Fixed Income & Credit – Opportunities and Challenges for the Year Ahead
Jan 19, 2022
As we turn the page into 2022, the first Hubbis Digital Dialogue of the year concentrated on the continuing search by private clients for yield across the world of fixed income and credit. Our panel of experts analysed where interest rates are heading, where there is the best alignment of returns, stability and liquidity, and how private clients should approach the opportunities that might lie ahead, such as allocating more to DPM mandates, investing more through ETFs as well as traditional active funds. And they discussed where the world of ESG aligns neatly with these fixed income strategies and approaches to tick more of the boxes that investors want to pursue today so that the search for yield, security and liquidity is also a search for transparency and sustainability. The panel discussed which regions, which countries and which segments are most appealing, and why, whether investors should increase allocations to sovereign debt, or credit, or to high yield, whether the world of EM fixed income appeals, and whether China is increasingly in their sights, or far less so since the Evergrande crisis. They scrutinised how wealthy private investors should slice and dice their fixed income portfolios, for example, whether they align with the indices or whether as private clients they are better off pursuing an entirely different portfolio curation to the global institutional investor community, which of course is driven more by indexing, weightings and benchmarks. Underling all their predictions, the panel painted a picture of the backdrop of economic momentum, or the lack of it, rising (and potentially sustained) inflation, the winding back of the G7 QE tsunami towards ‘normalisation’, and how different regions of the world will react.
- Maximilian Hoenigsmann, Managing Partner, Corecam Capital Partners
- Stephen Fisher, Principal & Chief Investment Officer, First Degree Global Asset Management
- Tariq Dennison, Wealth Manager, US-Asia, GFM Asset Management
- Frederick Chu, Head of ETF Business, Executive Director - Asset Management, Haitong International Asset Management
- Anson Chow, Institutional Sales & Trading, Jane Street
These are some of the questions the panel addressed:
- What is happening to interest rates, inflation and fixed income yields globally, why and what is the outlook?
- What might potentially rising/higher interest rates mean for the fixed income and credit markets?
- Within their fixed income portfolios, how should private clients be allocating amongst sovereign, credit, high yield, and how should they split between developed market or EM paper?
- What about private debt paper? Is there a compelling equation for locking up money for longer periods in order to bypass volatility and gain enhanced returns?
- What role should leverage play in Asia’s HNW and UHNW fixed income portfolios in the anticipated environment ahead?
- What is the trade-off between short-term and longer-dated paper in the fixed income markets?
- Has the popularity of fixed income ETFs been growing significantly globally? What is the landscape in Asia in comparison to Europe and the US?
- Institutional investors increasingly use fixed-income ETFs in portfolio construction, and what are the main reasons?
- How are fixed-income ETFs being constructed? Full replication vs sampling?
- How can Asian investors trade fixed income ETFs, and is there sufficient liquidity?
- Are fixed income ETFs suitable for HNW and UHNW investment portfolios?
- Can ESG help optimise the risk-reward profile?
- What are the several avenues of ETF trading and how institutional clients approach this, apart from the traditional route of trading on screen?
- Does Asia high yield offer appeal currently, and if so, why and where?
The Key Insights & Observations
Debunking the ‘boring’ headline for fixed income, an expert predicted 2022 will be an interesting year to watch
“Fixed income is usually supposed to be boring, but I don't think 2022 is going to be a boring year in fixed income,” said one expert on opening the discussion. “For example, negative inflation-adjusted 1.5% yields on five-year US Treasuries mean the market clearly does not think that inflation is a certainty. No one would pay 1.5% just to be in bonds unless they thought there was a real risk of deflation or disinflation. We actually think 4% inflation for the next several years is quite likely, and we don’t see rampant inflation, we don’t see deflation. If you don't expect deflation, there's really no reason to buy bonds, or there's very, very little reason to buy bonds.”
He explained that Japan had been struggling with deflation for several decades. “What's going to make the developed markets look probably more like Japan than like the US in the 1970s is population pyramids,” he observed.
“Don't forget,” he extrapolated, “that in the 1970s, when we had inflation, we still had population pyramids that looked like this, with lots and lots of young people, we had relatively few old people, not a lot of pensioners. The big difference now, which is why I don't see inflation going quite as high as some people fear, is that we have way too many old people and not enough young people. And that tends to keep interest rates low, which tends to keep inflation low. Now by low, what I mean is it might pop up to around 4%. But I don't think we're going to see double-digit inflation, or at least there's a lot of weight keeping that inflation rate and those interest rates down. All-in-all, at negative 1.5%, I'm not jumping into buying bonds or allocating for bonds in most portfolios. Some might argue every portfolio does need to have some fixed income, but I disagree, and since March 2020, we've had a record number of accounts that have 0% fixed income exposure.”
