Over the past months, bond investors continue to trend with caution their appetite for the fixed-income asset class, given the belief that 2018 will be a rate-rising environment. Thus, the question of where bond markets will be heading through 2018 is more than a legitimate question. However, despite the preposition of monetary tightening is a real threat to the fixed-income asset class per se, there will always be value in bond markets.
Over the years, the fixed-income asset class per se has expanded and thus, it would be unfair not to consider its diversity, which will ultimately also affect its sensitivity to the theoretical aspect of monetary tightening.
Indeed, opting for a look-through approach within the asset class is imperative in order to lock in attractive returns. In my view, to achieve such objective, it is important to take on a two-fold approach: that of primarily capital preservation coupled with decent returns and the need to search and exploit hidden value.
Looking at the first approach, despite that market participants do invest to increase their wealth, I think capital preservation is one of the initial objectives in the investment world. Thus, it is crucial that underlying investments are selected through a thorough analysis of both the macro and the micro factors – putting it simply on what we call systematic risk, i.e. market risk and idiosyncratic risk, i.e. specific risk, for instance to a particular industry or company.
Given the current market conditions, I believe most market participants are in consensus that in 2018 we will be faced with further monetary tightening not only in the US but also in Europe. Case in point: last Wednesday the Federal Reserve has once again increased interest rates and it announced that it expects to raise them further by another three in 2018.
Likewise, lately the European Central Bank - despite extending its bond-buying program - reduced its monthly purchases. In both cases, this is a clear indication that the path of monetary easing is approaching its end.
Given the aforementioned path, one example would be the rationale to reduce drastically exposures to sovereign debt (capital preservation), primarily to the long end of the curve. Clearly, the risk-reward element is unappealing in such case.
The second approach is more in line with the active management preposition of primarily finding relative value by exploiting specific risks which might have affected negatively a particular issuer. Such risks would be usually triggered by operational leverage or financial leverage or a combination of both. In my view, identifying the hidden value is not always that straightforward and this is why it is crucial that one should give the necessary importance to certain elements when analysing the said mispricing. It is also important to look at what could be the catalysts of upward pressures on prices, if any, and what is the probability that such catalysts occur.
Certainly, given the recent tightening in yields, one might argue that the second approach is irrelevant. However, given my experience within the sector, relative value opportunities are still in place. In such cases, this is why opting for a bottom-up approach is imperative in unlocking the hidden value, which is the prime element for attractive returns going forward.
One word of advice is that despite the fact that current yield scenario might be unattractive, while theoretically a rising interest rate scenario is detrimental towards the fixed-income asset class, bonds will continue to offer value in one way or another. Going forward, try to exploit hidden value by being very selective in your bond picking. That said, the current environment for bond markets from a monetary perspective is challenging, and yes, a cautious stance is warranted.
Disclaimer:
This article was issued by Jordan Portelli, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.