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Where the Value is in Credit

From the Nov 2020 Aviva Resilience Special Report

Investor resilience has come under severe strain in 2020; perhaps to levels not experienced since the darkest days of the global financial crisis. But as we move into the second half of the year, market signals and economic reality have become seemingly oblivious to one another, including in many areas of the credit market. This disconnect raises questions that emphasize the importance of integrating resilience into their portfolio construction process, as this special report explores.

1 Where the Value is in Credit

Even before the COVID-19 pandemic, low and negative interest rates and climbing valuations were making it difficult to construct a credit portfolio for all seasons. With the additional issues presented by the pandemic and its resultant economic fallout, the challenge became that much more difficult. You’d never know it speaking to Colin Purdie and Josh Lohmeier, however. Purdie, Aviva Investors’ Chief Investment Officer, Credit, and his colleague Lohmeier, Head of North American Investment Grade Credit, don’t downplay investor concerns – but they are confident that their approach and strategy can handle whatever global markets throw at them. II recently spoke with Purdie and Lohmeier about where they see value and alpha in the credit market right now.

When the pandemic emerged, did you find your credit strategy required some tweaks to deal with what was happening?

Colin Purdie: The short answer to that is no. We don’t just hold yield, we don’t just buy BBB and hope the spreads tighten. We don’t have that bias in our portfolios because of the process that we use.

Josh Lohmeier: We’re not trying to pump the gas or the brake, or time the market. Ours is a story of allocating risk more effectively than the market. We’ve built our entire strategy around portfolio construction and risk allocation so that we don’t have to guess the possible direction of the market. If we can achieve a better understanding of why and where credit benchmarks are inefficient at a point in time, and still get great idiosyncratic ideas bubbling up from our research team, our job as portfolio managers and risk allocators is to put those pieces of the puzzle together in a more thoughtful way. The end goal is to deliver consistently positive outcomes for the same beta as the universes we’re being asked to manage against.

Purdie: This crisis escalated quickly, but there was no need for us to panic at that point. Our beta was in line with the benchmark, so it wasn’t as if we were sitting long, felt wrong, and needed to jump out of it. The process stayed the same, but obviously we looked at things slightly differently.We’d been running with a positive technical in markets for a number of years in Europe based on everything the ECB [European Central Bank] had been doing with buying bonds. Alongside the positive technical environment, the prevailing fundamental story was that economies were starting to improve, and Europe ticking up from what was a relatively mediocre place. Then the pandemic struck, and the conversation suddenly changed to, “Well, actually, this is going to have a very sharp, potentially short but deep impact on economies, and it’s going to impact some sectors more than others.”

In the U.S., for example, the banking sector got hit quite quickly, because people were thinking it was going to be 2008 all over again. We determined immediately that it wasn’t a financial crisis, but a corporate crisis. So, it was a matter of looking at sector fundamentals and valuations and balancing that against the technicals – which were changing all the time – and trying to ascertain whether we were getting paid for the risk that we’re taking. Our process had us in the place we wanted to be – we didn’t need to offload risk as quickly as possible.

Even if you’re not stepping on the gas or pumping the brakes, you obviously can’t be coasting or sitting still.

Lohmeier: No, we still have a view on the markets. Allocating risk is like dancing a delicate tango – you work very hard to figure out where the best value is across sectors, curves and ratings, then you strategically position your risks in a way that allows you to neutralize your beta to the benchmark – all while getting rich alpha from your top idiosyncratic picks and being more efficiently allocated structurally. Overall, I don’t think our industry does a very good job of allocating risk. It does a great job of finding idiosyncratic things it likes and can articulate, but not a great job of holistically putting it together in a more thoughtful way that gives a client a better risk-adjusted return. That’s the area of the market where I think we’ve excelled, and we’ve really seen a lot of external growth over the last couple of years on the back of that process and that message.

We create a portfolio based on the world we think is going to happen, and then we stress test that portfolio against different environments, including severe systemic shocks. We do that to make sure the core portfolio we’ve built for the world we think is going to happen is also downside protected in a systemic shock environment. By forcing your portfolio to always serve those two masters, you’re prepared for an environment like we experienced in Q1. Instead of scrambling to change your strategy or position, you’re immediately going on offense and thinking, “Based on what I know now, and based on the valuations I see today post-volatility, where can I shift risk to take advantage of it?” You’re not adding or reducing risk at that point, you’re trying to recycle risk.

