The fixed income universe is home to a broad spectrum of opportunities, but many investors misunderstand exactly how diversified they are, according to Mike Riddell, fixed income manager at Fidelity International.
“People often talk about how some rating bands might offer better value than others, or how investment grade is cheap versus high yield or vice versa,” he told Portfolio Adviser. “All my career I’ve heard people go, ‘Oh, we love double Bs, we hate single Bs or Triple Cs’ or so on.
“But in practice the spreads on different rating bands tend to move closely together, and across different geographies or even sectors.”
In fact, most 10-year sovereign bond spreads are essentially a beta play, according to the manager, and so end up being much more correlated than investors think.
“10-year maturities tend to be very closely correlated among different global bond markets – they are generally driven by global rather than domestic factors,” Riddell said.
“If central banks don’t hike as much as expected then it’ll likely help a bit, but this maturity is also driven by global risk premia [or ‘term premia’ when looking at government bonds], or energy prices, global bond issuance etc.”
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As an example of this, he pointed to spreads on US investment grade bonds (based on CDX) and European high yield (based on iTraxx) since 2012. According to Bloomberg data, the two had traded almost in lockstep, he found.
“Sometimes there are differences, where for example US credit markets underperformed European credit in 2015 because oil prices were tumbling, and this was terrible for all the shale oil producers in the US credit indices, where European credit markets had a far lower oil weighting,” he conceded.
“But these markets are clearly very highly correlated most of the time, where the main difference is just beta,” he said.
There was a similar trend between different parts of the European sovereign bond market, he continued. Since the pandemic, the 10-year yields on the Italian, German and Spanish sovereign bonds have also followed the same line, he argued, demonstrating this correlation in action.
On top of this, not only are parts of the credit market more correlated to each other than investors may think, but they are also often more correlated to equities than they appear.
“Credit spreads behave like equities, and always widen during times of financial market volatility,” he continued. “This is particularly the case for funds that behave more like high yield corporates, where correlations between high yield bonds and equities are typically +0.6 to +0.8, or sometimes even higher in times of crises.”
While these markets have performed very well in recent years and may continue to perform in the near term, investors need to be more flexible, he argued.
“We really don’t understand why global investors continue to pile into US and global corporate bonds when there is so little value there, with credit spreads back close to record-tight levels,” Riddell told Portfolio Adviser. “If you want to create some diversification in your fund, then you need to have tools available to you.”
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For Riddell, a particular area of interest is emerging markets currency and rates, although he has reduced some of the positions recently.
One area he particularly liked was Colombia, which he said offered “superb value”. Sovereign bond yields in that market hover around 12%, while the inflation rate is currently around 6%. Additionally, its sovereign bond has risen while most competitors have not and has performed very favourably against the US dollar (up around 30% as of the end of August), he said.
“We’ve had exposure of up to 4% of our fund through this year, which has not only added to returns, but has also been a diversifier,” he noted.
However, EM currency is not the only area he’s been finding opportunities this year, with the Fidelity manager arguing some developed markets are mispricing the chance of a rate hike.
“We believe that rate markets in many countries globally are overestimating the likelihood of central bank policy hikes,” he said. “We think it’s more likely that there will be no rate hikes in these countries than twice as many rate hikes as currently priced in.”
For example, Norway has “super high interest rates that barely got going with cuts” but has enough money that it’s facing none of the fiscal problems that most other developed market economies seem to be facing, he said.
“Korea is another country where there are a huge number of hikes priced in, but where we don’t think these will materialise, which makes the country’s sovereign bonds look very cheap.”
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