While generating income in a low-yield environment is at the forefront of many investors’ minds today, the idea that the preservation of capital is more important than the return on capital may be as important as ever. Relative performance is nice, but losing money, particularly in fixed income, isn’t what investors sign up for. In our view, risk management is an essential skill of experienced fixed-income managers and the key to seeking income and preserving wealth for investors regardless of the market cycle.
When it comes to global fixed income, we believe there are four main types of risk. Depending on the cycle, each of these four risks can vary in importance. They persist in quieter times as well as during extreme events, including moments such as in March 2020, when fixed-income markets were fraught with peril. In our view, understanding these risks is the key to separating spread opportunities from liquidity traps in the midst of crisis and to seeing longer-term potential beyond the immediacy of turmoil.
1 Credit risk
Because fixed-income investing hinges on issuer solvency, the first risk is credit risk. Managing credit risk means generating income with careful bottom-up security selection and vigilant monitoring of issuers. In today’s market, when investors are starving for yield, it’s worth remembering that companies often have little difficulty raising capital through debt issues, even when their fundamentals don’t support them.
Credit risk also involves discipline about pricing. Tight spreads can get tighter and wide spreads wider, but managers who’ve experienced several market cycles have a natural edge over those who’ve only worked in the latest market regime. While credit risk management isn’t market timing, it can benefit from being well versed in history.
2 Liquidity risk
A second pervasive risk fixed-income investors face is liquidity risk—the management of which is about avoiding the trap of being unable to exit crowded trades when a major change occurs. We define liquidity risk as the opportunity to buy and sell the desired quantity at a price deemed reasonable. This can apply to a wide variety of bonds and related products and can carry extreme consequences for investors. This is especially true regarding high-yield and emerging-market bonds.
3 Currency risk
In a global fixed-income context, managers also need to be able to manage currency risk, knowing when hedging is essential and when forgoing the currency aspect of an international security hedge may be both prudent and an opportunity for incremental return. The risk of going unhedged can be significant, as can the rewards. As Morningstar recently wrote, “While unhedged foreign bonds have some diversification benefits, the volatility stemming from currency movements can swamp that of the bonds themselves.”¹
A global perspective helps in this area. After spiking during the March 2020 crisis, the dollar fell to levels not seen for several years, with many anticipating further declines. We’ve heard from prominent sell-side analysts a range of 3.5% to 15.0% falls in the dollar depending on developed-market currencies versus emerging-market currencies.² This makes for interesting opportunities in higher-yielding emerging markets on an unhedged basis. But that may expose a portfolio to unexpected events that might drive investors to the dollar as a traditional risk-off trade. This needs to be monitored closely.
4 Interest-rate risk
Finally, and perhaps most readily understood by investors, there’s interest-rate risk. In today’s environment, with the short end of the yield curve possibly depressed for years, investors must be prepared for a steepening curve while recognizing that different scenarios may play out. A low-rate environment may tempt some to take more credit risk than appropriate, or, depending on the slope of the yield curve, to expose their portfolios to excessive interest-rate risk. It’s also the case that staying at the short end of the yield curve when the U.S. Federal Reserve (Fed) is suppressing rates around zero makes it difficult or impossible not only to earn income, but to keep up with even modest inflation. Coming back to credit risk, since the four risks are intertwined, exposure to corporate debt may allow for spread tightening, or the perception of credit improvement, to offset a rise in rates.
Reading risk signals at the outset of the pandemic-led crisis
While the March 2020 sell-off created opportunities for managers who thought spreads were excessively tight in early 2020 and had consequently built up dry powder, it also benefited those with the ability to see beyond the immediate crisis. There were also warnings that some managers caught, giving them the opportunity to cut risk ahead of the implosion. On January 23, Hong Kong had two major cancellations because of only two reported COVID-19 cases. One was the Lunar New Year carnival³ and the other was the Lunar New Year Cup football tournament.⁴ While many global investors paid little heed, some recognized that these cancellations, though possibly made from an abundance of caution, might signify a much wider concern.
Managers who hedged or carefully reevaluated their credit, liquidity, and currency risk exposures at or around this point were generally better positioned to follow the Fed’s late-March programs than their less mindful competitors, profiting accordingly. High-yield spreads jumped from 358 basis points to 403 in the two days following the Hong Kong cancellations, but it’s worth noting that the S&P 500 Index hit a then all-time high nearly a month later, when spreads were back down in the 350s. Only in the ensuing weeks did spreads blow out. But those managers who recognized that this credit event was a widening healthcare crisis—rather than a structural financial one as had happened just over a decade earlier—and who bought aggressively would’ve benefited from spreads—particularly in high yield—largely recovering throughout the remainder of the year.
High-yield spreads stayed roughly flat well after Hong Kong COVID-19 warnings
ICE BofA OAS, bps
Source: fred.stlouisfed.org, 12/22/20. The Intercontinental Exchange Bank of America (ICE BofA) Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond's OAS, weighted by market capitalization. 100 basis points (bps) equals 100%.
Fixed-income risks and opportunities in 2021
While there are reasons to be cautiously optimistic—the potential game changing success of millions of vaccinations, the U.S. elections completed although not without incident, and a resumption of economic growth overseas—the pandemic remains a major risk to an uninterrupted turnaround. Local lockdowns across multiple geographies could set the recovery back considerably in the short run. If geopolitical concerns subside, emerging-market debt may be a bright spot for those with the requisite experience in active credit research and the liquidity nuances of local markets. Judging whether, or how much, to hedge currency risk will also be essential, given the dollar’s potential volatility.
Furthermore, with the Fed having announced its intention to let inflation run “hot,” a steeper yield curve may follow, and inflation-protected securities and floating-rate bonds may benefit. Along these lines, the Democratic victories in the Georgia senatorial run-offs helped push the 10-year U.S. Treasury above 1% in short order, breathing new life into the management of interest-rate risk.
It’s likely that the high recent level of mergers and acquisitions will broaden market activity and add to liquidity. Meanwhile, the Brexit resolution, though fraught with new regulations and likely harmful to the British economy overall, at least sets out a framework for Britain’s new relationship with the European Union. Liquidity will likely be less of a concern than it might have been in a no-deal Brexit, and despite criticisms, the United Kingdom is still considered a highly favorable location for international business.⁵ As always, risk management in all four critical areas will be paramount—keeping nimble, seeking opportunities, and recognizing where the pitfalls may lie.
1 morningstar.com, 6/4/20. 2 See, for example, Goldman Sachs’ “GS Macro Strategy 2021 Global FX Outlook Dollar Downtrend,” 11/13/20. 3 thestandard.com.hk/, 1/23/20. 4 scmp.com/sport, 1/23/20. 5 bloombergquint.com, 1/11/21.