Where are you seeing value and potential in the credit markets at the moment?

Lohmeier: One key area is the six-, seven-, and eight-year part of the IG [investment grade] credit curve for riskier credit, relative to the one- to five-year part of the curve. Structurally, we think it makes sense to own more of your riskier beta in the belly of the curve – between six and 10 years, and still have plenty of core defensive positions out on the longer duration part of the market, knowing that fundamentals in valuations have gotten a little stretched. The very front end one- to five-year part of the IG market has been incredibly bid up. Valuations are stretched based on where we’re at in the economic recovery. The technical/stimulus tail has wagged the dog with regards to valuations across all risk assets.

Now it’s about hunting and pecking to balance opportunities that you believe in fundamentally, versus the technical argument, and a very real risk that governments are going to do their best to inflate anything they can, including risk assets – so the technicals can keep grinding tighter, as well. Everyone knows that’s where the Fed is focusing its corporate bond buying and its liquidity measures: the market has grasped hold of that and almost priced it in as if companies can’t default. We would caution investors and say, “They’re providing liquidity, they’re not providing revenues or cashflows, so don’t mistake liquidity for bailouts.”

Purdie: From a global perspective, the technicals and the fundamentals pull you in different directions. For long-term investments, we’re looking to sectors where we have confidence in the cashflows and the business models. We’re not taking a bet on any particular timing for a vaccine or recovery of a particular industry. We hope a vaccine will come through at some point, but consumer trends have changed or accelerated. How people do what they do – and where they do it – will be different, even if there’s a vaccine. We have confidence in IG because of that buy-in that’s forcing people to look for yield, but at the same time, know what you’re buying, know your credits, and understand that the world has changed. A lot of companies that don’t adapt to change will ultimately suffer, and some within the high yield space are clearly going to default. So, one trading theme right now is to stay where we have visibility on cashflows and business models.

Josh, earlier you mentioned “rich sources of alpha.” Where are you finding alpha now?

Lohmeier: I would build a portfolio like this: A tiny amount of high-quality BBs inside of five years. I would own some BBB energy risk idiosyncratically, in the lowest quality parts of the IG market and highest quality parts of the high-yield market. I’ll caveat that by saying energy is a hot topic because we’re in the middle of a recession, and everybody’s worried about oil prices. I would argue that we are now in a scenario that will keep oil stable in the $40 per barrel range, and we don’t need a steep economic recovery to keep oil prices at a level that maintains solvency within the industry. As the economy slowly grows, oil demand will pick up faster than supply on a medium- and short-term outlook.

We still think quality banks are a good place to put some money to work. They’ve been forced by regulators to be capitalized and prepared for an environment like this, and they’ve been very proactive in reserving accordingly for a potential recession. And, as mentioned earlier, if you focus on where the cashflows are, you need to pay attention to certain areas of technology, telecoms, and cable because of where the world’s headed – working from home, needing access to data and technology, needing access to phones and internet. Those are all areas that have a longer-term stability to their fundamentals. We’re also still bullish on healthcare – not in the short term because of election rhetoric, but rather long-term due to aging populations, the need for drugs, and the need for healthcare services. Those are all extremely high cashflow businesses. Overall, if you don’t have enough high-quality duration in your portfolio, you’re probably not protecting the potential downside enough.

Purdie: There are quite a lot of tenders in the market right now – a lot of entities taking out higher coupon debt at a premium, and then reissuing at slightly tighter levels and better spreads. It’s difficult to try and identify where that comes through, but it’s a theme that’s coming into the market. You can screen the universe for who you like here, who has the higher coupon there, and we see deals coming through pretty much every day where companies are issuing and taking out debt at a premium.

Another area of interest in this market is potential M&A. There are quite a few rumors in the European banking sector, primarily in-country M&A, but also potential cross-border M&A as well. There are strong institutions and weaker institutions, some coming together where the sum of their parts is pretty strong. Some of the success we’ve had in the past have occurred when we’ve seen the right combination of companies coming together and have to fund debt for the deal to happen. It’s sector dependent and name dependent, but with the right analysis, you can identify who potentially could be a beneficiary. If you have access to the management and understand their long-term plan around deleveraging, M&A can be an investment theme.

