What the hell is going on in Fixed Income Portfolios?
By Yogen Mudgal, BSc Accounting and Finance Student at Warwick Business School
The early days of the pandemic were a bloodbath in the financial markets. In March, asset managers’ worst fears came to life as both equities and bonds came crashing down and experts around the world started questioning the relevance of the traditional 60/40 portfolio. “We have never seen anything like this” became the common theme when, almost immediately, April’s events in the oil market crushed investor sentiment. Suddenly, the pandemic took centre stage and continues to be the guiding factor in shaping the outlook for investors around the world.
However, for cross-asset strategists, the events from the spring shouldn’t have come as much of a surprise. Hedging strategies have been failing for a decade since 2008 and asset classes now tend to move in tandem. Long-short hedge funds are finding it impossible to short a market fuelled by stimulus; asset managers can no longer offer their clients protection through diversification and bonds come with little yield and fewer safeguards. While each of these themes should be explored, this article is only intended to look at the final point and consider how fixed income portfolios have evolved in the past few months.
Fixed income investors have been obsessed with talking about the lack of yield, why the job of heavy lifting is best left to equities and focusing on the protection bonds can offer. When the Fed finally began interest rates before Covid-19 devastated the economy, few were expecting a return to normalcy, and alas, that didn’t last. Bond prices had climbed so far high that it was almost inevitable that they couldn’t offer a hedge to a crashing stock market. And with no yields to fall back on, it seemed that at least investment grade fixed income bonds were becoming irrelevant.
Investors are already beginning to turn to macro hedge funds that invest in currencies and overseas assets to ensure constant returns through volatile periods. What is becoming clearer, however, is that the ways in which capital is managed on the fixed income end have also undergone a huge transformation. With no expectations of rate rises in the foreseeable future and gains in safe haven bonds already taken, investors have turned to risky and often creatively designed instruments that used to be tucked away to the fringes of the market before the financial crisis.
This was a subtle shift before 2020 but has practically exploded since. In recent days, asset managers have rushed to build hundreds of billions of dollars of capabilities in private debt, explored the idea of jumping into leveraged loans with fewer legal protections, increased capital allocation for distressed debt and bought into payment-in-kind bonds which don’t pay any interest until maturity. A recent article in Bloomberg explored how investors’ appetite for CAT bonds, preference share capital, royalties, whole-business securitisation, etc. is growing, fuelled by PE firms and capital market bankers issuing these instruments.
It is safe to say that fixed income investors have gone far beyond the (not so) high-yield bond market, chasing both interest and capital gains. The bounds of risk-taking have really been pushed in an effort to continue providing decent returns. If anything, the Fed’s strategy to try and push capital into more risky assets has worked. But it comes at a cost to those who hold fixed income assets with fewer legal protections and little upside compared to stocks. There is nothing inherently wrong with a riskier portfolio if it gives better returns, but perhaps then, the idea of fixed income being mostly risk-free needs to be rethought.
It is hardly surprising that in an era when businesses are already loaded with debt, bankers are having to find new and more creative ways to keep feeding the debt binge. It also makes sense that asset managers, faced with fewer good investment alternatives, are trashing every risk management lesson to stay relevant. However, it might be time to be clearer about the risks associated with fixed income post-GFC. The Nieman Marcus fiasco, where owners pocketed returns before debtholders is one of the best highlights that the new cult of debt investment funds needs to learn from.
Most of these riskier debt assets come from PE-owned companies, which themselves often have a significant private debt business. It has led to anomalies where buyout shops have been sued by other PE firms that extended debt to companies managed by the former. For restructuring advisors and bankruptcy lawyers, this is a new legal headache that needs to be dealt with. Most of these tactics would have worked well, had the virus not pushed businesses into bankruptcy; it goes to show how far the financial plumping of such companies has been stretched.
In conclusion, all there is to say is that the realms of fixed income investments have changed. It is quite possible that asset managers can now offer better returns with wholly new kinds of debt vehicles to be explored, but it definitely comes with risks attached. The power dynamics in the low-interest environment have radically changed and reading between the fine text is all the more important. Incredibly complex niches of the financial system are becoming mainstream, but that’s not to say that this is not uncharted territory for everyone: bankers, private equity groups and of course, lenders.
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