Expert Opinion - Tariq Dennison, Wealth Manager, US-Asia, GFM Asset Management: “You can see -1.5% (negative) real 5-year Treasury yields as either a high premium the market is paying for safety or that the market sees the risk of deflation and further rate declines as very likely.”
Views are split, and while some might advise avoiding or downsizing fixed income, others firmly believe there are still plenty of sensible reasons to buy bonds
The same expert then remarked that there are still core reasons for fixed income in portfolios. Firstly, they mature at a specific date, and you can be entirely, or at least very sure of the amount to be repaid, unlike equities or real estate, which could be up but could also be down. “For many investors, even if the yield is zero or close to zero, that's really just a way of managing the liquidity portion of the portfolio or the defined portion of the portfolio,” he commented.
Secondly, he explained that fixed income is a counterweight against equity or other risk assets. “It's effectively your risk-off asset,” he said. “When stocks go down, when everything else goes down, fixed income is the asset class that's supposed to go up, or at least that's how we've looked at it for the past 40 years. However, since the COVID crash, I no longer believe bonds will provide that function very well, and the typical 60-40 portfolio only makes sense if stocks and bonds move in opposite directions. If we're looking at a scenario where inflation might be bearish for both stocks and bonds, as it was in the early 1970s in the US, and this is a scenario we're considering, you can’t then expect bonds to be bailing out your stocks. But that is what the fixed income ETF market has been developed for so rapidly.”
And the third reason to include fixed income in your portfolio is it can provide sources of returns that you can't get from other sources, he explained. “For example, if you want to bet that Ukraine is not going to default, that their credit spread is wide, you can get a high premium on that paper. You can't buy shares in Ukraine. That is actually where I'd like to see more developments in the ETF market, to access more obscure parts of the credit market, for example, I would love to see access to private Indian credit.”
He reiterated the view that every portfolio should have some fixed income. “I rather think that potentially this market will give us another two to three years of bullish sentiment, at least on equity markets or markets in general, and that we will also avoid any kind of massive carnage in fixed income.”
Yields remain unattractive in the public market, but there are more and more good reasons to venture into private fixed income
Another guest observed that with yields in general not too attractive, and that while there are nevertheless reasons to keep fixed-income ETFs in any globally diversified portfolio, his firm had in recent years moved into more private credit type of deals and structures to substitute some high yield exposure and obtain more yield from debt, with lower LTVs. He said they prefer asset-backed debt in the developed markets over corporate paper. “In Europe, for example, we like Spain, on the direct lending side. We like, of course, the US as well, because the market is just so deep, and you have a very wide variety of different strategies and asset classes you can choose from. In Asia, we like Singapore to a certain extent because it's our home market, and also Australia.”
The same expert commented that as ETFs are also ideal instruments to create diversification, they should be part of any larger portfolio. “They're efficient, and give you a broad access, and we use them a lot of ETFs. But he said that private debt offers lower risk, especially with low LTV deals, and with asset-backed structures. “To give you an example, at the moment, we are quite active in Spain, we have been active there over the last three years on the lending side, we take senior lending on to real estate developers, with first-rank LTVs of 50% to 55%, sometimes 60%. And due to regulatory imbalances in Spain, where the regulator is forcing the banks out of the real estate market, we generate 13% to 15%, annual coupon which sounds super high, which is super high and Spain is in the EU and offers great safety with a lot of equity as a cushion. In the worst-case scenario, you could end up owning land at 50% of current values, which is a very comfortable position, although that has never happened, they are all paying up properly.”
He explained that they see similar appeals in Australia, which he described as a fantastic deep lending market, albeit with lower yields of 6% to 8% roughly. “That is still very appealing, and you can have very good asset protection in comparison to some other high yield bonds out there. However, you must be careful where you are in the capital structure.”
Another expert agreed that these private debt markets had become both increasingly popular and more institutionalised. “The yields have grown (as have expected returns) relative to Treasuries,” he told delegates. “There are several reasons for this, but one notable reason is the withdrawal of banks from traditional lending channels such as mortgages. For instance, many Central Banks have either explicitly forbidden or implicitly discouraged banks from lending to foreign property investors. Shadow intermediaries have stepped in to offer loans at SONIA+300/400 and structure lending facilities offering mezzanine debt at SONIA+ 550/600. The inability to pledge real estate assets (effectively credit rationing) has also pushed private borrowers into private markets where equity securities are pledged at rates topping 15 to 20%.”
