Resilient Returns: Unlocking Fixed Income’s Potential in Volatile Times

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Resilient Returns: Unlocking Fixed Income’s Potential in Volatile Times

Speakers
Pilar Gomez-Bravo
Co-CIO Fixed Income

Josh Barton
Senior Managing Director, Head of Australia & New Zealand

 

Josh: Pilar as you know last year that we celebrated at 100 year anniversary and as part of that we talked a lot about the fact that MFS was a pioneer of the mutual fund globally. But perhaps something that's less familiar to a lot of our viewers is the fact that MFS was also a pioneer of fixed income investing. Can you talk a little bit about the evolution of our fixed income platform and what our capabilities look like today?

Pilar: Yes, actually it is true that most clients know us for equities, but actually not many remember that actually maybe it's 30 years ago or more, we were actually equally split between the assets and fixed income and inequities. So we launched our first fund, which still exists in fixed income, which was our US corporate bond fund back in 1970, early 1970s. We launched our hard currency emergency market strategy in 1997. And in fact, we launched the global agg opportunistic strategy in 1989 before even the global agg existed. So we've had a long history of managing these strategies, global fixed income and regional fixed income for many, many years. and the evolution of this of the capabilities is that we now have about 130 fixed income professionals that are investing in fixed income. We are part of a broader investment team who with we collaborate a lot, 250 investors, so we're about a third of the investment team. And the other thing to note as well is that we kind of followed also the equities model and we've expanded over time, or international investment platform. to deepen that collaboration. And so now we have investors in Boston, in Toronto, in London, and in Singapore. So very broad base of capabilities across all the building blocks of fixed income and also multiple capabilities as well.

Josh: This week in travels, you've been talking about our full breadth of fixed income capabilities, but today I want to focus on our global aggregate opportunistic trust, which is available to Australian investors. Can you introduce that strategy in a couple of minutes?

Pilar: Yes. The global agg opportunistic strategy is the most flexible strategy that we have. It is a key flagship strategy that MFS and fixed income offers our clients. And it's the most, you know, core fixed income, what I call with a punch. So this strategy is a hedged Aussie dollar strategy offered in a trust, that pulls all the levers available to fix income investors, but still offering a solid investment grade fixed income experience. And again, sort of derives its value from being able to combine and collaborate with all the different asset classes. We buy high yield, we buy emerging markets. We obviously have a diversified approach to global rates, uh markets as well. So it really is a very diversified liquid portfolio in Aussie dollar.

Josh: As you well know, there's a lot of options for Australian investors in terms of fixed income in the market here. What are the key sort of differentiating factors of this strategy relative to some of those other options that are available out there?

Pilar: Yeah, I mean global fixed income is so eclectic and have a lot of different managers that are pulling all sorts of different levers. So I think that really what anchors our strategy is that we are benchmark aware because we do believe actually the global agg does a good job at giving you an indication what a global fix income return would be like. And so I do think that it's good to have that as a as a benchmark as an awareness. But there's a lot of flexibility in the global agg opportunistic trust to be able to move around the different areas of fixed income to deliver consistent risk adjusted returns. So what does that actually mean in practice? It means that being able to blend effects credit and rates gives you a pretty good mitigation of risk and a lot of upsides. It does also mean that we strongly believe that security selection can contribute to returns in a global fix income portfolio, so we don't have 5000 line items, we have more like 450 or 500 to deliver that security selection, which I think is quite unique in the world of global fixed income. And of course, you know, risk management is key when you're doing global fixed income, it can be quite complex. There are only a couple of things that are really important to note in the strategy. One is that we can buy up to 40% high yield. So even though we're always going to have a solid investment grade rating and trust, we are going to be able to move around quite a lot in terms of the flexibility around how you're corporate and how you'll emerging markets. And we don't always have to be at the same level. We've been up to 36, 37 and now we're around, you know, 13%. The other key element that defines the strategy is that we do have a guardrails around duration, which are plus or minus two years around this benchmark. Sometimes it's good, sometimes it's not so good, but the reason why we do that is because we want to make sure our clients have an experience with fixed income. And if you have no duration and you have 80% high yield, then you're going to be correlated with equity. So we’re true to our name, it is a fixed income fund, and that means that you have the guardrail of plus minus two years. It is hedged into Australian dollars, but we can be up or down 10% percent versus the Australian dollar.

Josh: There's a couple of things I want to dig into the first of those as you mentioned a couple of times around pulling the levers and having the ability to sort of allocate across subsectors of fixed income markets. I guess the question around that is why would investors give you the responsibility to do that rather than sort of doing that themselves? You know, by allocating to those subcomponents of fixed income markets?

