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Fixed-Income Insights

Why professional managers may be best positioned to uncover opportunities in a tricky fixed-income market 

 

In Brief

There are five market factors in 2014 that fixed-income investors should weigh carefully as they consider their next moves—and the role that active portfolio management may play in addressing them:

  • Most credit spreads are below historical averages. Yield spreads within the investment-grade corporate, high-yield, or municipal sectors likely will continue to widen until they eventually return to normal.

  • Call protection is being reduced. Call protection prevents bond issuers from redeeming a bond for a specified length of time. Recently, some corporate bonds have offered three-years' call protection, instead of the more traditional five years.

  • Covenant protections are waning. There was a dramatic increase in covenant-lite loans in the latter half of 2013. These issues are characterized by less-stringent financial requirements.

  • Markets continue to experience periodic bouts of panic. Emerging market concerns and Federal Reserve worries have contributed to volatility in the fixed-income market.

  • M&A deals are big and becoming bigger. One recent survey shows that companies expect to step up merger and acquisition (M&A) activity. Such a trend could result in larger, more leveraged corporate finances.

  • The key takeaway: The resources and experience of active managers should continue to provide rigorous credit analysis and may lead to opportunities that may not normally be available to individual investors.

 

Equity market volatility and emerging market concerns have increased investor focus on the fixed-income sector in recent months. While domestic equities have seesawed, and emerging market portfolios have suffered losses, many investors have sought haven in a combination of cash-equivalent and fixed-income securities. These "flight to safety" moves reflect a desire to balance equity volatility and a need for income. That combination of relative safety, balance, and income that investors seek from their fixed-income investments will inform the quality, maturity, and sector structure of their bond portfolios.

That structure may benefit from professional advice—and a rigorously constructed investment plan—not only to integrate fixed-income investments with the equity portion of an investor's portfolio but also to accommodate an investor's risk tolerance. In the current low-yield environment, execution of the portfolio structure—that is, professional management of the investments contained therein—can be as important as the overall design.

That professional approach takes on a greater significance in the current environment. Specific characteristics of U.S. fixed-income markets today combine to create more treacherous conditions for investors seeking safety, income, or total return. The gradual decline in interest rates that has been an underlying support to bond prices over the past 30 years seems to have run its course. Not only do bond investors lack this tailwind but, in 2014, they also will lose support of the Federal Reserve as the central bank unwinds its quantitative easing program. The Fed’s program of monthly bond purchases acted to dampen yields and reduce supply of available government securities on the market.

Other factors pose additional challenges. Low yields have pulled credit spreads below historical averages, implying less favorable valuations for certain classes of fixed-income securities. Increased demand for higher-yielding corporate debt has allowed issuers the opportunity to reduce covenant protection and call protection, lending additional risk to that asset class. Add these factors together, and the result is an environment for fixed-income securities that is not as friendly as it often has been during the last 30 years.

But investors don't have to navigate this tricky landscape by themselves. Below is an examination of five market factors in 2014 that investors should weigh carefully as they consider their next moves—and the role that active portfolio management may play in addressing them.

1) Most credit spreads are below historical averages.
Whether purchasing investment-grade corporate, high-yield, or municipal securities, a buy-and-hold market purchase within almost any bond sector at narrow yield spreads (the difference in yield between two securities under comparison) could produce disappointing performance as interest rates rise, because spreads likely will start to widen until they eventually return to normal. Although there is no guarantee that the market will perform in a similar manner in the future, professional management can evaluate the likelihood of further narrowing by analyzing past interest-rate cycles. They also can potentially mitigate at least some of the possible underperformance by focusing on specific securities or ratings categories whose spreads have declined less than similar securities or neighboring ratings categories. Active management can selectively avoid, or rotate portfolios out of, pricey securities and into those believed to have greater value.

Also important in 2014 will be a manager's access to attractively priced issues, as net new supply in many bond sectors is expected to be lower than 2013. Movements in yield spreads among fixed-income sectors, ratings categories, and types of securities can differ due to changes in supply, shifts in demand, and the impact of industry or sector-related news. Active management is designed to identify those changes and the valuation differences they create.