Globally, we are seeing a second wave or extended first wave of the pandemic, we’ve seen a very contentious general election in the U.S., Brexit is still unfinished business, and in most countries the economy is not really hitting on all cylinders. What are you hearing from investors regarding their concerns?

Purdie: From an international perspective, the primary concern that we hear from investors is about negative interest rates. Throughout continental Europe – and not so much in the UK right now, but potentially in the future – government bond investors are losing money by investing. That’s going to remain the case for some time, and it forces government bond investors to hunt for yield. They’re asking: “Where do we hunt? Where is the sweet spot?” It’s a case of how far you want to push yourself along the risk curve. And that’s what investors also talk to us about. They’re landing in a fairly similar spot to where we are – investment grade is the sweet spot because you still have higher quality companies, visibility around earnings, and a bit of comfort around a fundamental story, albeit in a challenged macro environment. You also have the extra yield coming from the credit spread, so you’re not structurally locking in a loss on the portfolio. In Europe specifically, that’s the key question that keeps getting asked: “Where do we put money so we don’t structurally lose it, but at the same time not open ourselves up to a deteriorating macro environment?”

Lohmeier: The U.S. may not have negative rates, but they are far from extremely positive. As Colin noted, our clients are worried about where they’re going to get the returns they need. It’s the same problem whether you’re the CIO at a pension fund or a retiree managing your 401K. Unfortunately, what governments need to do to stimulate the economy unfortunately punishes savers. One of the ways they can inflate the economy is to inflate risk assets, and by inflating risk assets, you’re inflating valuations. We can’t mistake bailouts for solving all the world’s problems and solving all the corporate problems that are out there from a growth, cashflow, and earnings perspective. Also, don’t mistake the liquidity being provided to the market for bailouts for the entire credit universe. We’re stuck in a cycle of investors feeling forced to take risk, and then relying on a bailout from the entity that forced them to take the risk. That’s not a fundamentally strong place to be as a global economy, but that’s the tug and the pull our clients are facing. Do they get rid of Treasuries and go into investment grade now, because Treasuries aren’t providing anything other than duration risk and liquidity? And for IG risk, because they still have a return target they need to meet, do they put some into high yield?

Purdie: You can’t be passive, you have to be active and pick your spots. The authorities won’t buy defaulted bonds, so don’t think they will. If you own them and the business model fails, you take a loss on it, and investors shouldn’t forget that.

What makes Aviva’s credit approach and strategy stand out?

Lohmeier: In a market where every manager is trying to out-research each other, our biggest differentiation is how much thought and effort we put into portfolio construction and allocating risk more effectively. You can give two portfolio managers the same 20 best ideas and they can deliver portfolios with totally different outcomes, based on how they deploy that risk. The biggest value adds we provide clients are a consistent outcome regardless of the direction markets are headed, a strong focus on downside protection at all times, and a risk profile that is neutral to the market. Most managers have a style bias – they’re either a beta manager that aims to out-carry the benchmark and they’re going to show volatility in both sides of the market cycle, or a defensive manager that is going to hide out and lose money in flat or rallying markets but win in a sell-off. Often multi-manager platforms are trying to package up the right balance of risky managers and defensive managers to get to the right conclusion. No matter who you place us with, we believe our style, our strategy, and our risk allocation process can result in a complementary outcome for an investor at all stages of the economic cycle.

Purdie: I’d also emphasize our approach on ESG. The importance people ascribe to ESG is slightly patchy in the U.S., but the trend is only going to become more and more important to all clients. It’s not enough to say, “We integrate ESG into the investment process.” You have to show what you do with the money, how it makes an impact, how it actually changes companies or investment portfolios, and that’s what we do. We’re currently aiming to engage with 1,000 companies on climate change, predominantly with CEOs; no one else is doing that. We are engaging with other companies on an individual basis to make them more sustainable – for example, BP and its changing climate strategy; Barclays, which we’ve helped push from a one of the laggards to one of the leading banks in Europe on that front. Volkswagen had to make a lot of changes following its emissions scandal and is now at the forefront of electric vehicles, and we’ve engaged with them through that whole process. Yes, we integrate ESG it into investment processes, but we also make companies better, so that active ownership is a meaningful thing.