Pilar: You know, the reality is that I’ve been doing this way too long. So clients go through cycles. you know, when dispersion is low, volatility is low, a lot of clients believe that they can do the allocation themselves, right? So you go through this more desegregated model of building the blocks yourself. and then you get periods of more volatility and more dispersion, and they some clients realize that they can't be as agile and nimble in making decisions around changing portfolios or their client's portfolios. And they go back into you know, delegating that responsibility to the manager that they believe are good at that. And so, I think that, you know, we believe that through the evidencing of our performance, we can show that the largest alpha lever that we pull is that asset allocation lever, successfully. And so you have an asset manager like we are that can show that you deliver consistent risk adjusted returns from being able to pull the alpha lever of allocation and on top of that you have the additional gravy of the security selection. I think it is quite a compelling case for clients that realize that they're not gonna be as agile in making those asset allocation decisions.

Josh: The second point was around duration and you sort of mentioned those guardrails that we have around the benchmark. One of the things that I've noticed in my sort of discussions with clients in the market is there still some reticence around using duration portfolios. Why should clients have duration in their portfolios and maybe more importantly, why is now a good time to have duration and portfolios?

Pilar: Yes, I mean I laugh because I think that duration is like the Lord Voldemort of Harry Potter, which, you know, is the name that shall not be named. And frankly, I understand because the brutal experience of 2022 has left a lot of scars in many investors' minds. And frankly, inflation has been coming down, but maybe not as fast as most would have expected or wanted. So there's this still aversion of having some duration in portfolios and there's still a lot of clients that sort of are sitting on cash effectively. I think that we're in a very different environment in general. And the reason for that is because you're starting with a very high level of yields now. So you have quite a big cushion to protect your returns, because fixed income is math pretty much. The level of your starting yield is going to be a pretty good predictor of what your total returns are going to be, you know, five years ahead. And so the starting point now is much more attractive in terms of having their cushion to protect your total returns and fixed income. And because you have a big dispersion in global rates markets, you have a global fixed income universe, then you can maneuver to find the opportunities in different countries and curves that you don't have if you only have one country's curves, where you might be a little bit more reticent to add duration, basically or to go along when you only have one country that you can work on. So I think there is value now to think about how you pull duration in the diversified portfolio, because I think the yields and the different macro environments are going to lead to potential total return abilities for a lot of the portfolios that have duration in them.

Josh: In this sort of broader dialogue around fixed income today, there's a lot of talk around private credit, not surprisingly, given the sort of exponential rise in private credit over the last few years and the offerings that are available in the local market. Can you talk a little bit about, you know, the maybe contrasting private credit with public fixed income markets and perhaps some of the risks and opportunities in inherent in each.

Pilar: Yeah, I mean, by definition, the biggest difference is liquidity. And I think again, because I've been doing this for some time, most of the investors that I talked to believe that they don't need liquidity until they actually do. And so it's very tempting to obviously go and add illiquidity to your portfolio with the expectation of a higher overall return. Because frankly, there's only four ways to yield into your portfolios. You can go to the duration route, which, again, at some point, you need something else and cash in a portfolio that goes up when equities goes down, so the duration helps that you can go down the credit quality spectrum, which is start correlating with equities. You can solve volatility, but it basically means having to have a lot of derivatives and mortgages in your portfolios, or you buy privates, basically, to get that link. And that's fine. The only issue is like everything is that how much private credit do you have in your portfolios. I do think that there is a role for some private credit in portfolios, but you have to be aware that when other public markets are falling, your weight in private is going to increase, and that's when you're going to be called for those commitments that you made. So, you know, you're going to be maybe with a different as allocation that you thought that you were going to have over time. But the big, big thing is obviously you have no transparency into the development of the loans, basically that you have under the hood of the private credit fund. So, like everything, there's going to be some good private credit managers and some that are not so good. And you know, at some point when you want to buy public markets that are down 20%, and you have privates that are not marked to market, then that could be a challenge. And they one last thing I would comment is that it's very different to be in a COVID environment where you get saved by the Fed. It's not the same when you're actually going through a proper recession, where you have to faults. And I don't think we've lived in a in an experience where private credit has gone through a default cycle.

Josh: So we sort of need that so I play out before we see what really happens. Now, I want to change tack a little bit now and talk about markets, which is something I know you love doing.

You know, as far as you're thinking about fixed income markets, what are the key drivers of fixed income markets today?

