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Our investment professionals share and challenge each other’s views, creating a diverse marketplace of ideas for the Wellington Blog.

As we explored in our last blog post, Helping European investors navigate inflation fears, the current market environment presents challenges for fixed income investors. Chief among them: rising interest rates. Against this backdrop, rather than simply take a portfolio’s effective duration1 at face value, we encourage investors to consider a multitude of factors when deciding how best to allocate their fixed income capital. One such factor is that of empirical duration, which (as opposed to effective duration) calculates a bond’s sensitivity to rising rates based on historical data versus using a preset formula.

Understanding portfolio duration

As global central banks take steps to tackle inflation, a variety of monetary policy responses remain possible throughout the remainder of 2022. Figure 1 highlights three hypothetical scenarios.

FIGURE 1

Possible monetary policy scenarios with potential impact on fixed income returns

From a purely theoretical standpoint, the concept of duration implies that all non-floating-rate fixed income portfolios will suffer…

MARKETS
Will Prentis
Will Prentis
Investment Analyst
London
Tobias Ripka
Tobias Ripka
CFA
Investment Director
Frankfurt

The first quarter of 2022 proved to be challenging for most fixed income sectors, and convertible bonds were not immune from the volatility. Year to date through March 31, global convertibles had returned -5.81% — their third-worst quarterly showing since the 2008 global financial crisis — compared to -5.54% for global high-yield bonds and -6.90% for global investment-grade corporates. 1 Sector composition particularly hurt global convertibles, including a sharp correction across technology (which makes up 23.8% of the convertibles universe) in response to concerns about the potential impact of higher interest rates on tech companies’ growth prospects; and a rally in the energy sector (4.0% of the convertibles universe), fueled in part by supply disruptions from the war in Ukraine.

Looking ahead, however, we continue to believe global convertibles are likely to outperform other fixed income sectors over an investment time horizon of approximately two to three years.

The five structural tailwinds

Our bullish secular outlook for global convertibles is based on five key considerations…

MARKETS
Barry, Michael
Michael Barry
Fixed Income Portfolio Manager
Boston
Dunkelberger, Raina
Raina Dunkelberger
CFA
Investment Specialist
Boston

An inverted US Treasury yield curve is often viewed as a reliable recession indicator, so the significant flattening of the curve over the past few months — and in an environment of persistent inflationary pressures, to boot — has some economic prognosticators calling for an impending US recession. I say not so fast.

While I acknowledge that the economic outlook will likely deteriorate at the margin as monetary policy tightens, particularly if energy prices remain elevated, I do not believe the recent flattening of the yield curve portends a US recession in the near term. US consumer balance sheets look very healthy, household savings rates are robust, and rising worker wages may help cushion against the impact of higher goods and energy prices. Furthermore, the US should remain relatively shielded from today’s uncertain geopolitical landscape, given its lower oil imports from Russia and its greater…

MACRO
MARKETS
Robert Burn
Rob Burn
CFA
Fixed Income Portfolio Manager
Boston

Fed embarks on much-anticipated rate-hiking campaign

Emboldened by a strong US economy and mounting inflationary pressures, the US Federal Reserve (Fed) enacted its first 25 basis-point (bp) increase in interest rates since 2018. Additionally, Fed Chair Jerome Powell’s recent rhetoric has become more hawkish, including suggesting the possibility of a 50 bp rate hike in the coming months. The market is now pricing in the fed funds rate to rise to around 2.5% by the end of 2022 (from its current target of 25-50 bps).

