Active Management in Fixed Income: Opportunities, Risks and Investment Approach

Title: Active Management In Fixed Income: Opportunities, Risks And Investment Approach

Speaker: Pilar Gomez-Bravo, Co-CIO Fixed Income

Good afternoon, everyone. My name is Pilar Gomez-Bravo, and I'm co-Chief Investment Officer of Fixed Income at MFS Investment Management®. I would like to cover three key topics today. Our macro views on global fixed income, the attractiveness of active fixed income and MFS’ approach to active fixed income management.

Macro Views on Global Fixed Income

How do you see the current macro and global fixed income market environment?
What can we expect from the market in the coming months?

There is still a significant degree of uncertainty around the near-term outlook, though it is not as challenging as it was last year. Given the rapid tightening of monetary policies across the world, inflationary outcomes are narrower, yet the growth outlook is less optimistic. The general market environment has been resilient, but we see it as vulnerable given the degree of indebtedness in both the public and private sectors and the significant increase in funding costs that is yet to be felt.

Drilling into the macro backdrop of the key large regions, in the US, whilst core inflation has likely peaked, it remains persistent, and disinflation is low due to the strength in services and the lagged impact of housing on inflation metrics. The labor market is still tight, and whilst unemployment and inflation are lagging indicators, these are the data points that the Fed is focused on. Thus, the central bank will likely continue to communicate its intention to maintain rates at these higher levels until there is more economic slack. We think the lagged impact of monetary tightening on the real economy will likely be felt in the next 6 to 12 months and see recession in the US as a base case. We expect one or two further hikes from the Fed.

In Europe, growth has slowed down significantly and is now verging on recession in certain large economies in the region. The large supply side disruptions due to first COVID and then the Russia-Ukraine War have led to significant macro-dislocations and sticky core inflation with the European Central Bank, keen to avoid second round effects or the anchoring of inflation expectations. We also see the central bank close to the end of its hiking cycle and are still mindful of the tail risk posed by the war.

Japan has also seen a gradual rising inflation towards the central bank target. The new governor has continued with a patient loose approach to monetary policy, though we would expect a change to its yield curve control policy at some stage in the not-too-distant future. And this could have significant impact on JGB yields and the yen, as well as lead to contagion to other core government bond markets.

Finally, China's growth dynamics have disappointed, and the stimulus measures to date, both monetary as well as fiscal, have underwhelmed the markets. We see significant constraints in material policy loosening putting continued pressure on the currency and leading China to start exporting disinflation.

So, what is our market outlook in the next 12 to 18 months? We expect the liquidity withdrawal will be compounded by the global nature of monetary tightening and lead to recession, given the significant risk of a policy error by most developed market central bankers. To be fair, we would have expected to see a more meaningful economic impact already, but lags may be somewhat extended, distorted by the effects of COVID. The markets are currently priced for a soft landing and we do not see enough risk premia priced into risky assets. In particular, the equity rally seems overdone considering our expectations for declining margins as restrictive real rates tighten financial conditions. Thus, we have a more defensive approach to credit markets and focus on security selection.

Whilst our expectation is for a traditional default cycle, high leverage and crowded positioning have led to financial fragilities that can have severe market impact, as we saw during the UK LDI crisis or the US regional banking crisis. Spikes in volatility and increased dispersion should provide attractive opportunities for active managers with a strong research ethos and a focus on issuer selection.

Are we at the point where investors should reconsider the allocation to fixed income?

Fixed income yields are attractive on a relative and absolute basis. The lack of yield and income available to investors in fixed income since the Global Financial Crisis has pushed asset owners towards more complex, higher risk and more liquid investments over time. We haven't seen the current level of yields for over a decade, yet uncertainties around where inflation and growth will settle, as well as the significant inversion of the US yield curve, have led many asset owners to take pause.

Currently, higher quality diversified portfolios of public securities can yield at least 5% in US dollar terms. In addition, going global allows investors to take advantage of different hedge shields and risks that a broader universe offers. This implies good long-term returns for a lower-risk asset class and provides attractive entry point today into global fixed income markets. Treasury yields are now higher than S&P earnings yields, returning the role of stable income provider back to fixed income and providing diversification benefits to multi-asset portfolios.

In addition, fixed income now also offers attractive total returns given the higher breakevens and late stage of the economic cycle. With a renewed market focus versus liquidity on growth as well as declining inflation levels, we would expect fixed income and equity correlations to revert back to negative.

