These are certainly interesting times to be a fixed income manager, and challenging too. With government bond yields at historically low levels, many offering negative yields, investors are right to ask why they should consider backing the asset class.
First State Investment’s Head of Asian Fixed Income, Jamie Grant understands the conundrum for investors; with a gradual uplift in volatility, are they getting the returns? But he maintains that the Asian fixed income sector has the ability to outperform its peer group over the short and medium term.
Concerns about market liquidity are overplayed, he says, especially in Asia where the market has grown significantly since the GFC. In November 2008, there were 127 issues in the JACI index (JP Morgan Asian Credit Index), but by November 2014 that number has grown to 334. New issuance is supportive of the market and according to First State Investments’ analysis, 2015 will be in line with 2014 issuance levels.
Despite this sustained growth and the macro-economic picture that supports it, Grant notes that Asian clients have a very different attitude to local bond markets compared to equity markets. “From an equity point of view, Asian clients will invest in the region, whereas Asians investing in fixed income will mostly invest outside Asia. This may change though, as we now have sector and country diversity to a much greater extent. This has really only evolved in the last five years.”
“In 2014 we met a lot of Asian investors who were invested in the US high yield and were concerned about the volatility experienced in that asset class, given declining commodity prices and the expected rise in interest rates in the US. We have been an advocate for a switch into Asian investment grade as the expected volatility is lower, yet the yield give up is less than you would think.”
To give an idea of how First State Investments shifted its portfolio stance in mid-2014, Grant says, “When considering our strategies for interest rates, we focus on the direction of 10 year government bond yields. In August 2014 despite the improving outlook for the US economy and expectations for higher yields, the bond market did the opposite. Our approach to US interest rates considers many factors yet at the time we felt if the 10 year German government bond yield fell below 1%, there were broader disinflationary pressures that could have a downward impact on the US yields and you needed to be long duration. Yet with such low yields, you have no protection if you get it wrong, so in the end we settled for a neutral strategy and employed various curve strategies instead.” And as we have seen, sovereign bond yields, especially in Europe, have plunged further, with German bonds at 0.35% in February this year.
When it comes to risk management, Grant says the fixed income team tries to adopt a simple approach. “The mindset is that when you enter a trade, before you do that, you need to think what will happen if you get it wrong. As a portfolio manager, you need the courage to hold your hand up on those occasions when your decisions go against you. No one can get every decision right and what defines a good manager is how they deal with the ones they get wrong. No position should ever be as big as to potentially destabilise the portfolio. So understanding what your breakeven is over your chosen time horizon will help you manage your risk.”
Grant points to a number of reasons why First State Investments’ approach is likely to deliver outperformance over the long term. “When building corporate portfolios we diversify through sector and country.” For country selection, the firm uses a factor-based approach; namely a macro-economic assessment, political environment (a key factor in Asia), market sentiment (level of issue oversubscription) and technical. “The number one factor, though, is valuation. This approach delivers an optimal portfolio basis that has delivered good risk-adjusted returns through the cycle. Interest rate strategies are managed (relative to benchmark) through the use of futures.”
Looking at the interest rate policy considerations, Grant says, “What I worry about is the use of models and the fact that most managers and sell side analysts are using a similar approach. So you will get a lot of very similar results. This is not a normally functioning market; it is still being heavily influenced by central banks. That is why we use a factor-based approach, rather than a model approach, and we analyse it every single day.”
He is also of the view that if you manage assets in the region, you need to be living in the region. “That experience of working in the region is important and has certainly worked for First State Investments since we took the decision that Asia was a major growth area for our business.” First State Investments’ analysis supports the view that Asian economic strength is set to continue, making Asia the standout in emerging markets.
“Another thing to consider is that some managers in the fixed income space have just become too big. You wonder how they are able to move their portfolios – it’s such a challenge. You don’t have the variety of derivatives in the region, and in any case, clients are very risk averse when it comes to derivatives.
Local currency considerations will become more important over time, but First State, like most of its peers, likes Asian corporates in USD. “A lot of attention was paid, post-2008, to investments in local currency bonds and setting up of funds. The returns are there- but you get more volatility”. Having said that, the firm does take positions and is currently still bullish about the Indonesian Rupiah and the Indian Rupee.
“We’ve been in Malaysia at different times, but it’s really suffered from the drop in oil prices. The US dollar strength and Yen weakness are impacting the Korean won. The Rupiah and Rupee are our favourite currencies at the moment, offering attractive yields and some fantastic opportunities. Russia’s recent downgrade to high yield has seen their bonds exit certain benchmarks. This plays well for the likes of Indonesia as its index weighting increases.”
“We expect volatility to pick up in 2015 as competing Central Banks seek to devalue their currency and drive up inflation expectations. This will pose challenges for Asian currencies and economies. As well, the likelihood that the Federal Reserve will raise rates.” Grant predicts however, that with the Federal Reserve likely to raise rates in the summer, financial markets in Asia will be able to cope relative to previous periods of raising rates, “given the general health of Asia economies and the fact that forward guidance has given us time to get ready,” he says.