Gopi Karunakaran: We specialise in one particular style of fixed income investing called pure relative value investing. To give some context around that, think about fixed income through the different levers that you can use to generate returns.
There are various fixed income products with different names but when you distil it down to what drives returns and risk in those portfolios, it comes down to a combination of two levers. The first lever is interest rate duration, which comes from long-dated government bonds and the other lever is credit.
"In stressed environments, the pure relative value lever has a bias to do well."
Duration and credit are the two levers that you will see in 99% of fixed income products which exist in the market.
We think of pure relative value as the third lever in fixed income; this behaves very differently to duration and credit. That difference in behaviour can unlock risk diversification benefits.
It's not to say that a third lever is necessarily better than duration or credit. The key is that it behaves differently, and particularly in environments where that duration lever or that credit lever may not do very well. In stressed environments, the pure relative value lever has a bias to do well. From a quality diversification perspective, it tends to complement conventional investments very well.
That's the crux of a lot of conversations we're having with insurers: “you have your government bonds and Credit Allocation but there’s something that sits next to those to improve your risk return profile by using the power of diversification”.
Mark Pearce: Referring to pure relative value, we are looking to exploit mispricing between fixed income assets with very similar risk characteristics, so for example, government bonds and government bond futures.
What creates these opportunities is surprising for a lot of people to hear, is the fixed income market, the second largest and most liquid market behind the currency market, is highly inefficient. The reason for that is the biggest players in the fixed income market transact for reasons other than profit maximisation.
The biggest players - governments, central banks, pension funds, insurers - will be either buying or selling bonds for policy reasons (i.e., governments). Whereas pension funds and insurance companies will be making asset allocation decisions that could reflect a change to their investment strategy or even a change in the regulatory environment.
So, these large movements are not designed to maximise profit and that creates inefficiencies. This is what our pure relative value strategy is looking to exploit.
Gopi: The context of that is we have been in an environment where, following the resurgence of inflation, interest rates had gone up and therefore bond yields have gone up significantly, having previously been near zero in many parts of the world.
That shifted the landscape in fixed income, because finally you could get yield, and so you could buy bonds and credit. It was starting to get interesting again.
Now we've come full circle, and we're going back into a rate-cutting cycle. Most central banks around the world, certainly the large ones, are already cutting interest rates, and there's an expectation that this will continue, and that's being priced into markets.
"With yields going down, and spreads going down, people are concerned about whether they are getting compensated for the risks that they’re taking."
This means the forward-looking return potential of those conventional yield-based fixed income investments is no longer as good as it used to be. If you look at something like the Bloomberg local government bond index, it's up 12% or thereabouts over the last year, which is a great performance. But with the yields then having come down, the trade-off is the future looks quite different, and that's something we're seeing in the conversations that we're having with insurers.
The nuance of that is the total yield component is starting to come down, but also credit spreads, which is that extra compensation for taking credit risk, as opposed to buying government bonds, has come down and it's almost back, in most places, to historically low levels. People are starting to get a bit more concerned about it.
With yields going down, and spreads going down, people are concerned about whether they are getting compensated for the risks that they’re taking on a forward-looking basis.
Gopi: When you think about conventional fixed income, a lot of it is about yield and the income or return that you're getting. It is important in the context of the risk side of the equation, and how you put together a portfolio, to think about how that return is being generated, and that speaks to the style of returns.
When we talk about the style of returns, we mean how that return profile will behave in different market environments. For example, in periods of market turmoil, or if inflation is going up or down. Also, how is that return pattern going to behave relative to other things that might be in the portfolio?
For example, imagine you've got two fixed income portfolios. Portfolio A is buying government bonds. Portfolio B is buying short-duration corporate bonds.
You could compose both of those portfolios to have the same yield. Therefore, from a size of return perspective, you could look at portfolios A and B and think they're similar. But the style of return in those two portfolios is going to be different because of what might happen if we went into an economic growth shock scenario; the corporate bond portfolio could perform badly in that scenario as corporate profitability drops, balance sheets get squeezed, etc. Whereas the government bond portfolio could perform well as central banks cut interest rates in response to that.
There are lots of fixed income investments that give you large return. How they are doing it is an important consideration, particularly in the context of what the world looks like going forward.
Mark: The style of return is as important today as it has ever been. Perhaps we are past the point of peak uncertainty as far as there's more clarity on the direction of interest rates.
"Then there's the geopolitical aspect – the potential for existing conflicts to escalate and new ones to arise."