2) Call protection is being reduced.
Call protection, which prevents bond issuers from redeeming a bond, or replacing it with a different security, for a specified length of time, is important to investors who want to guard against rapid loss of attractive income when a bond is called by the issuer and replaced with an issue with a lower coupon. Recently, some corporate bonds have offered three-years' call protection, instead of the more traditional five years. Unlike most exchange-traded funds (ETFs), which are designed to provide investors the performance of that market or sector—including poorly structured bonds—active bond management allows the manager to steer away from bonds with less protection, unless there is some form of additional compensation, such as a lower purchase price or a higher call price.

Active management of callable bonds also permits the manager to capture the price premium on a high-coupon bond before it is called away by the issuer at a lower call price. This call management strategy can be particularly effective with municipal bond portfolios.

3) Covenant protections are waning.
The dramatic increase in covenant-lite loans in the latter half of 2013 has important implications for fixed-income investors. These issues, characterized by less-stringent financial requirements, demand more thorough research and analysis of the issuing company, a better understanding of its management, and an ability to stress-test its financials. While evaluating the issuers employing covenant-light securities, it will be essential to distinguish effectively managed, thoughtfully structured, well-positioned companies with solid financials from those using debt to substantially increase leverage, provide payouts to owners, or fund potentially ill-advised acquisitions. Failure to correctly distinguish among credits could produce disappointing results and, at worst, defaults.

Although defaults are not expected to increase substantially over the next few years, it is important to understand that an ETF that is designed to replicate the bank-loan market makes no attempt to distinguish among different credits and, through its design, assures that its investors participate in all bank loans, essentially assuring the market rate of defaults.

4) Markets continue to experience periodic bouts of panic.
The comfort of active management may allow investors the opportunity to avoid panicked selling. Emerging market concerns early in 2014 led to an investor exodus from that sector and resulted in plummeting security values. Other risky fixed-income securities were also driven down in price, creating buying opportunities for experienced and less emotionally involved managers. At the same time, a flight to quality by some investors led to a price spike in U.S. Treasury securities, which subsequently was followed by a return to earlier lower valuations.

Active professional management can enable investors to avoid emotional investment decisions, embracing the herd mentality, or remaining too cautious when opportunities unfold.

5) M&A deals are big—and becoming bigger.
Ernst & Young's fourth quarter 2013 survey of senior executives from large companies around the world revealed twice as many executives intending to engage in larger merger and acquisition (M&A) deals compared with six months earlier. Larger acquisition activities could result in larger, more leveraged finances. If M&A activity reflects consolidation within an industry such as telecom or pharmaceuticals, the market could produce excessive amounts of debt in a particular industry. An ETF designed to reflect the debt market or bank-loan market would reflect M&A concentration and unwittingly pass on such exposure to investors. Increased debt in a particular issue or industry should not void the principle of portfolio diversification.

Most concerning would be ETFs of lower-quality securities that may include issues like Energy Futures Holdings Corp., which has raised market concerns that it will default on $45.6 billion of debt in 2014. While the research and analytical resources of professional managers would ideally help them avoid exposure to bankruptcies, even basic investment guidelines should limit issuer and industry exposure and assure the fundamental benefits of diversification.

Conclusion
The traditional benefits of active management are well known. But factors specific to the fixed-income market of 2014 lend this approach greater appeal; by contrast, these same factors could cause unpleasant surprises to those opting instead for unmanaged market exposure. Tight credit spreads, the increasing prominence of covenant-lite features in corporate debt, and reduced call protection are likely to continue to characterize markets as income-seeking baby boomers provoke a supply/demand imbalance that favors issuers. In addition, continued slow economic growth seems likely to promote mergers and acquisitions capable of producing large issuer and industry debt concentrations.

Active management seems better poised to resolve these concerns than unmanaged exposure. The resources and experience of active managers should continue to provide rigorous credit analysis and lead to opportunities that may not normally be available to individual investors.

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