Historically, rising-rate environments have been challenging for most fixed income assets, as bond yields and prices tend to be inversely related. (When yields go up, prices typically go down and vice versa.) However, as floating-rate instruments whose coupons reset higher as interest rates rise, bank loans actually stand to benefit from rising-rate regimes. With the market now bracing for more aggressive Fed tightening over the next 12-18 months, bank loans look poised to provide investors with…

MARKETS
Jeffrey Heuer
Jeff Heuer
CFA
Fixed Income Portfolio Manager
Boston
Dave Marshak headshot
David Marshak
Fixed Income Portfolio Manager
Boston
Nick Leichtman
Nick Leichtman
CFA
Investment Specialist
Boston

Regime shift

2022 promises to be another challenging year for central banks as they attempt to normalise policies in the face of surging inflation, while navigating the growing fallout from Russia’s invasion of Ukraine. Since 2009, there has essentially been one trade in capital markets: riding a huge wave of central bank liquidity in support of the financial system and the economy, with the G4 central banks alone pumping approximately US$20 trillion into the system via quantitative easing (QE).

The COVID pandemic took this stimulus to a new level with unprecedented fiscal and monetary policy support globally. Most of this liquidity and support has been recycled in asset markets, resulting in lower and lower yields and compressed spreads and volatility. However, as the world recovers from the pandemic, we believe that the supply capacity of economies will become much less flexible and slower to adjust to demand. Essentially, the output gap concept will become relevant again, producing higher and more volatile inflation. The unfolding Ukraine tragedy is accelerating and amplifying this shift, with inflation rates moving even higher and potentially becoming stickier on the back of an increased risk of energy and supply-chain disruptions. This leaves central banks in a perilous situation as they seek…

MARKETS
Mahmoud El-Shaer
Mahmoud El-Shaer
CFA
Fixed Income Portfolio Manager
Gray, Annabel
Annabel Gray
Investment Specialist
London

In recent months, significant investor concerns have arisen around persistently high inflation, the specter of rising US interest rates, and the potential for economic and/or market disruptions from these risks. Geopolitical escalations in Russia and Ukraine have added yet another layer of complexity to financial markets and the macroeconomic environment. We’d like to highlight four key themes that we believe may support the securitized credit asset class against this challenging backdrop:

  • Protection from rising rates: Many of the subsectors within the broader securitized sector have relatively short durations and/or floating-rate coupons, both of which could be beneficial in a rising-rate environment. Shorter duration generally means lower sensitivity to rate increases, while floating-rate coupons provide the potential to generate greater income as those coupons reset higher with rising rates.
  • Potential to benefit from inflation: The underlying collateral of the securitized sector, predominantly comprised of real assets, may act as a partial hedge in an inflationary environment. Furthermore, while wage inflation might adversely impact corporate profit margins…
MARKETS
Alyssa Irving
Alyssa Irving
Fixed Income Portfolio Manager
Boston
Perry Corry
Cory Perry
CFA
Fixed Income Portfolio Manager
Boston
Kyra Fecteau
Kyra Fecteau
CFA
Fixed Income Portfolio Manager
Boston

One of the discussion topics du jour is how the credit and equity markets might react to the US Federal Reserve (Fed) interest-rate hikes that are widely anticipated in the coming months. As is often the case with me, I find it helpful here to refer to past hiking regimes and market performances as a sort of guidepost.

The proof’s in the pudding

To wit, I examined the historical returns of both US credit (for this purpose, proxied by corporate high-yield bonds) and US equities (represented by the S&P 500 Index) during the six months before the first rate increase of a Fed hiking cycle through the 12 months after said increase. The data demonstrate that both markets not only performed well heading into the first hike (although there’s some circularity because the Fed likely wouldn’t hike amid sharply falling markets), but also that both were able to sustain…

MACRO
MARKETS
Robert Burn
Rob Burn
CFA
Fixed Income Portfolio Manager
Boston
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As discussed in our 2022 credit sector outlook piece, Break with tradition in 2022, we see opportunities in a few nontraditional credit sectors that stand out to us as having a higher probability of generating excess returns in the months ahead (Figure 1):

  • Emerging markets (EM) high-yield sovereign debt looks attractive because it is one of the few sectors whose credit spreads have been trading wide to their historical median. Although many EM countries’ fundamentals have deteriorated somewhat as a result of increased debt burdens amid the COVID crisis, global institutional support has been forthcoming from the likes of the IMF and World Bank. While we do expect some idiosyncratic EM debt defaults (as always), we believe…
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Robert Burn
Rob Burn
CFA
Fixed Income Portfolio Manager
Boston
Campe Goodman
Campe Goodman
CFA
Fixed Income Portfolio Manager
Boston