Expert Opinion - Tariq Dennison, Wealth Manager, US-Asia, GFM Asset Management: “The lack of liquidity in private debt, or illiquid public debt for that matter, is an illusion - any illiquid credit should be evaluated on its own merits, to maturity.”
For those that want broad exposure to global fixed income, ETFs offer liquidity and diversity
An expert observed that liquidity is a significant advantage offered by fixed income ETFs, something that had been very well-proven, especially since the March 2020 crash.
“Many people before then were saying that ETFs might not be able to survive a crash, or they might cause the next crash, but at that time we saw many fixed income ETFs were far more liquid than any of the individual bonds inside of those fixed income ETFs,” he reported. “That is not the case with all fixed income ETFs, and indeed for some types of ETFs access is more important than liquidity, for gaining exposures to some more unique paper. But in general, for private clients, being able to simply buy smaller denominations of fixed income ETFs, knowing that you're going to get the right price because it's listed on an exchange, getting daily NAVs, it is all highly convenient. ETFs are all about packaging, with liquidity an important part of that package, but sometimes other things like access and tax efficiency are important parts of that package.”
Expert Opinion - Tariq Dennison, Wealth Manager, US-Asia, GFM Asset Management: “Fixed income ETFs continue to serve traders and allocators, but not bond investors who like to build ladders of bonds held to maturity. It would be great to see a rise of fixed maturity bond ETFs in the UCITS or Asia-native markets as we’ve seen with BulletShares and iBonds in the US market.”
Extolling the appeals of ETFs, a panellist observed that the most important feature of ETFs is the ease of diversification, with the ability to rapidly tilt according to positive or negative news and trends. He pointed to the September listing of an Asian High Yield ETF on the London Stock Exchange that provides exposure to the breadth of the Asian high yield markets, including China high yield and China property, but for risk management purposes with carefully managed caps on such sectoral exposures, important in light of the events in China since that time.
“With regards to ETFs more broadly,” he reported, “we are picking up our participation, to really beef up on this asset class, in line with the global trends, and also due to internal synergies in our business.”
Expert Opinion - Stephen Fisher, Principal & Chief Investment Officer, First Degree Global Asset Management: “I have been using fixed-income ETFs for macro-trades since March 2009, when I first bought the JNK fund. That was the depth of the global financial crisis when High Yield bond yields were touching 20% on average. JNK was a 'new' ETF with less than USD100m in AUM, and the trader I was using was reluctant to take my order for USD1m. Now JNK is over USD9 billion in AUM.”
ETFs are an increasingly useful and efficient vehicle for playing fixed income in today’s markets
“We use ETFs for strategic exposure to portfolios that have public market investments as well as to make tactical macro trades,” another guest reported. “In fixed income in particular, many of the individual components have very similar characteristics; hence rather than try to buy individual bonds, we prefer to buy the ETF which behaves very similarly to each individual security, except it doesn't have that concentration risk. I've been using ETFs for macro trades for many, many years. And now, we look at tactical trades and assess the relative risk premia offered by one ETF over another. In the current environment where you have government bonds that say, five-year duration maybe less than 1%, but you have five-year high yield Asian bonds or less offering 10% to 12%, the risk premium for that trade is very attractive. So, typically we take credit exposure through ETFs rather than any other form, whereas for government exposure, we might use futures or some of the other instruments. But credit, generally speaking, is something we'd like to diversify across and make that macro trade.”
The heightened use of ETFs in Asia is driven by global and regional factors and is a snowball effect
The same expert observed that investors increasingly seek diversification at the country level, regional level and globally and within those geographical parameters within sectors as well. He explained that as most of the fixed income ETFs are actually constructed on a sampling basis, that provides an additional layer of flexibility towards the underlying baskets. He explained that ETFs could be rebalanced regularly to add or subtract names when the pricing indicates. “For equity ETFs, you have no way out, otherwise you're sacrificing the tracking error, but for fixed income, the difference is we can still use portfolio optimisation to complete the portfolio constructions over rebalancing or position openings to match with the tracking quality of the entire basket.”
