In a brave new world of tight regulation, central bank intervention and overhauled financial markets, investors must shelter from the liquidity storms by refocusing on the fundamentals, say Salman Ahmed and Carolina Minio-Paluello of Lombard Odier Investment Managers.
The direct intervention of key central banks to fulfil economic objectives has structurally altered fixed-income markets. Central banks are now policy-makers, asset owners and regulators in a completely revamped financial system.
This influence from central banks is extraordinary. They now hold on average 25% of sovereign bonds in advanced economies, with the European Central Bank extending its buying to corporate bonds. We see this as a massive shift that is likely to continue, with widespread disinflation forcing the central banks to keep policy easy and to maintain negative interest in a number of major economies.
This dominant investor status means central banks may skew investment performance, if often unintentionally, making markets potentially more difficult to navigate and forcing other investors to take on more risk.
Over the past two years, fixed-income markets in particular have undergone a number of what can be termed micro-liquidity ‘accidents’, where the act of moving bonds into cash has had an outsized impact on pricing. In our view, there are two reasons for these accidents – increased herding and tighter regulations.
Herding, or commonality, in investor positions has risen sharply since early 2011 – especially in fixed income – driven by the extensive use of quantitative easing. Investors were incentivised by central bank policies to increase fixed-income allocations, which were then implemented predominantly through market capitalisation-weighted portfolios. This means that when there is a shock to expectations, investors tend to move together in herds, resulting in a ‘rush for the exits’.
However, that is only part of the story – tightening regulations have directly impaired the banking sector’s ability to intermediate, especially in corporate bond markets. These actions have resulted in frequent micro-liquidity accidents as the rewired financial system struggles to cope with shifts in investor expectations, leading to episodes of sharp volatility accompanied by widening transaction costs.
The importance of mitigating default risk in today’s new world
Against this backdrop, investors could be forced to search for yield to meet their investment objectives. However, given the sheer dominance of central banks, coupled with a structurally fractured fixed-income liquidity environment, we believe it has become incredibly difficult for investors to rely on markets alone to meet their liquidity needs.
We firmly believe that the status quo of using market capitalisation benchmarks (which are based on price and size of debt) is unequipped to deal with the present environment. The ability to assess each issuer on its own merit is vital in a world of fractured liquidity, low-risk premia and important tail risks.
Fundamentals-based portfolios are constructed to directly mitigate underlying credit risk and deliver quality-based diversification. By focusing on the credit quality of the issuer rather than the amount of debt outstanding, the aim is to minimise default risk. Furthermore, in the current environment, we believe there is a requirement for buy-and-maintain frameworks, where the need for trading is decreased to only default risk mitigation-based interventions, thus reducing sensitivity to liquidity accidents and any potential rise in interest rate.
A prudent search for yield – Exploring emerging markets
We believe the need for yield coupled with signs of attractive valuations demands a reassessment of emerging market risk. In the current climate, there is a large differential in yields offered within these markets compared to those from companies and countries in more developed parts of the world.
Despite the sharp asset-price pressures, sustained capital outflows and downgrade shocks we have seen over recent years, a number of emerging market economies have improved their current account balances and are now managing them at more sustainable levels. We expect these underlying fundamentals to become a more permanent feature of the landscape.
In our view, the label of ‘emerging markets’ has become less helpful, especially when it comes to asset-allocation decisions, as idiosyncratic country-specific factors continue to become more dominant. This structural difference means it is vital to treat each country on its own merit, especially in a world that consists of structural tail risks.
There are likely to be more issues with liquidity if central bank intervention and tighter regulation persists. There will also be continuing disinflation and low rates across most markets, so the need for yield from fixed income will remain. By focusing on the fundamentals underlying their investments, we believe investors should be able to mitigate underlying credit risk and have the confidence to look for yield in markets traditionally seen as riskier. That includes those markets labelled ‘emerging’. When liquidity storms hit, a portfolio designed like this should be able to better withstand the shocks, thanks to reduced risk of default.This is the new world order for fixed-income investing.
For professional investor use only. This article contains the views and opinions of LOIM as at the date of issue and does not contain personalised recommendations or advice. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax and accounting consequences. This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the FCA), and entered on the FCA register with registration number 515393.Lombard Odier Investment Managers (LOIM) is a trade name. ©2016 Lombard Odier IM. All rights reserved.