Nigel Jenkins

In recent years, many investors have shifted towards passive fixed income strategies, seeking lower fees. However, passive approaches have often lagged behind active fixed income strategies. Active management offers the potential for higher returns and can add value through agility.

Active managers can respond to market events with adjustment in asset positioning, a capability lacking in index-tracking approaches. This agility is crucial in today’s uncertain economic environment in our view.

Bond markets have become increasingly volatile over the last couple of years, as interest rates have been raised from ultra-low levels. The market has gone from the certainty of very low and stable interest rates and inflation to an environment where very little seems certain anymore. As a result, the active management of bond investments is highly relevant.

In recent times, we have seen a sharp turnaround from solid expectations that the US central bank would cut interest rates this year to investors questioning whether any rate cut will come at all. As a result of stubbornly high inflation in the US, Treasury yields have jumped. Most recently, a higher-than-anticipated US inflation report for March delivered a dent to bond prices and to market hopes of the dialling back some of the past year’s interest-rate increases. While US inflation is down after cooling in the second half of 2023, it still seems stuck at over 3 per cent.

On top of the uncertainty about inflation, multiple elections around the globe this year add complexity to the bond market outlook. The outcomes of US presidential and congressional elections in November, could be very influential on financial markets. We are watching for potential fireworks. Even before then, there could be other fireworks and surprises from European Central Bank policy decisions, from inflation releases in developed countries and other elections around the world. And that’s all apart from jolts that could come from geopolitical hotspots around the world, especially associated with Russia-Ukraine and the Middle East, but plausibly also from other zones of tension like China-Taiwan for example.

Need for quick action

This uncertainty underscores the need for nimble management. Investors need to be fleet-footed to best preserve their capital and take advantage of opportunities in the bond market, where they emerge.

Importantly, while passive funds offer low fees, they more or less guarantee net of fees underperformance versus their index. Active management, on the other hand, can prioritise risk management and seek to protect investors’ principal.

An absolute return strategy is untethered from traditional benchmarks, so managers can invest where they see the best risk-adjusted returns in the bond market. In addition, active managers have several tools that can help produce alpha and offset downturns, such as varying bond duration, carefully selecting sectors and securities, as well as geographic and currency exposures. Active managers can also use derivatives, the new issue market and other strategies to cushion portfolios during bond market downturns and uncertain environments, such as those currently prevailing.

Contrast that to passive managers, where a manager must work with a given bond benchmark and allocate investments in a rigid fashion; returns of a passive fund are almost entirely driven by the performance of that benchmark. Managers are not able to reallocate portfolio assets across different sectors and respond to market developments very quickly. They are stuck with fixed choices.

If investors are seeking an efficient allocation of capital to the best risk-adjusted return opportunities, it makes much more sense to give discretion to fund managers who can choose the best opportunities rather than simply invest in a portfolio of bonds determined by a market benchmark. Passive funds give you beta, but in bond land, you’ve got nowhere to hide in terms of duration if interest rates start rising. Almost all bond prices will be pushed down.

An active manager can lower duration to reduce sensitivity to interest rates. In a passive fund, investors are essentially rolling the dice with the future and their capital is in no way over the short term, and sometimes not even over the longer term. Whilst the fees might be low, passive funds can lock in underperformance or loss of capital.

Additionally, for fixed income, as opposed to equity allocation, if you are investing in the bonds of corporations in proportion to the amount of their outstanding debt (that is after all how bond indices are constructed – more debt means a higher weighting), you are at risk of locking into the idea that the more debt a company has, the more of it you will own. That is different from passive investing in the equity of a successful company. It grows and you invest more as a passive investor because of that growth. In bond land, you are investing more because a company has got more debt. Is that an implicitly attractive proposition? Not at all, and in extremis it can even expose investors to a greater risk of default.

As active managers, before we consider the direction of markets or the value opportunities that are presented, our first responsibility is to protect an investor’s principal against the potential for loss. Risk management is paramount.