Speaking of complementary, one gets the sense speaking with you both that Aviva’s scope as a global organization can help investors, too.

Purdie: The U.S. and global markets are connected. You can’t understand one without understanding everything else that’s going on. We’re a global organization with a structure that encourages collaboration. Josh and I are on the same team. Our analysts globally are on the same team and organized by sector, and that gives us the ability to understand what’s happening in each individual market and how it impacts the whole. We call it connected thinking, and it’s not only an efficient way of working – it gets us to the truth quicker.

2 How Volatility and Performance Accelerated Institutional Adoption

The onset of the COVID-19 pandemic triggered unusual disruption across fixed income markets and led to an uptick in activity for fixed income ETFs. During multiple periods of market stress over the past decade, the transparency, access, liquidity, and efficiency of on-exchange trading had already proven valuable to fixed income investors. Despite a solid track record, certain market participants theorized about what might happen should fixed income ETFs be tested by an unprecedented market shock such as that triggered by the pandemic. Questions persisted about whether ETFs would be able to withstand the pressure of continuous selling, and whether they might exacerbate price declines in the underlying markets.

When the shock came, the results were clear: Fixed income ETFs not only held up under stress, but they became important tools for market participants. Institutions turned to the most liquid fixed income ETFs as sources of real-time price discovery and cost-efficient execution when transparent quotations and liquidity had sharply deteriorated in individual bonds.  

Volatility followed by surge in fixed income ETF trading

Investors have tended to increase their use of fixed income ETFs during times of uncertainty because they have shown to be efficient and effective tools for rebalancing holdings, hedging portfolios, and managing risk. In fact, during the immediate COVID-19 financial crisis trading in U.S. fixed income ETFs surged to $1.3 trillion in the first quarter of 2020 – half of the $2.6 trillion for all of 2019. 

During volatility jumps, investors want to weigh all their options and have maximum flexibility. Practically speaking, that means they need liquidity, and U.S. corporate fixed income ETFs demonstrated they could provide incremental liquidity to the market as trading rose at a faster rate than trading in individual bonds as credit risk spiked. 

Trading volume in all U.S.-listed high yield fixed income ETFs averaged as much as $7.8 billion per day in March 2020 and represented as much as 29% of individual high yield bond trading in the over-the-counter (OTC) market; for comparison, high yield fixed income ETFs averaged around 11% of OTC high yield trading in 2019.  The trend was similar in U.S. investment grade corporate bond trading, where fixed income ETFs in March represented as much as 24% of individual investment grade bond trading in the OTC market, compared with 10% in 2019. 

In both high yield and investment grade, as markets became more volatile, investors turned to fixed income ETFs. 

Fixed income ETFs indicators of real-time, actionable prices

Many fixed income ETFs traded billions of dollars and tens of thousands of times per day on exchange during the peak of 2020’s early-year market volatility.  This frequency of trading is orders of magnitude more often than the most heavily traded corporate bonds.

On March 12, one of the worst days for equity markets in modern history and a day during which credit markets sold off sharply, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) traded almost 90,000 times on exchange compared with just 37 times on average for its largest five bond holdings. 

From February through April, the iShares iBoxx $ High Yield Corporate Bond ETF’s (HYG) and LQD’s average daily dollar trading volume was 25 times and 7.5 times more per day, respectively, than their five largest bond holdings. 

High trading volumes support the notion that fixed income ETFs provided actionable prices for investors at a time when the underlying bond market was challenged. The on-exchange market prices for fixed income ETFs reflected both absolute and relative values and helped enable investors to understand rapidly changing market conditions.

Because they offer real-time pricing and trade often, fixed income ETFs are central to valuation, portfolio construction and risk management for institutional investors. In particular, fixed income ETFs have emerged as benchmark references for returns, volatility and market sentiment.


More efficient to trade, too

Market volatility creates pricing uncertainty and often translates into wider bid/ask spreads for all securities. Investors who turned to fixed income ETFs during the volatile early months of 2020 found not only real-time, actionable pricing but also lower transaction costs than were generally available in individual bonds.