Pilar: I mean, you always have three ways to look at investing in fixed income. You have the fundamentals length. You have you know, you have to make sure that you're getting paid for the risks that you’re taking, so you look a lot at relative valuations. And of course, you have to be really aware in fixed income about what we call the technicals, which is what is the position in the market, how many crowded trades there are, and why? Why is it so important? It's because obviously we have an over the counter market, where you need somebody to make you a bit of an offer and therefore you really need to be aware of some of these technicals of supply and demand in the fixed income markets. But more importantly, going back to the original part of that question, which is a fundamentals, is that a lot of it really boils down across the world as to what you think this combination of growth and inflation looks like. So you have to understand that setting. And in general, you sort of, you know, think about the period that we've been living through, which I still think is valid, and you sort of expect a slower growth, global growth, and inflation slowly coming down. But, obviously, countries have very different macro environments and the US is in a very different position, then maybe Australia, and other markets around the world. So that sort of lower growth, lower inflation gradually, right now in certain markets like the US, maybe in question and upended. For us, it just creates more opportunities. So the more of volatility there is, the more dispersion of dislocations, the more that we can sort of see mispriced risk premia. And I think that if you're a fixed income investor today, not only are you getting higher yields, but you're also getting a lot more potential opportunities to find mispriced value.

Josh: I just want to dig on that a little bit more around volatility. I mean, I know you talk about how excited you get about volatility when you see it as an active manager because it gives you opportunities. Can you talk a little bit more around how you try and take advantage of that volatility in your portfolios? Or maybe protect against the volatility as I guess the other aspect of that.

Pilar: I think that you, you know, as an investor, you have your base case with you operate with when you're constructing your portfolio, right? So we as portfolio managers construct risk, right? That's what our job is, right? And we obviously rely on our wonderful research platform to deliver the risk management from the bottoms up, right? So they're the ones that are protecting the portfolio from the bottoms up. So when you're investing in credit in particular, you kind of have to be contrarian. You have to be early not to be late. When you're investing in rates and effects, you can be more trend driven. But in that context of being contrarian, if you want to protect your portfolios, it's much better to do it when volatility is low. And that's when you add protection in your portfolio through hedges, that are cheap, so that, obviously in periods of volatility, you can monetize those hedges without having to trade a lot of bonds around. So the reason why you want to sort of move around and sort of understand the volatility is because it's very expensive to trade in and out of bonds every time they want to change or you're scared about all the volatility, it’s much easier to have hedges and so at the beginning of the year, we had some protection that we bought through the credit derivatives markets. when volatility was low and it was cheap, but we're also concerned about inflation, so we bought some inflation swaps in case there was more volatility around inflation expectations. So that allows you to keep the core of your cash bonds that are, you know, are the collective wisdom of the analyst team without having to maneuver around a lot of bonds and you still optimizing portfolio construction for periods of volatility.

Josh: I guess further to that it would be remiss of me not to talk about politics in this environment, I guess geopolitics as well.

I suppose one of the challenges for you is that one of the key drivers of fixed income markets is something that you can't really forecast. So how do you deal with that? I mean, is it is it again getting an earlier, but how do you think about sort of playing around any portfolios in an environment that's so hard to predict?

Pilar: I mean, I would sort of say that you don't have to be a hero. I there's no point in taking very high conviction views when you don't have conviction, right? So at the end of the day, if you're an active manager, you're getting paid active fees, you're getting paid to take smart risk. You're not getting paid to whipsaw around and try to see what the next headline's going to be. So you need to, you know, be sanguine enough to distill the signal from the noise. And in certain periods, where you have less conviction, the key thing is to diversify. This is why global fixed income is so good, because we can keep a lot of diversification in the portfolio and liquidity whilst we wait to sort of get more signal from all the noise. And in periods of uncertainty, diversification really helps in portfolios. And that's how we are approaching the current environment is to make sure that you have enough diversification to then be able to jump into the market when you have more conviction. But if you don't, then it's much easier to sensibly, you know, obviously still keeping returns, but not have to stretch yourself and then get caught out by the next headline, that comes out from the politics. So for now we're dealing with uncertainty by having diversification and focusing specifically on the bottoms up, because you're always going to have winners and losers when these things happen, and that's always going to be a compounding regular source of alpha that you can rely on in periods of uncertainty.

