FIXED INCOME – Getting into Debt

Sub-prime hit bond flows as much as equities. Fiona Rintoul looks at how fixed income fund managers are reacting and finds that they are increasingly looking at local currency debt

The sub-prime crisis hit fixed income just as hard as equities in Europe, if not harder. Lipper Feri reported €87bn of outflows from fixed-income funds in 2007, with the hardest hit markets being those where fixed-income funds have traditionally formed the bedrock of portfolios – Italy, Germany and Spain.

But these figures don’t necessarily tell the whole story. “Not all flows are in response to recent volatility and the credit crunch,” says Maria Ryan, a strategist at Barclays Global Investors. “Some flows are strategic. For example, we are seeing pension fund flows into bonds continue as they try to better match liabilities.”

Ryan says there is increased interest in bond products with higher-alpha targets. “Investors want their bonds to work harder,” she says.

The key issue is that the fixed-income arena is a great deal more complex and diverse than it used to be. “Remember when bonds were boring?” asks James Mitchell of Russell Investments in a recent presentation on ‘The Evolution of Debt Investing’. “Well, they’re not now.”

In the past, bond portfolios were often managed passively, whereas now there are more specialist managers. The non-government bond market was immature; now it’s mature. Bond choices were typically driven by minimum fund requirements; today there is a much less prescriptive use of bonds in many cases.

In the last ten years, there has been a surge in issuance of non-government and off-index products. In 1996, sovereign debt accounted for 70% of the global total. By 2006 the figure had dropped to 52%.

“There’s been an evolution of debt investing into areas that investors haven’t looked at in the past,” says Mitchell.

Within this much richer environment, there are pockets of gold. It’s all a question of making the right choices.

In the second half of 2007, when the sub-prime crisis started to unfold, it was government bonds that did best, says Ryan, with the result that strategies with a lot of exposure to government bonds that underweighted riskier non-government bonds will have outperformed.

“Corporate bonds underperformed with financials being badly hurt as investors became concerned about banks’ exposure to sub-prime and other underperforming assets,” Ryan says.

Going forward, many eyes will be on the emerging markets, including local currency bonds. Emerging markets have held up so well and the fundamentals have been so strong that many have been upgraded, and there are more and more investment grade bonds too.

“With the improving fundamentals of all these countries, they are building local capital markets, therefore investors are more open to buying local currency debt,” Mitchell says. “You get a lot more diversification and a lot more opportunities in local currency issuance.”

Jerome Booth, head of research at Ashmore Investments, says: “Quite simply, local currency debt is, in our view, the best hedge against dollar weakness.” It is a deep, liquid, highly diversified, low-volatility asset class expected to do well even without dollar weakness, he says. “With dollar weakness it can be expected to outperform significantly as the coming dollar weakness should be against emerging currencies.”

Local currency emerging market debt is a specialist area, however, requiring a fairly sophisticated manager. This chimes with another trend that Mitchell sees in the fixed-income area: the rise of the specialist manager.

Financials is also an area to watch. Due to forced selling, prices are being marked down pretty indiscriminately, says Mitchell, at Russell. But often the fundamentals are not that bad. “Obviously, the fundamentals have deteriorated somewhat,” says Mitchell, “but it is our belief that they are still quite strong.”

It’s a buyer’s market, says Mitchell, who advocates broadening investment guidelines and making new allocations to get the most out of the current bond market evolution. But the old adage caveat emptor also applies. Mitchell see opportunities in CDOs and leveraged loans, for example, but emphasises that these are areas where “you need to do analysis and know your stuff”.

There are opportunities out there, but they must be well understood. As Mitchell says, “Embrace the evolution, but know your managers.”

© fe March 2008



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