In our early December quarterly strategy group meeting, we debated the outlook for the high-yield market in 2022 and what it means for portfolios. At present, we favor maintaining a slightly defensive risk positioning given tighter valuations. While the macroeconomic backdrop and corporate fundamentals generally remain positive, we see some points of concern emerging at the margin. We expect high-yield credit spreads to move sideways in a year that could see plenty of volatility given multiple tail risks. However, we believe the ability to dynamically adjust positioning in the event of a significant repricing of credit risk will be key in 2022.

Macro: positive, but less positive

We continue to observe “yellow flags” on inflation and are watching for signs that inflationary pressures could shift from transient to permanent, leading to faster-than-expected tightening. On the flipside, previous Federal Reserve (Fed) policy cycles suggest that the high-yield market tends to perform well during the early stages of hiking when rate increases are…

MARKETS

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Barry, Michael
Michael Barry
Fixed Income Portfolio Manager
Boston
Michael Hong headshot
Michael Hong
CFA
Fixed Income Portfolio Manager
Boston
Konstantin Leidman headshot
Konstantin Leidman
CFA
Fixed Income Portfolio Manager
London

The fixed income market dislocations triggered by the onset of the COVID-19 pandemic left active portfolio managers with extraordinary opportunities to generate alpha not seen since the 2008 global financial crisis. Accordingly, many are well ahead of their benchmarks since COVID: The percentage of active core bond-plus and global aggregate bond strategies besting their benchmarks has spiked sharply to over 80% and 90%, respectively.1 Many fixed income allocators have, of course, benefited mightily from this recent spurt of active manager outperformance.

On the surface, there doesn’t seem to be a problem here, right? However, a closer look at this “golden era” of excess returns reveals potential structural manager biases and stylistic tilts that most investors may not expect, or necessarily want, from their fixed income allocation. These risk factor leanings have enabled many active managers to…

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Brendan Fludder
Brendan Fludder
CFA
Research Manager
Boston
Carlos Coutinho
Carlos Coutinho
CFA
Solutions Portfolio Manager
Boston
Noah Comen
Noah Comen
CFA
Investment Strategy Analyst
Boston

For many fixed income investors, we believe high-quality securitized assets can play a valuable role in a diversified credit portfolio — and they have become even more attractive thanks to new risk-based capital (RBC) factors being adopted by the National Association of Insurance Commissioners (NAIC).

Should non-insurance entities care about these changes? We think so because the changes could impact credit spreads and investor demand across the securitized sector. For instance, we may see greater demand for AAAs/AA rated bonds and less demand for As, which could affect…

MARKETS

ARCHIVED

Alyssa Irving
Alyssa Irving
Fixed Income Portfolio Manager
Boston
Tim Antonelli
Tim Antonelli
CFA, FRM, SCR
Insurance Multi-Asset Strategist
Boston
Klimas Celene
Celene Klimas
CFA
Investment Specialist
Boston

In many cases, investing in an alternative (hedge fund) strategy requires a totally different mindset and starting point than traditional, long-only investing. Yet we often find that the “lines get blurred,” so to speak, when talking with clients about our alternative investment capabilities and the numerous opportunities that may be available to them in this dynamic space. Let’s take a closer look.

Long-only investing vs long/short investing strategies

Typically, the process that traditional long-only investors follow when making an investment decision is to first conduct research (or have others do so) to identify an existing market opportunity and to then determine the best means of deploying the capital needed to exploit that opportunity, which most commonly takes the form of an equity or fixed income strategy. This concept of “idea generation and pursuit” has spawned…

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Christopher Perret headshot
Christopher Perret
CFA, CAIA
Investment Director
Boston

Last week, a blog post titled Fixed income investors warily eye Congress and the Fed discussed three likely government policy drivers of fixed income markets in the period ahead — US monetary policy, US fiscal policy, and the US debt ceiling. Here, we’ll take the next step of briefly highlighting some fixed income market sectors where investors might turn for attractive total return opportunities in today’s challenging environment. Indeed, it’s perhaps the most pressing question many fixed income clients have been asking lately.

