That said, rate risk management remains a significant issue for fixed-income investors. An active investment strategy – so-called “absolute performance” – and keeping away from the euro aggregate segment will provide strength and stability.
With the United States taking up its place as the engine of recovery in global economic growth, the US Federal Reserve began to normalise its monetary policy in December 2016. The Fed is pencilling in another rise in its leading rates in 2017, to follow the one in March, along with another three in 2018. The solidity of US economic fundamentals is supporting the valuations of risk assets, and the Fed could finally – albeit gradually – normalise its monetary policy.
The rise in the federal funds rate should support the increase in interest rates in both the United States and Europe. US interest rates have already rebounded by 50 basis points (for 10-year rates) since hitting their low in June 2016. European rates have done the same and will continue to follow this trend in the coming months. This rate risk – or, to put it another way, the risk of corrections on the fixed-income markets that are most sensitive to rates –, associated with the resurgence of political uncertainties in Europe, is exposing the euro aggregate segment, and the sovereign debt segment in particular, to potential underperformances.
Turning to politics, the French presidential election is a major source of uncertainty. According to the latest polls, the possibility of an extremist party coming to power and triggering “Frexit” still seems rather unlikely. That said, should such a scenario come about, it would have a disastrous effect on the European sovereign debt markets and investors cannot ignore this risk, no matter how small it may appear.
Active risk management
Given these conditions, an unconstrained – or “absolute performance” – investment approach should be favoured. This involves the active management of debt exposure, and rate and political risks. An example of this is the increase in the exposure to UK bank bonds.
Now, the risk associated with Brexit seems to be correctly priced in; the situation is more readable, and it is known that the process of leaving the European Union will take at least two years, without any real surprises on the horizon in the meantime.
Active risk management also relies on an underexposure to the European fixed-income market, to the benefit of the US market instead through derivatives, which provide greater carry and roll-down. In terms of bond-picking, US investment-grade corporate bonds with a 4-year maturity are favoured, as their current performance is yielding close to 3%, plus a roll-down of 1%.
There is also an attractive entry point in global high-yield credit default swaps (CDS). Entering the high-yield compartment through CDS rather than directly through securities offers an additional premium for identical credit and rate risks, as well as notably lower liquidity risk. This means that for a rate risk of a little over one year, the strategy offers a carry and roll-down of 6.5% in dollars and 4.8% in euros.
Last, subordinated bank debt is offering value. On top of banks’ higher common equity Tier 1 ratios – a source of protection for holders of bank bonds – the profitability of the sector is constantly improving. Banks’ fundamentals are better, their shareholders’ equity levels are more solid, while the exceptional charges associated with litigation that they inherited from the 2008-2009 crisis is dissipating over time.
Christel Rendu de Lint
Head of Global & Absolute Fixed Income