CIO views: seizing policy-driven opportunities

Asia and EM fixed income: financing a crisis

The Fed’s plans of extensive liquidity injection into US credit markets, along with efforts by Asian and emerging central banks, have allowed primary market issuances to reopen. This is allowing emerging market (EM) sovereigns to tap the global USD bond markets to finance their large and ballooning fiscal deficits for 2020, as governments take centre stage to stabilise growth until the private sector can return to the fore.

Market expectations for EM sovereign hard-currency issuance have increased to between USD230bn to USD250bn for 2020, compared to around USD130bn pre-COVID. So far, within sovereign investment grade (IG), countries such as Abu Dhabi, Qatar, Saudi Arabia, Israel, Indonesia, Philippines, Mexico, Peru and Chile have raised billions of debt. Israel raised more debt since March than the entire stock of its outstanding USD bonds. Within high yield, we have started to see the market reopening with Bahrain’s successful launch of USD 2 billion sovereign bonds last week. A significant part of this debt, given the unexpected large volumes, come with attractive net new issuance premium which investors can enjoy. 

Such positive price action has spilt into non-developed credit markets. Higher quality Asian markets have been first to reopen primary markets, namely China, Hong Kong, Korea and Singapore. We are now starting to witness Indonesian banks and quasi-sovereigns tap the market at concessionary levels, and expect others such as India, Gulf Cooperation Council and Latin America corporate IG markets to follow suit soon. This is likely to lead to some reversal of underperformance of EM vs DM credit in the short-term, although the next policy action required is for central banks to aid in the unclogging of non-performing assets from lenders’ balance sheets. We believe bad banks should be set up for this, thus creating truly functional and independent credit transmission channels - the next step needed, especially in emerging markets.

Convertibles: a valuations boost

Sometimes it’s better to be out than in. Convertible bonds are not included in central bank purchases of corporate credit. Their omission has dislocated valuations, meaning convertibles offer investors more generous returns than straight corporate debt. 

Indeed, large pockets of the convertible bond market now reward investors with significant carry and a severely discounted option. In many cases, the yield on the convertible is higher than the yield on the equivalent straight debt from the same issuer. We see this price mismatch (and clear investment opportunity) as partly caused by central bank intervention.

In addition, we see the optionality within convertibles as cheap at present (particularly when comparing implied volatility and recent realised equity volatility). It is important to remember that the optionality of convertibles is long-dated, and thus gives longer-term exposure to a recovery of the underlying shares.

Finally, investors should note that unlike straight credit, convertible bonds are issued predominantly by growth companies with low levels of leverage. Technology, healthcare, industrials and consumer cyclicals dominate convertible bond issuance. There is very little exposure to energy, financials or other highly leveraged sectors.

Equities: infusions create little value

Central bank intervention is now underpinning many challenged businesses, in particular those most exposed to the brutal stop in activity from containment measures. 

Boeing¹ is a good example. In mid-March, the company sought Federal assistance in the form of loan guarantees. Eventually, thanks to the Federal Reserve and US government action, the company raised a mammoth USD25bn bond offering, just one month after it had fully drawn down its USD13.8bn credit agreement.

Generally, such liquidity infusions serve political purposes for strategic industries and encourage employment. Similar action has taken place across many industries from airlines to auto manufacturers. These capital infusions, however, create little value for equity investors because such support alters competitive positioning between companies.

In a world of lower growth, focusing on structural trends and sustainability challenges is a better way to capture growth opportunities, in our opinion. FinTech (financial technology), as well as climate transition strategies serve as examples in this context. 

We believe equity investors should focus on the ability of companies to capture such trends while generating structural excess returns with strong, so-called “economic moats”. This ethos is at the heart of our investment process.

Multi-asset: diversifying within and from sovereign debt

Central bank intervention in bond markets has been on a monumental scale since the global financial crisis, resulting in a fall of global yields. This has led market participants to question the usefulness of sovereign debt in multi-asset portfolios, both from the perspective of a less attractive risk-return tradeoff, and of diminishing decorrelation benefits.

On the other hand, sovereign debt has proved surprisingly resilient in recent equity shocks, having moved in opposite direction to equity markets two days out of three this year. Nonetheless, the extent of the protection is potentially weaker, given rates have less room to go – the World Government Bond Index is up 4.3% this year vs 8.7% in 2008. 

All in all, as a systematic investor, our response to these challenges is to continue to ensure meaningful diversification. We look to diversify across regions in sovereign baskets, to diversify risks across asset classes, to expand sources of returns by adding alternative risk premia. Even traditional safe havens are no exception – (long) volatility has turned out to be a worthwhile shock absorber for portfolios. 

Alternatives: controlled chaos for alpha generation

In periods of vast central bank interventions, markets tend to be much less discerning of quality of companies, and tend to move in one direction - up. A good result for long-only strategies perhaps, but not always a sustainable environment for alpha generation. 

Alternative investments are designed to perform in varying market environments. They often look to benefit from increased volatility, market mispricings and when functioning price discovery mechanisms are necessary for the strategies to perform. The two worst environments for our strategies would be a world with no volatility at all, where asset prices move like clockwork or absolute chaos where pricing is totally disconnected from fundamentals for a prolonged period. 

Looking back on the crisis period, there was certainly stress in the market in March but not complete chaos. Fundamentals did matter and still do. Companies more impacted like airlines, hotels or cruises certainly underperformed technology companies, for instance, and that was overall an interesting backdrop for alpha generation.

Going forwards, we believe it is important that governments maintain financial stability. That said, saving markets still need to be efficient and financing should reward the better, more innovative and sustainable companies.