Secondly, he said another advantage is the flexibility of ETFs in being able to access secondary market trading. “A lot of people talk about liquidity, and in fact, people should look at the underlying liquidity of an ETF rather than just looking at the secondary market,” he advised. “The total market cap of the underlying constituents of an ETF is the true liquidity of that ETF, so if you're running a USD10 billion plus ETF, that compares to the entire total market cap of the underlying, that only presents a very small portion of that, and to access that liquidity, that is where firms that are liquidity providers come into play as that they provide at the level of the primary market, to facilitate the trading and let the investors access the hidden liquidity of that ETF.”
Accordingly, he concluded that institutional investors, especially within Asia-Pacific, have been greatly improving their understanding of how to use ETFs in general for both diversification and flexibility.
Asia’s ETF market has become more institutional and higher quality over the years, especially since 2020
Another guest highlighted the diversity as well as increasingly competition amongst the ETFs available in Asia (he is based in Hong Kong), and noted that his firm provides liquidity for investors in the market, making their investments smoother and more cost-efficient.
“We agree that the tactical nature of ETFs is really one of the key motivators that stimulates a lot of institutional client interest, so being able to gain exposure rapidly to a large basket of bonds, or a large basket of equities, is highly convenient. Avoiding the need to look into all the details of each stock or asset and basically go passive and choose a benchmark to get exposure into is very valuable. We expect significant growth ahead for ETFs in Asia.
He explained that in the past five years roughly, and in particular since 2020, there had been far more institutional usage of ETFs, whereas before it was considered more retail in Asia.
“We see more insurance companies, more family offices, some of the sovereign wealth funds, in fact quite a large range of clients, who use ETFs more as part of their toolkits. They like ETFs as they can basically execute anytime of the day. Five or 10 years ago, clients used to wait until the US opens to trade US ETFs, but now for ETFs with all types of exposures, they can trade at any time from Asia. So we see more sophistication from the institutional clients, and we see more private bank clients, for example EAMs, coming through. And as we see ETFs getting very commoditised, the fees are going lower and lower., and they are paying more attention to the cost of trading, as well.”
The OTC market for ETFs also provides much liquidity that might not be visible on-screen
Another expert also pointed to many ETFs available globally, and in particular in the European market, where the AUM is large, but the onscreen turnover is very small. “I am often asked what is wrong with those ETFs,” he said, “and why AUM is continuing to grow whilst turnover is still very low, some clients might even have the wrong impression that these are like penny stocks that don't trade that much, but the answer is, in fact, OTC trading, so beyond what you can see on-screen there is a bigger picture of active OTC trading.” He said that while people might think they need to play with millions of dollars in order to access that liquidity, but the growing activities in liquidity provision services by market makers, by banks, and by a wide spectrum of the industry is allowing access to more and more investors OTC.
He explained that there is a general increase in awareness that it's actually not that difficult to execute liquidity across the various ETFs, even if optically they do not appear to be liquid looking at the on-screen trades.
The right duration and risk strategies are essential to robust performance
As the discussion drew to a close, a panellist explained that their model had outperformed the index by 3% to 4% consistently for over a decade, in fact for nine years out of 10. “And the model is still predicting that you should be overweight duration, and the model is simultaneously saying take credit risk,” he told delegates. “So, whereas the yield disadvantage in government bonds has become kind of marginal, you can pick up 5% or 10%, even additional yield for the same level of interest rate risk in the credit market. I wouldn't underestimate the bid from sovereign wealth funds and those other investors that look to government markets, and that pushing the rest of us into the credit markets. Accordingly, credit ETFs will become useful in that respect because they have diversified exposure to credit. For example, I'm not smart enough to tell you which property developer in China you should buy and you should not, but I am smart enough to tell you that they are pretty cheap as a group, and certainly cheaper than US treasuries.”
Another guest disagreed, arguing that yields on lower rated credit are too low
Still playing the avoid fixed income card, another expert offered the polar opposite perspective, reporting that even all the way down on the credit curve to BBB names, they yield only about 100 basis points over Treasuries in the US market. “To me that is a horrible risk premium, you are really not getting paid a heck of a lot to take that risk.”
He did however comment that with the types of returns available in private debt could be captured in ETF, clients would love to see that. “When is someone going to launch an ETF tracking that as well, because obviously clients would love to have 15% with very, very low risk, even though if you say the type of risk that you're taking is liquidity risk.”
The final word – Asian high yield beckons, and that means playing the policy-supported Chinese property sector where some see significant value
The final comment went to a guest who highlighted Asian high yield. “Within that, some 45% comes from China high yield and the China property sector,” he said. “It is cheap, and relatively attractive at this point of time. This whole sector accounts for 25% of the country's GDP, so policy support will be there. With the current level of valuations, it's definitely going to be a value trade.”