So, what are some of the specific opportunities in fixed income? Investment grade credit is probably the sweet spot for exposure in fixed income, given the low growth environment and reduced inflation expectations. The reason for that is twofold. The absolute level of yields are supported by the underlying elevated government bond yields as monetary policy tightens, and on top of that, you have a nice spread that provides you with cushion for returns in the higher-quality segment of the credit market. That spread cushion provides even higher breakevens, helping buffer returns from rates' volatility.

Other high quality spread markets such as mortgage-backed securities are also attractive.

Adding Long-term Value Through Active Bond Management

Why do you think we need to consider active management for global fixed income now?
What is the attractiveness and power of active fixed income?

The current inflation regime change brings necessary shifts in investment approach. During the low-yield period following the Global Financial Crisis, we saw a move to passive investing. But as we approached the end of the cycle with more inflation than is comfortable and a likely downturn of recession, security selection and asset allocation increase in importance in navigating the more challenging markets. Given the macro backdrop, we don't expect central banks to jump in quickly to bail in markets, unless financial stability comes into question. So in-depth research that leads to conviction positions will provide superior risk-adjusted returns.

Many years of increased moral hazard in the markets due to quantitative easing and central bank market manipulation has led to complacency and has increased fragility. Thus, with a focus on obtaining alpha but also avoiding capital losses, we are seeing large institutional investors switching back from passive to active investing in fixed income.

The dislocations provide an opportunity to position with conviction for more abundant risk premia. One of the active alpha levers with very attractive information ratios is security selection. The larger the issuer valuation dispersions, the more opportunities active managers have to position within credit, rates and effects markets.

Active management also allows for a flexible approach to asset allocation to complement our performance further. A nimble discipline process can generate consistent alpha through the cycle as fundamental valuation and technical elements create dislocations across spread sectors during different time periods. Top-down active management includes regional allocation, sector selection, as well as credit quality positioning.

Finally, active managers will fully utilize the risk budget that clients give them to take advantage of periods with heightened volatility. Volatility that provides opportunities as mispriced risk premia increases and one composition portfolios with more duration directionality or beta to take advantage of anticipated inflection points or turning points in the cycle.

It is important to also note that successful active management in fixed income requires long-term and patient approach, given the bouts of illiquidity and its nature as an over-the-counter market.

MFS’ Active Fixed Income Approach

What are the strong points of MFS’ active fixed income approach?

As an active manager, we believe our long-term collaborative fixed income approach is a critical advantage in navigating today's challenging bond market and generating consistent alpha through the cycle. Our fixed income investment value proposition combines the strength of our experience in long-tenured research and portfolio management teams with a robust disciplined fundamental investment process supported by excellent quantitative frameworks and strong risk management.

MFS has a long history of fixed income investing, with over 50 years of expertise. It has played a pioneering role in the development of credit-oriented active bond management since the early 1970s, with the first institutional account established in 1972 and the MFS Corporate Bond Fund Launched in 1974. We took our focus research approach to a global investment universe early on with the launch of our global opportunistic bond strategy in 1989 and our emerging market strategy in 1997.

From the outset, collaboration has been a hallmark of our investment culture process. And today, structural connectivity, the seamless sharing of information between analysts, traders and portfolio managers across sectors and asset classes, is a key competitive advantage.

Through our 360 peer review process and compensation framework, we ensure all investors are aligned in creating value for clients. We do this by generating insights and disseminating ideas based on strong fundamental investment analysis and the identification of attractive valuations.

Risk management permeates everything we do, and we take risk intentionally, ensuring that our risk exposures are consistent with our level of conviction and our clients’ expectations. As we move through a cycle, we are constantly discussing risk budgeting for the different portfolios that we manage. And we believe in a dynamic approach to risk and portfolio construction. Whilst every investor has a strong risk ethos, we also work closely with our independent risk team based on ongoing dialogue and their participation in investment meetings to ensure all risks are known and wanted and can deliver on clients’ anticipated outcomes.

In closing, I would like to leave you with three key messages. First, fixed income is an attractive asset class that can benefit investors in today's uncertain and volatile environment. Second, active management can take advantage of volatility and dispersion in the markets. Third, clients can benefit from MFS's long history and expertise in fixed income, our strong culture of collaboration, and a robust risk-managed process focused on dynamic investment approach. Thank you very much.

 

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