While bid/ask spreads for fixed income ETFs did increase somewhat during this period of market volatility, they remained lower for iShares flagship fixed income ETFs than for individual bonds and bond portfolios across sectors; from the emerging markets to U.S. Treasuries, bid/ask spreads of the most liquid iShares fixed income ETFs remained lower than corresponding underlying bond portfolios (Figure 4). 

3 Positioning for Big Tests to Come

For credit investors, resilience is about taking appropriate levels of risk, understanding market dynamics, and identifying companies best prepared for the future. All these qualities could be tested given the wide range of possible outcomes as the world begins to recover from COVID-19.

When looking at primary market activity and yield movements, one could almost be forgiven for thinking the market meltdown in March was an anomaly. Global investment-grade corporate issuance reached $2.8 trillion in the first half of the year, according to Refinitiv data, up 39% year-on-year and on track to break records; global high-yield issuance stood at $259.8 billion by the end of June, up 19% compared to 2019.

Meanwhile, yields on the Bloomberg U.S. Corporate Investment Grade Index were close to 2.2% per cent – 70 bps lower than where they started the year. These levels were probably outside most investors’ projections for the asset class, but not completely beyond the realms of possibility.

They look more perplexing, however, when you consider that yields spiked to over 3.8% in March. The high-yield market saw even more dramatic moves: from January 26 to March 26, the yield on the Bloomberg U.S. Corporate High Yield Index more than doubled to 10.3%. To put that in context, the last time the yield was over 10% was in 2009. And despite recovering some ground, it was still close to 7% by the end of June.

Policymakers restore order

Valuations have clearly been underpinned by the much-needed policy interventions of central banks and governments to support economies and companies devastated by COVID-19. For example, France and Germany announced the state would guarantee certain loans, and the U.S. Federal Reserve’s (Fed) intervention on the U.S. corporate bond market is helping many companies stay afloat, by keeping their borrowing costs artificially low.1

“In that regard, it has not been different from the last 10 years, in that it is not a true reflection of the economic situation. The underlying economics would suggest a lot more companies should go bankrupt,” says Colin Purdie, Aviva Investors’ chief investment officer for credit. Illustrating just how precarious the economic situation is, the International Monetary Fund in June revised its forecast for global GDP to a contraction of 4.9% this year, considerably worse than the 3% estimated contraction it announced just two months earlier.

Although credit rating agencies were quick off the mark in downgrading companies due to the deteriorating economic conditions, there will undoubtedly be another round to follow the first and a rise in defaults.2 On July 1, Fitch announced that the number of defaults in the first five months exceeded the full-year number for 2019, and that the pandemic fallout will erase more than $5 trillion in revenue from its global corporate portfolio in 2020. “At the current rate, the annual volume of corporate defaults could exceed the record set during the global financial crisis in 2009,” the agency added.

Such gloomy projections serve to highlight that government support programs won’t last forever, and the impact will be felt in the medium term. When policy support is removed, companies with unsustainable business models will come under pressure as it becomes more expensive or even impossible for them to borrow. At that point, the aftermath of the COVID-19 crisis will reveal some major differences with the situation companies have enjoyed in the last ten years.

“In the short term, the crisis hasn’t changed anything on credit markets, but in the medium term it will. Changes will come through, both on the company side in terms of who is sustainable and who is not, and also in terms of the voluntary or forced changes to behaviors and consumer trends,” adds Purdie.

Building resilience into portfolios

When it comes to investing, he says resilience in such a challenging environment is about taking appropriate levels of risk, commensurate with clients’ expectations: “It’s not about running away or being overconfident; it’s about understanding the markets and companies you invest in, and ensuring you adapt to the current environment. In many ways, resilience comes from having a strong process in place to give you the confidence to take as well as manage risk.”

Strong fundamental analysis coupled with robust portfolio construction can deliver a structural advantage over benchmarks. Portfolio construction aims to optimise risk-adjusted returns and to embed diversification and resilience into the investment process, identifying the best way to put idiosyncratic ideas into practice.3

“What has helped us in the first instance is that our process is based on strong fundamental analysis: we invest in companies that we know and like. The markets have benefited from stimulus for a number of years, which has led to a lot of companies coming into market, both high yield and investment grade, but it’s important not to get carried away with that and to focus on the fundamentals,” says Purdie.

