For those of you who don’t follow weather as a hobby (I happen to cover a number of property and casualty insurers, which are constantly focused on the weather), the doldrums is the colloquial name given to the area around the equator where the northeast and southeast trade winds converge. The resulting low pressure trough generally results in hot stagnant air where nothing seems to move for long periods. However, occasionally a monsoon will move into this area (more properly known as the Intertropical Convergence Zone) and the result is dramatic and violent thunderstorms. Mariners must pay careful attention to these erratic weather patterns.
In my mind, the doldrums seems like a perfect parallel as I evaluate the current state of the fixed income markets. The global deleveraging (fiscal policy) and the counterbalancing monetary policy, have come together to create a sort of financial doldrums. For some time now we have been held in this balance and the result has been low volatility and little real movement. However, global flash points (Cyprus?) are like gathering monsoon clouds on the horizon and investors must keep careful watch on how the winds are blowing.
With 10y Treasury Bond yields at the nosebleed inducing heights of nearly 2% and investment grade credit not too much above 3%, not to mention the increasingly misnamed high yield, it does at times feel like we are constantly on the look out for stormy skies. This cautiousness is illustrated by the question I am repeatedly asked by my insurance clients, “where can I invest now to get higher yields without taking too much risk?”
The possible answers are well known; to increase yield you need to call on one of what I call the Five Horsemen of yield enhancement:
So, given where we are in the market cycle, which of the five offers the best solution? Let’s look at each of them in turn.
Duration has often been the “go to” way to increase yield and while the 2y-10y curve doesn’t look especially steep in absolute levels (around 170bps) relative to its range the past 10 years that steepness as a percentage of the total level of the 10yr yield is very high. However, given the very low level of yields, it takes increasingly strong conviction to maintain all but the smallest of duration overweight.
Adding credit risk may be a solution. This has worked well so far as all spread assets have rallied. Within the investment grade universe we like financials relative to industrials. They are still recovering lost ground from the financial crisis and we feel that financials will ultimately revert to trading inside industrials. The fundamentals across the market still appear sound but we are keeping a close eye on valuations and the potential for idiosyncratic risk to rear its ugly head in the form of shareholder friendly activity. Likewise in the high yield market strong fundamental and technical conditions are running into high valuations. While high yield rates are a bit scary, spreads still offer value relative to default expectations. One of the better spread trades last year was emerging market debt but it now appears that much of the low hanging fruit has been picked through. For investors comfortable with emerging market corporate bonds and local market instruments, there are opportunities for strong managers to identify and we feel this should remain a focus.
When thinking about leverage, investors often envision buying securities with borrowed funds or using derivatives, however, there is also structural leverage. In the CMBS market, mezzanine tranches offer leveraged exposure to the underlying mortgage pool and we are seeing good value in these areas for clients willing to take a little more risk and venture out of the AAA super-senior classes.
Liquidity provides the investor with both a cushion if funds are needed in a crisis and “dry-power” to exploit opportunities after a market dislocation. However, liquid assets trade at a premium and the bottom line is that not everything in the portfolio needs to be liquid. Once you have determined, based on your liabilities and the economic environment, the optimal amount of illiquid assets, you are left with a portion of your portfolio that you can dedicate to illiquid opportunities. The key is determining the optimal use of this scarce resource. Historically, investors have gravitated to alternatives such as private equity, real estate and infrastructure debt. Each of these products can be very attractive but they tend to add to the overall risk in a portfolio, in addition to simply being illiquid. Another alternative which we think looks particularly attractive at this time but is still generally considered lower on the risk spectrum is direct commercial mortgage loans. We are seeing increased interest in private commercial mortgages and feel there are excellent opportunities in this market for core (albeit illiquid) investments.
In its simplest form, structure can refer to things like embedded options. Given the prepayment options in underlying mortgage pools, products like Agency RMBS have historically offered higher spreads than other non-negatively-convex bonds of similar credit. The combination of an extremely low rate environment, dislocations in the underlying mortgage market that can hamper the ability to refinance, and the presence of a massive non-economic RMBS buyer (read: FED) have created dislocations and opportunities for knowledgeable investors.
So where does this leave an investor? While absolute rates are low and it may feel like there is not adequate compensation for risk, for careful investors, there are still pockets of opportunity … if you can navigate the doldrums.