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Magazine Issues » September 2020

Bond investing: Making volatility your friend

Todd_ThompsonMixed data has thrown bond markets into choppy waters, but bond issuance backed by physical assets in sectors such as tourism could help investors through them, Todd Thompson of Reams Asset Management tells Funds Europe.

Like many fund managers, Todd Thompson, a bond manager at Reams Asset Management, has been wading through data in a volatile market environment. This includes mixed signals from the labour market, for example, which surprised in the first week of June when US employment data registered a jobs gain rather than a loss. Subsequent weekly figures showed unemployment stubbornly refusing to fall, however. 

And of course there has been the Covid-19 infection rate, which recently rose in the US – though Thompson, largely unconcerned from an investment perspective, told a Funds Europe webinar that this was already factored into prices. 

Bond investors should also take note of data for airport check-ins and restaurant reservations, he added. Both are currently just off their lows, which signals how far the travel and leisure industries have to go. 

The figures’ significance extends beyond individual industries to provide a measure of the economy’s condition overall, and could even indicate the extent of any permanent structural damage.

Trajectory
But what about data for the bond market itself? Once the scale of the pandemic became clear in March, bond markets reacted with widened spreads, reflecting weakening fundamentals and credit quality. However, once corporates were able to issue bonds again in mid-March, they issued as much as possible to raise cash and tide themselves over for an unknown period of reduced consumer demand, said Thompson, noting that the trajectory of corporate issuance was 99% higher than the same period in 2019. 

“This excess supply in a skittish market meant corporate spreads widened even further,” he added. 

Reams Asset Management, he said, increased corporate exposure as spreads increased, but defensively opted for investment grade over high yield. “The former experienced favourable valuations as wider spreads prompted a steady increase in credit exposure, whereas high yield have some challenges of their own.” 

Valuations in markets that have improved remain elevated. Nevertheless, industries that could suffer permanent damage – and see defaults – as a result of Covid-19 include airlines, hospitality, cruise liners, commercial real estate, and even oil and gas. The “unique challenges” faced by these sectors are more closely linked to high yield bonds. 

Another data-centred difficulty facing bond investors is the relative ineffectiveness of economic forecasts, which (at the time of the webinar in June) ranged from -20% to -50% in annualised GDP for the second quarter. As a result, much of Reams’ investment thesis is based on decisions by policymakers and interventions by central banks. 

The latter have acted to provide fiscal stimulus to fill a hole in demand broadly equivalent to a 10% loss in their respective GDPs. Monetary stimulus has exceeded most bondholder expectations, which has effectively levelled out volatility for the next 12-18 months, says Thompson. Furthermore, monetary stimulus is targetting investment grade bonds, providing another reason to favour this asset class. 

Thompson also backs the Federal Reserve’s move to buy up bond ETFs. The disorderly liquidation of the market following the Covid-19 outbreak had created huge stress for these products, he said. 

“The Fed saw that and just the announcement that it would buy bond ETFs was enough to cause the market to correct and to ease the pressure.” 

Backed by ships
Opportunities for bond investors include residential mortgage-backed securities, said Thompson. There was a narrow window of opportunity in early March when pressure on mortgage rates produced high volatility, but the Fed’s inclusion of mortgages in its buy-back programme meant that dislocation evaporated almost immediately. 

Further dislocation in the commercial real estate mortgage market as demand for office space further dwindles could create opportunities, as could asset-backed securities in sectors such as auto rental, where Hertz has been a high-profile casualty. 

Industries most acutely affected by the pandemic – such as airlines, hospitality, commercial real estate and retail – have started to issue securitised bonds. “A security interest limits downside risk for the bondholders, so that could create new interest for us in markets where there has been limited participation,” said Thompson. 

Bonds backed by physical assets are likely to be more prominent and already feature in Reams’ portfolio. He highlights a recent issuance from cruise operator Carnival, which used its own fleet as collateral. Carnival could literally sell ships to avoid default if it had to. The issuance was oversubscribed. 

“If you have a collateral pool which is arguably four or five times more than the nominal value of the debt, it provides a significant cushion,” said Thompson. “We can make the most draconian assumptions for the industry and at least the bondholder will still be made whole. That is how we like to run our credit analysis, because the essence of bond investing is quantifying your downside risk.”

Finding opportunities for the best bond returns in the next few years will mean a tighter focus on time horizons. “In the near term, you have the presence of central banks doing extraordinary things, adding liquidity though buying investment grade bonds in the secondary market, ETFs and fallen angels,” he explained.

“All of these things will have to play out for some time and will lead to a suppression of volatility. But once this abates and goes in reverse, what does this mean? The market will see elevated volatility and that is what investors need to focus on.” 

Strategies
According to Thompson, then, a reactionary strategy will be more effective than a buy-and-hold position, because reacting to events in scenarios like the current one embraces volatility and generates higher risk-adjusted returns. 

“Many people have been lulled into complacency because of the presence of central bank intervention over the last ten years. Some day that will no longer be the case, so you need to find more strategies where you can make volatility your friend.” fe

Listen to the Funds Europe/Reams webinar ‘Navigating volatility in the bond market’ at www.funds-europe.com/webinars-channel-0.

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