By Roger McEniry, co-manager of the OYSTER US Core Plus fund
Fixed-income markets – including US corporate bond markets – have rallied from their 2020 lows and credit spreads are tighter than pre-pandemic levels. From our perspective, this is unsurprising – interest rates are near historic lows, and investors holding fixed income need yield, so they keep on reaching for it. The problem is the more they reach, the more they hover over a precipice.
Unprecedented amounts of fiscal and monetary stimulus have created what we see as an infertile ground for value opportunities in the corporate bond space, as prices are warped by super-sized liquidity and excessive demand. It almost seems as though corporate bond investors have forgotten a sobering fact – you can lose money in bonds.
In the US, default rates have been lower than many economists expected given the recent recession. We think this is a reason investors are becoming complacent when evaluating the risk to return profile of their investments. In our opinion, default rates are bound to tick back up, and if investors are not cautious, they could get burned.
Trimming the sails
As value managers in corporate bonds, we seek to uncover undervalued fixed income securities – those we believe are relatively low risk yet attractively priced. Therefore, the current climate presents a challenge. With good value opportunities near impossible to come by, we believe the best way to navigate the current situation is to shift our position towards a more defensive strategy.
Faced with prices that no longer reflect the commensurate risk involved, we believe now is the time to apply one of investment’s greatest virtues: patience. This will mean swimming against the current for a while, but we think any active manager worth their salt must be prepared to turn his or her back to the crowd occasionally.
Therefore, we have positioned ourselves defensively across our five strategies. We have sold positions we viewed as having too much risk and are now drawn to safer ports – for example, highly-liquid corporate bonds with more balanced risk to return profiles.
Currently, we are investing in higher-rated high-yield and lower-rated investment grade bonds. We have found this to be a sweet spot where active managers can still hunt and fish for undervalued securities to bolster clients’ portfolios.
While opportunities may be hard to come by now, we are confident they will emerge again in the future. When that time comes, we think it will pay to have the ability to pivot back and capitalise on compelling valuations. Until then, we believe it is time to exercise prudence.
Timing the market is tough
The current outlook may seem bright to some investors, but it is based on the Fed’s continued involvement in financial markets, so risks remain. The combination of monetary stimulus and increased fiscal spending may unleash the spectre of inflation, not to mention the economic recovery may lose speed or yield to further COVID-19 variants.
Those who have seen a few market cycles should attest, it is difficult to time the market. However, we trust our investment strategy and process will guide us through future market shocks, taper tantrums, and the threat of an accelerating inflationary environment.
As an active manager, we recognise shifting market conditions have necessitated a change in positioning, but, at the same time, our process remains unchanged. We will continue to be duration neutral to our benchmarks and refrain from betting on the direction of interest rate movements.
As always, our in-house analysis of credit risk and relative price guides our investment decision-making, and we heed the advice of legendary investor, Warren Buffett – ‘never invest in a business you cannot understand’.