If investors believe fixed income is a defensive allocation, then they should probably stick to just Australian and US government bonds, according to a Willis Towers Watson consultant.
Institutional investors have been reviewing the role of fixed income in their portfolios, as many credit-heavy strategies failed to protect them from the turmoil experienced during the March quarter of this year.
It turns out that good old government bonds were the only assets that provided relief when equity markets fell sharply in March.
“We would agree that the role of fixed income in a multi-asset portfolio is defensiveness and what I mean by defensiveness is that we would hope that it would deliver a capital gain when risk assets fall,” Simon James, Head of Australian Credit with Willis Towers Watson, says in an interview with [i3] Insights.
“I think it is more than just something that is capital stable. The real benefit comes from giving some offsetting return in an environment that is bad for growth assets.
“What really set investors apart in this latest period is whether their fixed income allocation was true to label. How defensive was it and how liquid was it? Investors who got that right and didn’t get lured into the late cycle urges of pushing harder and harder into credit and into illiquidity, they fared well,” he says.
With bond yields at record lows, a number of institutional investors have been searching for strategies that diversify from equities, but provide a better return than sovereign bonds. Under the crisis risk offset model, investors looked at trend following, global macro and volatility selling strategies as a way to diversify, in addition to their traditional bond holdings.
We would encourage fixed income allocations to focus on high quality, sovereign exposures, almost exclusively, because it plays those [defensive] roles. For investors that can go one step further..., I would reduce the universe to probably just Australian and US treasuries.
But the experience during the month of March has been mixed, as there has been a great dispersion between the individual managers in these various strategies.
Yet, sovereign bonds held up consistently well during this time.
“What are some of the lessons learned? Sovereigns worked well,” James says. “We would encourage fixed income allocations to focus on high quality, sovereign exposures, almost exclusively, because it plays those [defensive] roles.
“For investors that can go one step further – these are probably larger funds who can access those allocations through bespoke mandates – I would reduce the universe to probably just Australian and US treasuries.
“You are looking for countries that are high quality and that still have some yield, albeit much lower than we are used to. But an Australian 10-year government bond is a lot different than core Europe or Japan.
“Fixed income is a hedging tool, a downside tool, so you shouldn’t try to eke out that little bit of extra return here and diminish the defensiveness,” he says.
But not everyone had a sizable allocation to sovereign bonds, as in the years leading up to the crisis investors took on increasingly more credit exposures.
“There are two common pitfalls, I think, which investors employ in this space,” James says. “One is the use of global aggregate bond indices as a benchmark in the global space.
“If you look back at pre-GFC days, the global agg was the standard way of accessing global fixed income. But it was clearly shown to be suboptimal during the GFC, from a performance and liquidity perspective,” he says.
One of the main problems with the global aggregate bond index is that almost half of the assets in the index are credit assets, which do little in terms of providing defensiveness.
“Many investors have moved on from using the global aggregate bond index as a benchmark, but it does continue to surprise me, as I look across the investor universe, that there are plenty of investors who are stuck in that old way of thinking.
“They certainly felt more pain in Q1 this year with the non-government pieces of global agg not playing that defensive role.
“What has exacerbated that is that global agg managers have a tendency to run structural overweights to credit risk.
“They also tend to be permitted an off-benchmark allocation, so they tend to hold high yield, emerging markets, the higher credit risk pieces, so when you combine those things, the benchmark is only 50 per cent defensive plus the managers’ behaviour and you end up with something that is very different to what the role of fixed income is and what the desired characteristics are,” he says.
Pandemic and Defaults
The role of a core allocation to fixed income is defensiveness, but the current environment also lends itself to opportunities in more aggressive, return-seeking fixed income strategies, taking advantage of stressed pricing.
Clearly, these strategies should never be thought of as defensive, James says.
“The returns that we are expecting are in the mid-teens, net of fees, so there is obviously a level or risk attached to such a number. So you do need to think of this as a mid to high risk part of the portfolio,” he says.
“It should sit alongside asset classes with similar risks; it does not sit anywhere near a defensive fixed income portfolio. These are closed-end funds, so you need a tolerance for illiquidity too.
“But once you get over some of those hurdles, from a risk/return, liquidity perspective, there is an appetite, I think. We have seen that in our client base and from a global perspective there has been an enormous demand, even in the last month,” he says.
Opportunities can especially be found in the US, where corporates have accumulated record high levels of debt, James says.
Companies that can borrow, are borrowing, I guess in an effort to cash up to weather the storm. We think those leverage levels were excessive before this, and they are only getting worse, so for us it is only a matter of time before that comes home to roost
“US corporates are already at levels that we have seen in the run up to the GFC and on many metrics, they are at historic [record] levels. And we are only seeing that leverage increase, even throughout Q1,” he says.
