CIO views: capturing the recovery

Fixed income: carry strategies and finding the green recovery

Recoveries heal economic scars whilst opening up opportunities for leaders to emerge. What has worked historically does not necessarily work in the future because investors rethink business models.

In fixed income, we use a fundamental approach with rigorous bottom-up analysis of all issuers. Alongside nimble active management, we believe that this is the key element to benefit from a shift in economic environments. We focus on quality to express our highest convictions and promote a multi-manager approach to foster diversification and deepen the expertise in each market segment. Additionally, we structure our investment processes to leave flexibility for portfolio managers to seize the opportunities they see emerging.

Today, several months into the recovery but still in an environment of interest rates near the lower bound, we continue to favour carry strategies. Ample fiscal and monetary easing are supporting credit and we favour moving lower in ratings to capture this premium. We continue to see the most opportunities in crossover (rated BBB to BB) and high yield, but highlight that bottom-up expertise in these areas are key as idiosyncratic risk dominates.

Finally, rethinking business models also involves searching for sustainability-challenged ones, and we believe that the green recovery stands out as a substantially undervalued investment opportunity.

Asia fixed income: favourable credit valuations for inflows

We believe that the bulk of the US Treasury yield rise is behind us¹, and with rates volatility trending lower, attractive opportunities within Asia credit are developing for investors with a long-term view. From a fundamental perspective, the growth rebound in Asia remains intact, with further support from the large US fiscal stimulus likely to generate positive trade spillovers for Asia. Medium-term growth prospects for Asia are still in the 4-6% range, which is far higher than developed market (DM) peers.

Furthermore, compared to history, the traditional current account deficit economies in Asia (such as Indonesia and India) are now in a much stronger position thanks to increased foreign exchange reserves and economic reforms. With China’s economic recovery set to be strong, the authorities have now switched focus to financial stability and long-term economic sustainability.

Against this backdrop, we believe valuations appear attractive, especially since new issue supply of hard currency denominated credit is not expected to be large this year. Asia corporate investment grade (IG) credit spreads on average trade approximately 50-60bps wider than US corporate IG at present, with a shorter duration (5.6 years vs. 8.5 years)¹. Ample liquidity in DM countries should continue to push capital into higher yielding asset classes, and Asia IG credits are well positioned to benefit from these structural inflows, in our view.

¹ Yields are subject to change and can vary over time. Past performance is not a reliable indicator of future returns. For illustrative purposes only.

Convertibles: tapping pent-up demand; an inflation cushion¹

As the economic recovery from the pandemic builds, the convertible bond asset class offers substantial exposure to companies that we believe will benefit from a return to normality. Convertibles could also provide a buffer¹ against potential inflation due to the hybrid characteristics of the asset class.

Over the past year, the convertible bond universe has expanded rapidly, and a significant number of new issues reflected high growth themes linked to the pandemic such as digital consumption or work moving online. Considerable new borrowing also came from companies that we see as ‘recovery candidates.’ These companies suffered from a drop in earnings due to lockdown measures, and broadly shared the trait of having high fixed costs. Included in this trend were airlines and aerospace, the travel industry, luxury and lifestyle goods. As lockdown measures are loosened, we expect significant pent-up demand in services linked to these areas because consumers are eager to book flights or buy sporting goods, for example.

Secondly, the spectre of rising inflation has also accompanied the recovery, even if the outlook is for global central banks to remain accommodative. Convertible bonds could afford some protection¹ against potential inflation through their typically shorter duration, and the positive contribution of the optionality in inflationary environments. The asset class is generally less sensitive to interest rates than traditional bonds because of the embedded option, which usually gains value in times of rising interest rates.

¹ Capital protection is a portfolio construction goal that cannot be guaranteed.

Multi-asset: looking into the distance

From a multi-asset perspective, positioning for a reflationary scenario may seem straightforward: overweigh risky assets, while possibly shifting within asset classes towards most inflation or reflation-sensitive sectors and regions. Commodities, while not always systematically part of strategic asset allocations, also look relevant in this environment, given their ability to hedge portfolios from a potential acceleration in activity and the accompanied stress in production chains. Given the impact of rising rates on bond prices, the current consensus is a cautious stance with regard to duration sensitivity.

On our part, we like to always maintain an extended investment horizon and think about possible alternative scenarios down the road. Long-term yields have risen quite substantially and yield curve steepness has reached a level not seen in years. As such, while government bonds have hurt investors so far in 2021, their potential for future diversification has risen, too. Any bump in the reflationary road could trigger new spikes in volatility across risky assets, and we believe government bonds could again play a diversification role, such as they did during the Covid-19 crisis a year ago.

To be clear, we do not make a straight long bet on duration at this stage, but seek instead to make sure that our multi-asset portfolios maintain strong diversification. For us, it is key to balance duration with inflation or reflation-sensitive assets, which benefit from some definite tail winds at present, while maintaining some long volatility exposure across all asset classes, including rates¹.

¹ Target performance/risk represents a portfolio construction goal and cannot be guaranteed. Holdings/allocations subject to change.

Alternatives: exploiting mispricings

When it comes to investing, it’s key to always consider the timeframe, and that the path can be as important as the direction. Like many, we are optimistic as to the overall direction. The combination of increased immunity (natural and vaccines) combined with unprecedented policy support, should lead to a very supportive environment. The markets, for instance, are overall certainly not pricing a very prolonged period of continued lockdowns followed up by an economy that is only partially reopened for an extended period of time.

As such, we are particularly optimistic on strategies that can exploit mispricings because we believe that periods of euphoria will be followed by periods of extended pessimism. The mispricing and dispersions resulting from this should be very supportive of hedge fund strategies. A typical dispersion, for instance, could be set to exploit a situation where an index only moves marginally whereas the constituents inside of the index could move substantially (this typically happens when a situation leads to large gainers and losers in an index, or when we move from reopening trades to work from home companies and vice versa.) We think this indecision will somewhat dominate the market.

In effect, volatility, credit and equity markets are all linked, and although the volatility market remains elevated, the credit market remains (overall) somewhat tight. Furthermore, inflation will create reflation trades but also more currency volatility and potential dislocations; another tailwind for our strategy. Finally, we strongly believe that the direction is overall supportive but some sectors, in particular within the sustainability spectrum, have strong tailwinds behind them.

Sustainability: the green wave

In stark contrast to a year of doom and gloom for public health, the end of 2020 was marked by the world’s two largest economies making major steps for the climate transition: with Joe Biden’s election, the US officially rejoined the Paris Agreement and China made a pledge to reach net zero by 2060.

Although China’s enormous pandemic recovery package is not entirely climate friendly, it includes major investments in digital infrastructure, electric mobility and high-speed public transit projects. President Biden’s plan to “build back better” should see USD 2tn worth of investments towards climate-aligned projects including a net-zero power sector by 2035, net-zero public transports, as well as upgrading 4 million buildings, weatherising 2 million existing homes, and building 1.5 million new sustainable homes.

Lombard Odier has developed a range of forward-looking analytical capabilities and products to help institutional investors catch the green wave of the economic recovery. In particular, our Lombard Odier Portfolio Temperature Alignment (LOPTA) framework allows us to identify mid to long-term climate transition risks and opportunities globally across sectors and asset classes (read an independent review of our framework here).

Moving forward, we see untapped opportunities for both active and passive investors to minimise their exposure to transition risks while benefiting from long-term secular trends stemming from our current economic model accelerating in the race to net zero.