Unlocking the value in fixed income

At first glance, bond markets these days may look like deserts – there is little or no yield on offer with large patches appearing barren or even offering only negative yields. That is to ignore a plethora of opportunities, argues Jean-Paul Chevé, head of the Fixed Income Insurance Team within the Specialty Fixed Income Product Group. 

What is your assessment of fixed income markets today?

Fixed income markets are facing challenging times. However, they are no more challenging than those we have seen over the last 10 years.

If we cast our minds back to the 1990s, the fixed income environment was fundamentally different. When the French Treasury issued France’s first inflation-indexed bond in 1998, it came with a nominal yield of around 5% and a breakeven rate of 2%, giving a real yield of 3%.

Today, the breakeven inflation rate is roughly similar, but the real yield is negative at around minus 1.5%. That is a dramatic change, but low real yields are something we have had to live with for the last 10 years.

There have been structural changes in fixed income markets. I see no reason to expect real yields to rise significantly in the near future. This expectation is an important element in our vision of the fixed income opportunity set.

Our approach involves combining two distinct investment styles:

• The long-term investment approach we use to select securities for buy-and-hold insurance portfolios. By that, I mean applying a ‘buy-and-enhance’ mind-set to investing. Each investment is analysed with regard to the value it can generate in the long term. Dedication to detail and rigorous analysis in our security selection is at the heart of our process.
• An active approach with a shorter investment horizon aimed at generating incremental returns relative to a standard multi-sector eurozone benchmark (such as the Euro Aggregate index). We actively manage duration exposure, positioning on the yield curve, issuer selection and positioning within the issuer’s capital structure.

Each of these investment styles has strengths and weaknesses. By combining them, we are seeking to take the best attributes of each. The result is a rigorous process of identifying fixed income instruments offering potential value over a long-term investment horizon. We are seeking to unlock the potential for strong returns across the full spectrum of fixed income markets.

What is your investment horizon and investment universe?

We are an active manager with a focus on outperforming our benchmark over a three-year rolling cycle. To realise the potential value in fixed income instruments, we look beyond the next quarter or year. We are investors, not traders.

Our benchmark (the Bloomberg Barclays Euro Aggregate Bond RI) is used for performance comparison only. By that, I mean our high conviction strategy is not benchmark-constrained. Performance may sometimes deviate significantly from that of the benchmark. We aim to add value over the medium term by implementing a discretionary managed portfolio invested in debt instruments.

We invest mainly in corporate and government bonds issued in European currencies. The guidelines of this strategy allow for an allocation of up to 50% in different categories such as contingent convertible bonds and subordinated debt.

We invest in instruments with a minimum rating of BB-/Ba3/BB- (S&P / Moody’s / Fitch) or an equivalent rating. Securities that are non-investment grade with a rating between BB+/Ba1/BB+ and BB-/Ba3/BB- (S&P / Moody’s / Fitch) cannot represent more than 20% of the assets in our portfolio.

Here is a representative portfolio to give you an idea of the sort of sector allocations we might hold in our high conviction strategy:

We are focused on beating the benchmark over a rolling three-year cycle by taking a holistic approach, positioning ourselves in the best segments of the corporate bond markets to capture high carry and roll-down along the interest rate curve.

We can find instruments with the potential for very attractive returns. We look closely at bonds issued by financial institutions in particular. These tend to have a broad hierarchy that allows us to pick bonds in the capital structure such as subordinated bonds with spreads that are attractive relative to government bonds. If we see value, we may invest in perpetual bonds.

We believe there are many ways to find value in the bond markets as long as you concentrate on visibility in the long term. We manage portfolios using modified duration, or interest-rate sensitivity. The portfolio currently has a duration of 8-8.5 years. At times, that may generate volatility, but not to an extent that is out of line with our three-year investment horizon.

Taking positions in credit instruments requires you to take the time to get the best results, to set a target for a holding and to be willing to hold a position for a number of years.

So fixed income offers an alternative to equities today?

Yes of course. Remember equities are nothing more than that sliver of hope that separates assets from liabilities.

Fixed income instruments on the other hand provide investors with a clearer visibility in that the cash flows are certain over a longer horizon. There may be periods of volatility when the performance of our high conviction strategy lags behind that of the benchmark.

However, our high conviction strategy is calibrated to deliver significant incremental returns over a three-year rolling cycle with a very different risk profile to an equity portfolio.