Investment managers can tend to be optimistic about their ability to forecast performance, creating a bias toward riskier allocations. Portfolio construction helps identify and mitigate those biases, using tools like sensitivity analyses of portfolios under multiple scenarios. These show the level of risk taken in pursuit of returns and what can happen to a portfolio when the central investment thesis does not play out. It is a good recipe against overly optimistic assumptions.

Building in resilience also rests on diversifying the drivers of returns, keeping a close eye on correlations, which can change over time, and stress-testing portfolios.

For instance, even though no one could have seen COVID-19 coming, credit markets have seen a steady decrease in liquidity over the last decade,4 so adapting their approach to allow for periods of illiquidity could have given investors comfort when markets sold off brutally in March.

Looking at longer-term fundamentals, resilience also means having a business model that can adapt to reflect changing conditions and consumer trends. History is littered with examples of companies that resisted change and did not survive; from Kodak to Blockbuster. Purdie says a common characteristic of resilient companies is that they remain on the front foot and focus on the longer term.

“Companies doing better in this environment are those that have technological solutions. Retailers that can’t have people in their shops are not going to do very well in a lockdown. But a retailer that has a strong online presence and has really embraced that market will do better,” he says.

To quote Canadian ice-hockey player Wayne Gretzky: “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” Applying the analogy to businesses, resilient companies are those with the foresight to move ahead of market trends. It doesn’t necessarily need to be a revolution, but it should be an evolution.

There’s more to know about the big tests to come – find out here.


1HoU.S.e View Q2 2020,” Aviva Investors, April 9, 2020

2Colin Purdie, “COVID-19: Will credit markets remain open for bU.S.iness?” Aviva Investors, May 1, 2020

3Cinderella science? Why portfolio construction holds the key to resilient investment outcomes,” Aviva Investors, June 9, 2020

4Colin Purdie, “COVID-19: Will credit markets remain open for bU.S.iness?”Aviva Investors, May 1, 2020

4 Have Safe Havens Lost Their Hedge?

Within a 10-day period in mid-March, yields on 30-year Treasury bonds rose significantly just as the S&P 500 Index fell by about 30 per cent. The price of Treasury futures became disconnected from the underlying bonds, while liquidity – especially in off-the-run securities – unraveled.

Sunil Krishnan, head of multi-asset funds at Aviva Investors, was among those concerned about how events were unfolding. “Investors typically lean on government bonds to provide insurance in terms of negative correlation with equities, but also potentially to rally sharply,” he says. “In this case, bonds didn’t quite deliver. And it’s not just the direction but also the magnitude of the move, which went quite hard the other way.”

A raft of explanations quickly followed, most of which focused on the deluge of forced sellers in the market, from emerging market central banks needing US dollars to defend their currencies to funds selling assets to meet redemptions, and investors unwinding highly leveraged strategies such as risk parity to meet margin calls.1

Matters were not helped by the fact that investment banks now have significantly less capacity to act as market makers and warehouse assets (a legacy of tougher post-financial crisis regulations). So, during times of acute market stress, such as we saw in March, this structural lack of liquidity can exacerbate price fluctuations. Investors needing to quickly raise cash were forced to sell what they can, including other traditional safe havens such as gold, which also declined during the same period.

This raises some existential questions about which safe havens can be relied upon to provide ballast to portfolios in future.

The limitations of 60/40

It is important to note that the breakdown in correlation between equities and bonds didn’t last long. Synchronized central bank actions, including large-scale asset purchasing programs, helped normalize markets. However, the level of protection offered by bonds has been noticeably lower in this crisis compared to previous episodes, according to James McAlevey, head of rates at Aviva Investors. When equities previously dropped by 30 per cent, bonds rallied much more materially than they have this time around. This is a function of an already low-yielding environment and the weaker responsiveness of Treasuries to act as a risk diffuser.

“Negative correlation [between bonds and equities] will probably stay, but it’s unlikely to deliver the positive return delivered historically. Interest rates are at the zero bound, so it’s difficult to see that there’s going to be another 100 basis points of protection [from yields falling] in your back pocket,” says McAlevey.

The weakening capacity of bonds to hedge equity risk has a material impact on asset allocation decisions. “The assumption that a balanced 60/40 equity versus bond portfolio will provide enough of a diversification buffer is increasingly being challenged,” says Mark Robertson, head of multi-strategy funds at Aviva Investors.