“Companies that can borrow, are borrowing, I guess in an effort to cash up to weather the storm. We think those leverage levels were excessive before this, and they are only getting worse, so for us it is only a matter of time before that comes home to roost.
“It is also the reason why, leading up to this, we have been quite cautious on high yield and bank loan exposures,” he says.
James says we shouldn’t underestimate the impact this pandemic has on companies and the economy more broadly. The depth of the recession is likely to be much worse than the global financial crisis.
“It is helpful to look at the aftermath of the GFC and I think what we will see is that this is going to be a true recession with a deeper impact than 2008,” he says. “The GFC was more of a systemic crisis. It certainly spilled over into the real economy, but it had its origin in financial markets.
“Once those systemic issues were addressed, and of course we saw an enormous amount of stimulus, many of those distressed situations snapped back quite quickly. It didn’t actually enter into a wave of bankruptcies and defaults.
“Yes, we saw a spike in 2009, but then it went back to normal levels,” he says.
It is, therefore, puzzling to see that equity markets have held up well. After the steep drops in March, many equity markets are now nearly back at the levels seen at the start of the year, some of the highest levels on record.
“Maybe equity markets are factoring in the experience during the GFC, where there were limited defaults, but we have already seen a wave of bankruptcies in the corporate space in the US and Virgin Airlines here in Australia.
“Yes, the policy response has been very significant, which offers some sort of relief. But there is so much uncertainty about what topline revenues will look like in the new world. I just don’t think it will solve the insolvency problem; businesses are already overextended. The failures will come through,” James says.
A Broader Universe
Institutional investors are generally focused on corporate debt in these return-seeking strategies, but James argues that there is a much broader universe to choose from.
“Corporate Credit is arguably the least diversifying to your portfolio and the least useful, particularly from an Australian portfolio perspective, where equities tend to be the dominant risk,” he says. “Yes, you are adding a different part of the capital stack, but at the end of the day the health of corporates drives both credit and equities.
“We think the credit space is broader than just the corporate debt side. It includes things like access to the consumer balance sheet. You can access this via securitised or structured credit, that is not an exposure that many investors currently have in the portfolio.
“It is also one of the pockets, where the policymakers and the US Federal Reserve haven’t offered direct support yet, so their pricing is still at quite distressed prices, whereas we have seen some retracement in high yield and bank loans following the Fed support,” he says.
Another area of interest is the so-called ‘fallen angels’, bonds that previously rated investment grade but which during the pandemic have been re-rated to junk bond status due to the financial struggle they are facing.
“Essentially, you are buying into the corporate risk, but you are also taking advantage of that wave of downgrades that we are expecting to see in the coming years. We’ve already seen a wave of that thus far. I think it is the fastest wave of downgrades, faster even than during the GFC.
“The third opportunity that we see is distressed debt, as a way of taking advantage of that wave of bankruptcies and restructurings that we expect to see as the economic effect of COVID-19 goes through the system,” he says.
Not all strategies will be a good match for institutional investors, particularly when considering the social impacts of some of these distressed strategies. Funds with comprehensive environmental, social and corporate governance (ESG) policies might choose not to invest in the more predatory strategies in this field.
It is something that has caused much debate within Willis Towers Watson, and rightfully so, James says.
There are various flavours to distressed debt, and where we think there is the most potential for ESG conflicts is in ‘loan-to-own’. This is where the manager is essentially lending to a company late stage, the company is already deeply distressed, because you want to get in and own that company
“There are various flavours to distressed debt, and where we think there is the most potential for ESG conflicts is in ‘loan-to-own’. This is where the manager is essentially lending to a company late stage, the company is already deeply distressed, because you want to get in and own that company.
“You get in at the last minute, get into the bankruptcy proceedings, you are on the credit committees, and your goal is to own the reorganisation equity on the other side. That clearly has significant ESG implications, because your strategy is very likely to mean cost-cutting, significant restructuring of businesses and, therefore, implications for the workforce.
“Where we are focused is not so much on that but more on the corporate piece of distressed debt, where the goal is acquiring tradable securities that have been beaten down in price, but where there is the belief that the company is fundamentally strong enough to weather the period. You are actually trying to see it recover.
“ESG considerations are a key part of our manager due diligence in any asset class, but on this one, that headline risk, reputational risk, and the direct impact on the social side, that took up a lot of airplay.
“And it is good that asset owners think about these things, because it should be one of the first questions to ask,” says.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.