Josh: Let's talk a little bit about rates, obviously a key driver a fixed income markets. So keen to your thoughts on rates, but also, I guess Australian rates are obviously of interest to our investors in particular, you know, given the market here is so driven by at least the homeland market is so driven by rates, variable sort of market. How do you think about rates broadly, but also what are you predicting that the RBA is going to do in this environment?

Pilar: Yes. So, I mean, I think again, uh we find the rates, the global rates markets very interesting because they’ve been correlated, well in Australia has been quite correlated in terms of the moves around what the treasuries are doing in the US. But the reality is that there are very different macro environments in each of these countries, right? Not everybody had the fiscal stimulus that the US had, right? Not everybody has very high potential demand. And so understanding the differences in that sort of growth and inflation paradigm in these markets will offer you opportunities to position in several in different countries or different parts of the curve, right, depending on those expectations of monetary policy or cuts or not. And so I think that right now we find ourselves finding a lot of opportunities within the different curves of the different markets, diversifying across. I'm not having to just have one view on Australian rates or Treasuries. Within Australia specifically, it's actually very interesting because coming into the Trump uncertainty that we just had with tariffs, we actually thought the RBA was going to be one of the more hawkish central banks. We didn't really see significant drivers of lower inflation or looser labor markets that would allow the RBA to follow the path of maybe other central banks that were a little bit more dovish, which didn't have this sort of tight labor markets and some wage pressures that were coming. You're obviously going to an election. Usually in election years, you tend to have more fiscal promises and a bit more loosening, which is just natural in every country that goes through elections. You're always going have more promises of fiscal. And again, we thought that that meant that the RBA was going be one of the banks that would cut the latest. Things have changed significantly, obviously, and we do expect that the RBA will cut rates and follow through just given the uncertainty of the markets. And especially given Australia's role, within, you know, providing commodities and trade, especially with the Asia region. And obviously, tariffs that were announced originally although things can change at the, you know, at one comment from Trump, will mean that Australia is more impacted as well, from the China issue. So we do expect the RBA to cut. We don't think it's going to be as aggressive as maybe other central banks like the ECB. But you know, I think that that also means that the curve will steepen at some point, those yields at the long end of Australia will be quite interesting.

Josh: Amazing how quickly things can change, isn't it?

Pilar: Yes, definitely.

Josh: So just to wrap up Pilar, I’m keen to hear your outlook broadly for fixed income. I mean, you've kind of touched on that already. But stepping back a little bit, what your outlook is for fixed income and then how are you positioning your portfolio for the environment that's ahead of us?

Pilar: Yes, as I said, you know, we continue to have a diversification and so I think that having diversified risk is important. So what we're doing in duration, specifically, we are slightly overweight duration, not by a lot. I mean, as I said, we can go up to two years and you know, we're right now about a third of the way there, I would say. But it's quite diversified which countries do we like. We like Korea, we like certain parts of the Australian market. But we prefer things like Europe. We think that's going to be an area that's going to offer a lot more potential returns and we have some local emerging market exposures very limited in certain countries that we like. And we have, you know, things like Canada as well. So there's quite a lot out there in terms of that overall duration position, but we do think that these central banks are going to be forced to cut and cut more than maybe what the market is pricing in at any point in time. So overweight duration, it’s very diversified in global rates. It's not just one market. In credit basically, we've maintained a very low level of exposure relative to the magnitude of the flexibility that this strategy has. So if I said, we are up to 40% high yield that we can go. We're sort of closer to 10% percent than we are 40% percent. So we have a lot of room to potentially add in these dislocations for volatility. We still prefer investment grade. I think that, you know, that is kind of a common theme that we're sort of seeing is that investors are a lot more comfortable with investment grades because of a low default risk and we as well, but we tend to favor a little bit more Europe exposure than US exposure, as well, especially if it turns out that you do go into a recession in the US, obviously it's going to be more difficult. And finally, you know, with regards to the US dollar, which a lot of people talk about, we’re slightly underweight US dollar, we don't want to deviate too much in the US dollar paradigm because again, it's still kind of will be seen depending on the circumstances as a safe haven. So one last comment on securitized and structured, we don't have a huge amount of structured or securitized in the portfolio, but we still have maybe eight percent mortgages. We might sort of have some structure diversified structure credit. But the key thing for us and the reason why we're not having as much in things like that is because it becomes illiquid quite quickly. And so we do think there's going to be a lot of opportunities we're actually excited about all utility and dispersion, because we do think 12 months later, you're going to see significantly higher excess returns after periods of volatility.

Josh: Thank you for the insights Pilar, I really appreciate that. And thank you to the audience for joining us today. We appreciate your time.

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