With fixed income managers predicting for some years now that the party is all-but over as rates start to rise again, a plethora of new strategies has been launched looking to provide yield through taking more and different risks or abandoning a benchmark through absolute returns strategies or – increasingly popular – a combination of both.
One manager with a multi-asset pedigree dating back to 1978, with what was then known as a “balanced” fund, is Newton Investment Management, a BNY Mellon affiliate company. On a visit to Australia recently, Paul Brain, investment leader for fixed income and lead manager of the firm’s ‘global dynamic bond strategy’, an absolute return offering, says there is no need to panic but investors should be aware of the clear trends.
Newton launched its global dynamic bond strategy in 2006, two years after Brain joined the firm. He previously held senior roles in fixed income at Credit Suisse, Investec and MSG & Partners Asset Management.
While the 30-year bull market in fixed income looked like coming to an end by 2006-2007, no-one probably saw what would happen next, with about 10 years of zero or near-zero interest rates in most major markets.
“By the end of March 2009 our strategy started to do very well,” Brain says, “although it did “get tested” again in 2011.” For instance, the strategy’s return in 2009 was a stellar 21. 8 per cent compared with the benchmark return of 2.8 per cent. The benchmark is monthly GBP LIBOR plus 2 per cent. The following year it returned 14.1 per cent against the benchmark of 2.5 per cent. In 2011 the benchmark won, with 2.7 per cent against Newton’s 2.5 per cent but order was restored in 2012 with Newton posting 12.0 per cent against the benchmark’s 2.6 per cent. Overall, since inception, Newton’s strategy has returned a cumulative total return of 105.1 per cent compared with the benchmark’s 55.0 per cent.
Brain believes that this year is a “transition year” for fixed income and that the US Federal Reserve will continue to increase rates although “not too high”. The US tightening has affected different fixed income sectors differently, because they are at different stages of the cycle.
He wrote in a note to clients in August: “First to feel the negative impact of the tightening were developed-world government bonds, followed by emerging-market sovereign bonds. Finally, the effects ripple out into the real economy and thus to high-yield corporate bonds.” He uses the analogy of a clock to map the various stages of the cycle.
“Prior to 2016, we were at midday on the clock – the growth stage – when economic growth was strong and monetary policy was loose. Then the US Treasury market started to react to the US Federal Reserve’s (Fed) decision to raise rates and talk of reducing its balance sheet, which sparked a sell-off in US Treasuries in the second half of 2016. This period equates to 4pm on the clock,” he says.
“We have been experiencing stage three – the unwinding of US monetary policy (8pm on the clock) – since the beginning of this year, as the tightening of US-dollar liquidity causes stress in emerging-market countries exposed to US borrowing. Stage four, at 9pm on the clock, is the point at which US Treasuries rally and credit sells off as the economic outlook deteriorates. At this stage, we think high-yield bonds (and probably equity markets) are likely to be in decline on the negative outlook.
“Our best guess is that this could occur in the fourth quarter of 2018 as the market becomes concerned about 2019 economic growth forecasts, and is able to make an educated guess as to when the Fed will stop raising rates… Eventually there will be a price to pay for assets which have run ahead of growth.”
Brain says that Newton does not have the same sort of hierarchical structure for its investment team as many other fund managers. The portfolio managers have the power to make their own decisions but they also share their information.
“Companies equity analysts and credit analysts can work together and get a different take on things. A company’s ability to borrow is important to us. The two groups should work side by side while retaining a certain autonomy.”
Another feature of Newton’s style is the integration of ESG processes into all its decision making. The firm is also in the process of launching a range of specific “sustainable” funds for some markets as demand for those investment products rise.
ESG assessment includes the analyses of governments wanting to use their capital better and for the manager to spend time on engagement. “If we don’t like something we will enter into a dialogue, so there’s a positive engagement,” he says.
He believes emerging markets are still vulnerable, but investors will probably buy back in once they get used to the idea that US interest rates have peaked in due course.
The global dynamic bonds strategy has about A$6.2 billion invested, plus Newton advises on an additional A$8.75 billion in fixed income assets in its multi-asset portfolios (as at June 30). The firm says this gives it critical mass with capacity to grow the strategy.
“We think that absolute returns fixed income strategies are the way forward after 30 years of declining yields,” Brain says. “Investors need to think about moving away from high yields, but not quite just yet.”
– G.B.
