ColumbiaManagement
- For the right sized asset manager, disruptions in the fixed income market can create short-term opportunities.
- Liquidity has deteriorated in recent years and can escalate when a mega manager needs to sell a large position.
- The case for exercising caution around interest rates is strong, but investors shouldn’t paint all bonds with the same brush.
Fixed income investors face some big challenges — low and potentially rising interest rates, poor liquidity and most recently, a shake-up at the top of the asset management world. The result has been increased uncertainty, volatility and downward pressure on asset prices. Several strategies can help mitigate these risks by focusing on the most attractive parts of the market such as corporate bonds, recognizing liquidity constraints posed by Wall Street and mega managers, and using market disruptions that do not have lasting effects as investment opportunities.
First, the case for exercising caution around interest rates is strong, but investors shouldn’t paint all bonds with the same brush. Fed policy makers appear set to conclude their large scale asset purchase program (quantitative easing) in October. Earlier this month, they increased their median forecast for the funds rates to 1.38% at the end of 2015, 2.88% by the end of 2016 and a “neutral level” of 3.75% by the end of 2017. But while government bonds appear mostly unattractive, corporate bonds still offer reasonable yield premiums with attractive credit fundamentals, moderate risk profiles and historically low default rates. Moreover, corporate bonds are an excellent sector for right sized, research driven firms to uncover value, assess risk and add value to client portfolios through security selection.
Another challenge for bond investors is liquidity — the ability and cost to transact. Liquidity has deteriorated in recent years as the industry experienced dramatic change since the financial crisis. On the sell side, there are fewer broker dealers — no Lehman, no Bear Stearns, no Wachovia, no Merrill. Firms still in business face higher capital requirements that reduce profitability and the incentive to carry large inventory of bonds, while traders are socked with punitive aged inventory charges for holding bonds too long. Finally, new regulations related to proprietary trading versus market making create another layer of uncertainty. The days of counting on Wall Street to help provide liquidity in the bond market are gone.
Changes in the asset management business also contributed to the decline in fixed income liquidity. Several bond managers experienced massive growth in assets under management, surging well in excess of $1 trillion. As a result, a small number of fixed income managers now oversee a large percentage of assets. Liquidity is usually less of an issue for managers who are buying, accumulating bonds, but more of a problem when managers need to sell. The problem escalates when one of the mega managers needs to sell a large position because of a strategy change or redemptions. The combination of fewer broker dealers and XXL asset managers can put significant downward pressure on individual bonds or entire sectors that are being liquidated. The important point is that reduced liquidity increases transaction costs and hinders alpha generation, especially in larger size. Buying into a mega-firm can hurt you on the way in, on an ongoing basis (more difficult to fully exploit security selection strategies), and on the way out.
Though no firms are immune to liquidity challenges, right sized asset managers — those large enough to have deep research resources, but not so large they can’t to be nimble and impactful — appear best positioned to weather liquidity storms. In fact, last week’s market dislocations driven by concerns related to one of the mega managers, may be creating some investment opportunities for long-term investors who can selectively buy at cheaper prices in investment-grade corporates, high yield, mortgages and asset backeds.
The bond market’s concerns of the last few weeks are noteworthy — and mostly justified — but should also be viewed as an opportunity to reflect on portfolio strategy, liquidity risk and firm risk. Sized for success at this stage of the cycle should mean moderate size positions and capacity sensitive asset managers. The risks of going big and being wrong have never felt greater.