Given that opportunities in fixed income will shift over time, asset allocations should not remain fixed during a credit cycle. The active manager can recognise and add value by identifying opportunities across a broad spectrum of perspectives across multiple bond sectors and issues, and add alpha when dispersion is elevated. While absolute return fund fees will likely be moderately higher than those of passive funds, that can be a small price to pay for the prospect of better capital protection and superior performance over time.

By Nigel Jenkins, managing director

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Nigel Jenkins

Bond markets have become increasingly volatile over the last couple of years. In the first few months of this year alone, the market has gone from confidently expecting interest rate cuts to an environment where inflation is sticky and rate cuts are in doubt. Bond yields have accordingly jumped again so far in 2024. Active bond management offers investors downside protection and the potential for higher returns, according to Nigel Jenkins, managing director at Payden & Rygel who shared his views with GSFM during a recent visit.

“The active management of bond investments and flexible asset allocation is more important than ever as economic uncertainty and volatility increases. Just this month, we have seen a sharp rise in Treasury yields to year-high levels as expectations drop that the US central bank will cut interest rates this year, given persistently high inflation in the US.

“This underscores the need for nimble management of bond allocations. Active managers can anticipate and respond to such market events and adjust bond asset positioning accordingly to minimise losses and maximise gains. This agility is crucial in today’s uncertain economic environment, especially with more potential shocks to come in 2024,” Mr Jenkins observed.

The US presidential and congressional elections take place in November, and those outcomes could also be very influential on bond prices and broader financial markets.

“We are watching for potential fireworks. Even before then, there could be other fireworks and surprises from European Central Bank policy decisions, from inflation releases in developed countries and other elections around the world,” he said.

“As we have entered a new regime for financial markets, where close to zero interest rates are no longer the norm, we are likely to see higher volatility not only in interest rates and credit spreads, but also in equity values and economic variables (inflation and growth) for the next one to two years at least. As a result, having flexibility around asset allocation decisions, being able to adjust bond duration and credit risk without being tethered to a benchmark, is very important for fund managers to be in a position to protect investors’ capital and produce income.

“Investors need to act quickly to best preserve their capital and take advantage of opportunities, where they emerge. The fixed-income investment universe is very broad, including developed and emerging market government bonds, investment grade and high-yield corporate bonds, bank loans and other debt assets. So, you need experts to navigate such a huge and diverse asset class,” Mr Jenkins said.

Importantly, while passive funds offer low fees, they will lock in net of fees underperformance versus benchmark. Active management, on the other hand, is able to prioritise risk management and seek to protect investors’ principal.

“An absolute return strategy is untethered from traditional benchmarks, so managers can invest where they see the best risk-adjusted returns in the bond market. In addition, active managers have several tools that can help produce alpha and offset downturns, such as varying bond duration, the careful selection of sectors and securities, as well as the active management of geographic and currency exposures.

“The aim is to generate income and preserve capital while containing volatility. Contrast that to passive managers, where a manager must work with a given bond benchmark and rigidly allocate investments. Managers are not able to reallocate portfolio assets across different sectors or respond to market developments.”

Given that opportunities in fixed income will shift over time, asset allocations should not remain fixed during a credit cycle. The active manager can recognise and add value by identifying opportunities across a broad spectrum of perspectives across multiple bond sectors and issues, and add alpha when dispersion is elevated. While some absolute return funds charge higher fees, that can be a small price to pay for the prospect of better capital protection and superior performance over time according to Mr Jenkins.

“As active managers of a fixed income absolute return strategy, before we consider the direction of markets or the value opportunities that are presented, our first responsibility is to protect an investor’s principal against the potential for loss. Risk management is paramount.

“The foundation of our strategy is a relatively short-duration fixed income portfolio where risk premia from global credit markets and interest rate curves may provide dependable and repeatable returns.

“Diversification – the ability to move between multiple sectors that aren’t perfectly correlated with each other just smooths return over time. It’s a good part of the market to have an active manager be in a position to respond quickly to new market developments. And if the last three or four years have shown us anything, it’s that things can happen very quickly that cause a rapid change in market perceptions and the value of securities. The fund puts investors’ capital in a position to be able to respond promptly to new developments,” he said.

The Payden Absolute Return Investing (PARI) strategy is distributed in the Australian market by GSFM.

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