Multisector Matters: Volatility Means Mispriced Bond Opportunity
Flexibility to go where the potential opportunities are in today’s fixed income markets
For a closer look at how a veteran fixed income team with a flexible, multisector approach thinks about security selection opportunities in a tightening cycle, Loomis, Sayles & Company’s Elaine Stokes, EVP, Co-Head & Portfolio Manager, Full Discretion Team, shares her team’s philosophy and market insight today.
In a challenging environment for fixed income – with the successive shocks of the pandemic, a spike in inflation and the war in Ukraine signaling a global shift – we do not want to be boxed in by an index.
Despite the challenges of higher expected volatility and a greater risk of a downturn scenario, we think now is a time for investors to be discerning, not discouraged. During our decades as bond investors, we have consistently observed that the market is inefficient at pricing specific risk. Even a market like the one we are in today can offer opportunities to take security-specific risk.
We rely on two core philosophies to guide our go-anywhere style and help us capitalize on corporate credit mispricing and drive excess return potential.
Multisector Investment Approach
We believe these two core philosophies differentiate and define our multisector approach to investing:
- Determine Enterprise Value: We take an equity-like view of company valuations by focusing on long-term enterprise value and identifying risks to that value. This foundation gives us the conviction to take contrarian positions.
- Build In Convexity: We seek bonds that we believe can offer call protection and price appreciation potential. These bonds tend to have positive convexity, which can help maximize yield and total return potential while minimizing downside risks.
We also incorporate six pillars of security selection. Through fundamental research and active management, we seek to capture risk premiums that other investors may be unable or unwilling to access.
Where Are We Today?
Investing with a cycle-based approach helps inform our understanding of which sectors could be coming in and out of favor. The majority of our alpha-generating ideas are derived by layering the top-down view with our bottom-up research analysis. With this in mind, our first step in identifying opportunities starts with a view of market fundamentals and where we are in the credit cycle.
We believe that we are currently in a late cycle environment with higher levels of inflation. Inflationary pressures could continue with higher expectations for commodity prices and persistent supply issues, along with a tight labor market. Despite a solid earnings backdrop, we expect recession concerns to increase. We believe that corporate fundamentals remain on solid footing. Easier monetary policy and economic reopening have contributed to the recovery and strengthening of corporate balance sheets over the last two years. We expect corporate earnings to remain reasonably strong over the intermediate term with low rates of defaults and low losses from ratings downgrades.
The first quarter of 2022 saw elevated market volatility. Spreads have widened but not dramatically. Yields on corporate credit have risen, mostly as a result of anticipated Fed actions. The volatility and spread widening has largely been orderly, in our opinion. There has been little evidence of forced selling outside of the sectors most directly impacted by the war in Ukraine.
Going Where Potential Opportunities Are
In the long run, higher yield levels can be a potential source of return for fixed income investors, as can wider spread levels. While we remain cautious, we continue to focus on seeking to deliver higher levels of income and total return potential over time. Given our concerns on inflation and expectation that interest rates will move higher, we remain defensive on interest rate risk and continue to have our portfolios positioned with a relatively short duration stance. We have used the more recent flattening of the yield curve as an opportunity to shorten the maturity profile in some of our higher conviction issuers, which helps to reduce interest rate risk without sacrificing yield. We have also modestly dampened credit risk and improved the liquidity profile in our portfolios, increasing the level of reserve-like, higher quality instruments that can offer flexibility. We expect heightened volatility and uncertainty to continue as we move through the Fed tightening cycle, which could help drive future opportunities for investors.
High Yield: With absolute yields around 7%, the name “high yield” seems like a misnomer. Currently, this sector still can offer some of the highest yields in the world. When spreads are tight, investors should ask if they are being paid for the credit risk they’re taking. We see low expected losses for high yield in 2022. Also, we expect increased dispersion in the HY market as volatility increases with the Fed’s tightening actions, which could help create opportunities to add individual bonds at favorable prices.
Companies have two essential ingredients: liquidity and time. We are currently in the later stages of the expansion phase of the credit cycle, and corporate fundamentals continue to remain strong. Supply has calmed down. There are not as many bonds coming to the market as there are people who want to buy them. Late cycle expansions can be protracted, so we think we have time in the high yield market. Overall, we believe high yield credit is well positioned for rising rates given strong yield per unit of duration. Credits with the ability to pass through rising input costs and defend margins should fare well.
Securitized: Given its favorable carry and low duration characteristics, securitized credit has an attractive risk/reward profile relative to other asset classes. Consumer ABS (Asset-Backed Securities) fundamentals have been stable so far in 2022 as consumers transition away from a stimulus-driven economy to a self-sustaining expansion. While growth is expected to slow toward its long-term average, inflation could remain stickier and be a burden (especially for the subprime consumer); however, the employment picture, which is the largest driver of collateral performance, remains strong.
Un-box Your Portfolio
For more than 40 years, we’ve been honing our multisector skills and applying our distinctive style of bond picking to help deliver solutions for our clients. We are passionate investors, dedicated to providing excess yield potential and low correlations to traditional benchmark-focused fixed income strategies. We believe having the flexibility to diversify away from broad-market risks, coupled with the deep research and experience to uncover potential opportunities, is key.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.
This material is provided for informational purposes only and should not be construed as investment advice. The analysis and opinion expressed represent the subjective views of Elaine Stokes as of April 2022 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted. Actual results may vary.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Credit risk is the risk that the issuer of a fixed income security may fail to make timely payments of interest or principal or to otherwise honor its obligations.
Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
High yield fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.
A yield curve represents the different interest rates that are paid to people who own bonds by each of the U.S. Treasuries.
The yield spread is the difference in the expected rate of return between two investments.
Bond duration measures the change in a bond's price when interest rates fluctuate. Convexity builds on the concept of duration by measuring the sensitivity of the duration of a bond as yields change. If a bond's duration rises and yields fall, the bond is said to have positive convexity. In other words, as yields fall, bond prices rise by a greater rate – or duration – than if yields rose.
Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.
Securitization describes the process of pooling financial assets and turning them into tradable securities.
Alpha is a measure of the difference between a portfolio’s actual returns and its expected performance, given its level of systemic market risk.