A supportive US policy backdrop

The prevailing US monetary and fiscal policy backdrop continues to be broadly supportive of credit fundamentals, but many credit sectors are not currently…

MARKETS

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Brij Khurana
Brij Khurana
Fixed Income Portfolio Manager
Boston
Amar Reganti
Amar Reganti
Investment Director
Boston

The growth of portfolio trading has been a constant theme in fixed income markets throughout the volatility of the pandemic. This continues the trend of clients increasingly relying on a broader variety of liquidity sources to achieve their objectives. Trading a portfolio of multiple bonds with a range of credit qualities and durations in a single transaction allows clients to access aggregated liquidity more efficiently. It can improve timing, execution, and cost, while minimizing a client’s exposure to uncertainty and volatility.

In this short blog, we share our views on the best uses for portfolio trading and discuss the current state of the market.

ETFs and portfolio trading

Importantly, standard “voice” trades remain the core of risk transfer in credit markets. However, the persistent development of the ETF ecosystem has added a…

MARKETS

ARCHIVED

A. Scott Janes
CFA
Trader
Boston
Richard Lewis
Director of Credit Trading
EMEA

As credit spreads have compressed to post-global financial crisis tights, and with bond yields hovering near all-time lows, I believe the total and excess return prospects for investment-grade fixed income look rather grim. Tight valuations, coupled with some looming risks on the horizon (the COVID Delta variant, inflationary pressures, fading fiscal stimulus, and China’s slowdown), may present an opportunity to “take some chips off the table,” so to speak. I recommend reducing both credit and interest-rate risk in many investor portfolios.

The technical backdrop remains strong

Investment-grade credit has been well-supported by strong demand from non-US investors and the domestic pension community. For overseas investors, US credit is still their best option on the yield “menu” (made even more attractive on a currency-hedged basis), given lower prevailing yields across most other developed markets. Many defined benefit pension plans have been…

MACRO
MARKETS

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Connor Fitzgerald
Connor Fitzgerald
Fixed Income Portfolio Manager
Boston

The Chinese government’s aggressive regulatory crackdown on the country’s private technology companies (most recently, the online education sector) has shaken investor sentiment toward a range of Chinese assets, causing China’s equity and bond markets alike to swoon in recent days. The crackdown comes as Chinese policymakers embark on the delicate balancing act of redefining the role of private enterprise in China, versus the often-competing objectives of the nation’s common prosperity and social responsibility.

Here’s a distillation of our global fixed income and emerging markets debt teams’ latest views on some of the potential investment implications.

Fixed income investment implications

China equities and sovereign bonds, along with the Chinese currency, abruptly sold off in unison following the government’s latest regulatory actions during the week of July 26. But most Chinese household wealth is still mainly invested in…

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MARKETS

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Jitu Naidu
Investment Communications Manager
Boston

Our ESG philosophy for short-duration investing

Environmental, social, and governance risks have always been key considerations in our research and investment process. These factors are particularly critical given the core objectives of a short-duration portfolio: to maximize liquidity and preserve capital while achieving attractive total return.

Importantly, adverse ESG factors increase the risks of credit deterioration and illiquidity. We believe that there are areas where these risks are not currently compensated by valuations. In our view, heightened global scrutiny of issuers from an ESG lens will eventually drive up the cost of capital for many issuers with outsized ESG risks. In addition, we think it will potentially lead to lower liquidity in their bonds as more investors avoid these issuers. As an example, the tobacco sector already has a higher cost of debt and less demand for issuers on average versus…

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Balaji Venkataraman
Balaji Venkataraman
Investment Specialist
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