Although investors have been diversifying away from listed equities and bonds, particularly into private assets, equities still make up a large chunk of most institutional portfolios. To hedge this, investors often seek exposure to government bonds, using either physical bonds or swaps. The U.S. Treasury market is the deepest, most liquid and transparent – therefore widely held – but investors also have turned to other nation’s government bonds, depending on their currency risk appetite. But with governments around the world ramping up spending in response to COVID-19, investors face an extra dimension of uncertainty as to whether that long-held strategy will continue to work.

Source: Centre for Economic Policy Research, April 10, 2020

Diversifying safety

“There’s a reasonable argument that March was a blip – that bonds and equities will resume negative correlations because their economic sensitivities are natural opposites,” says Krishnan.  “But it would be naïve to assume forced portfolio liquidations won’t return to the detriment of both.  It’s just not that straightforward.”

In effect, if the way correlations break down could vary according to the specific characteristics of a crisis, traditional safe haven assets may not be able to fulfil that function and portfolio managers will need to look at alternative ways to manage risk. This was a challenge well before COVID-19, but is becoming more pertinent as certain strategies have lost their safe haven characteristics, such as Japanese government bonds (JGBs).

In 2016, the Bank of Japan was the first among central banks to initiate yield curve control (YCC), which typically aims to peg a specific level at some point on the yield curve, essentially by buying any outstanding bond at a price consistent with the target yield. 

“Once the Bank of Japan effectively fixed the JGB curve, the reactivity of Japanese government bonds to risk-off events was effectively gone so it was no longer valid as a portfolio hedge,” Robertson says. “You saw that same sort of dynamic start to come through in German bunds with rates in negative territory. And now you can question whether that will be the next step for US Treasuries. Therefore, you need to start thinking about other options to protect portfolios.”

It’s not clear whether the Fed will follow Japan and Europe into negative territory, although in May the futures market was pricing in a cut to the policy rate below zero.2 Jerome Powell, the current Fed chairman, has consistently pushed back against such a move. However, former chairman Alan Greenspan claimed last year “it is only a matter of time” before the US will enter negative territory.3 If that happens, US Treasuries will likely lose even more of their appeal as a risk reduction tool.

Increasingly, the answer may not lie not in any one particular asset class, but a combination of different strategies offering a target level of resilience that can change over time.

Gold, for example, may become more attractive. Historically, it has been shunned by some investors when interest rates are high because there is no yield available from holding gold. But as interest rates are at the zero bound for major economies, that differential has markedly decreased.

“Our central scenario is central banks will continue to maintain interest rates at very low levels and negative in some cases, so the opportunity cost of holding gold is low,” explains Peter Fitzgerald, chief investment officer, multi-asset and macro at Aviva Investors. “In addition, there is increasing evidence of monetary financing, which should be positive for gold.”

Investors are mainly worried about deflation being a consequence of the COVID-19 crisis, driven by a recessionary outlook combined with expected lower prices for energy, property and other items. Longer-term, however, inflationary pressures may be rising due to a combination of factors including a global supply shock, which could increase the price of goods; escalating trade tension between China and the US; and unprecedented monetary and fiscal expansion. If investors are worried about inflation, gold or inflation-linked bonds may be more appropriate to protect portfolios than conventional bonds.

Source: Aviva Investors, Macrobond, data as of May 18, 2020

“Gold and other precious metals have historically acted as a store of value in times of uncertainty. If uncertainty rises, particularly due to fears around inflation or helicopter money, one could see a substantial rally in gold,” Fitzgerald adds. “In an environment where you get unfunded fiscal expansion, which acts to debase fiat currencies, inflation could ultimately be engineered in order to reduce debt.”

Take a deeper dive on this topic.


1Robin Wigglesworth, “Analysts point finger at ‘risk parity’ strategy in market rout,” Financial Times, March 20, 2020

2Steve Matthews and Matthew Boesler, “Fed officials pU.S.h back on market view rates may go negative,” Bloomberg, May 11, 2020

3Sylvan Lane, “Former Fed Chairman Greenspan: ‘Only matter of time' until U.S. sees negative interest rates,” The Hill, September 4, 2019


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