We don't have to go back very far to where there was uncertainty about whether central banks would be lifting rates or cutting them. Now we are in an environment where there remains a high degree of uncertainty and questions on valuations.
Then there's the geopolitical aspect – the potential for existing conflicts to escalate and new ones to arise. How quickly are economies slowing if at all? A strategy that can deliver a style of performance in a wide variety of market environments is important.
Gopi: This is an area where we think there's been a regime shift. With the classic 60/40-style multi-asset portfolio construction, most investment portfolios tended to have a lot of equities and have a lot of equity beta exposure.
The way you would balance that, or introduce some defensiveness into your portfolio, is by government bonds. So, for many periods, including the financial crisis of 2008 that strategy worked well. Things are different now because we have inflation uncertainty, which we haven't had for a long time, and that changes the behaviour of government bonds.
If you're thinking about government bonds – which are long duration – as your sole defensive lever then the problem with that is, yes, there are scenarios where that's going to work, such as an economic growth slowdown scenario or recession scenario, but there are many scenarios where other catalysts could cause equity markets to fall. In those scenarios, bonds may not behave defensively.
As an example, we have uncertainty around geopolitics – i.e., what's going on in the Middle East – so if that has contagion effects on financial market performance, and risk assets more broadly were to suffer because of that, and if these things happened at the same time that inflation doesn't come down as quickly as people had hoped, or starts to go up again, then you're going to find a situation that's a repeat of 2022 where equities, credit, and other risky assets fall. Government bonds could also fall at the same time.
Therefore, the conversations we're having are around “diversifying their diversifiers”, rather than relying on that one defensive idea of only using duration.
That goes back to the style of return; look for things that have a style of return uncorrelated to other asset classes and behave defensively, i.e., it’s biased to do well in periods where other asset classes might be struggling.
Mark: A lot of these portfolios, such as 60/40 and 70/30 style strategies, are premised on the concept of diversification. The challenge in periods of stress is that diversification benefits disappear.
"Just because something has the label ‘fixed income’, or ‘bond’,
doesn't mean it behaves defensively."
What CIOs are being forced to think about is how each part of their portfolio will behave in a different market environment, and how that broader portfolio will behave in a wide variety of market environments.
We talk about risk diversification as being very important but the focus in building our portfolios is risk balance.
Gopi: It’s important to look beyond labels. Just because something has the label ‘fixed income’, or ‘bond’, doesn't mean it behaves defensively, because the association is that just because it's fixed income, it's defensive. There are many types of fixed income – for example, things that involve high-yield credit, which may not behave defensively, but they may be correlated with equities on the downside.
Gopi: This relates to how the behaviour of investments can change in different market environments.
Many investments appear to have diversification benefits most of the time so if you look at how they performed on average – and they can show low correlation versus other asset classes, which is what you want when you're looking for something that's a diversifier – then when you transition to a stressed market environment their behaviour can change, and they can become highly correlated with other asset classes on the downside.
The classic, in the fixed income world, is anything that has an amount of credit risk associated with it. In the good times, it will be stable, and you'll get your yield, and it's going to look uncorrelated to equities, but then you move into a stressed environment, such as 2020 when Covid-19 hit, and it starts to behave more equity-like on the downside.
Therefore, it’s important to ask how this behaves on average, but separately, how's it going to behave in various scenarios? Is it going to retain those defensive benefits when it’s needed?
Gopi: The common perception amongst people in fixed income markets and investing, is that there are well-defined frameworks for ESG in equities and in credit and corporate securities as well – but when it comes to government bonds, people have put that in the ‘too hard basket’, because it’s not a space that's well researched and doesn’t get a lot of focus.
We think there's a lot that can be done in that space. For example, engaging with government bond issuers. So, as active participants in buying bonds when governments come to issue new finance deficits, we then have the opportunity to sit in front of the key people at Treasury Departments to these countries and can convey the concerns around the ESG-related concerns and aspirations of our stakeholders with the people that invest with us.
"What the issuers find helpful is when an investor shows them how much and where there would be demand if they were to issue a bond today."
We can act as a conduit to pass and encourage them to do things such as issue more green bonds. It’s an area where we've had success because in certain markets there's openness to that.
What the issuers find helpful is when an investor shows them how much and where there would be demand if they were to issue a bond today. They can say here's how much we buy at this price that we want to buy at, for instance.
That gives the treasury confidence that there's going to be demand for them to build a new issue around, which incentivises them to issue more of these types of bonds.
