What strategy for bond investors?

Asset Management - 9/15/2016

Investors are still facing a problematic environment of low, and even negative, interest rates and slim yields and are changing their investments’ risk profiles. The bond market offers attractive opportunities, notably in financial and emerging country debt. However, benefiting from this rich and very varied universe will still require flexibility and selectivity.

An all-purpose approach to the bond market

A heavy political agenda could trigger turbulence and disrupt markets in coming weeks. October and November will host several hard-to-predict electoral battles that will certainly generate volatility. In the economic sphere, central banks will remain centre stage. The pace of monetary tightening in the US is unclear. But the Fed will most probably choose to gradually raise rates before the end of 2016. Meanwhile, the ECB is expected to continue with its highly accommodating monetary bias.

Today’s situation is hard to assess but growth has returned and fundamentals are robust, a situation which means European company debt still offers investment opportunities albeit essentially in the lowest rated segments. Financial debt also looks attractive: underperformance so far this year means the segment is not overvalued, bank solvency ratios have improved and the sector benefits from benign regulatory trends. Elsewhere, emerging country debt should also provide numerous investment opportunities given the absolute level of hard currency bond yields and the possibility that monetary easing will boost local currency debt. Duration risk will still have to be actively managed with such extraordinarily low government bond yields and the prospect of persistently volatile conditions.

The Edmond de Rothschild Bond Allocation fund is managed by Guillaume Rigeade and Eliezer Ben Zimra and offers a particularly appropriate solution to meet today’s bond market challenges. The fund is doubly flexible, first because it takes an active approach to managing sensitivity, a big plus at a time of shifting interest rates; second, it is also flexible over exposure, as it has broad investment limits on the various market segments.

Financial bonds: light at the end of the tunnel

Financial debt is an essential component of any diversified bond allocation. The asset class, which is less correlated to bank equity since the Brexit vote, boasts attractive prospects as the major risk factors which triggered volatility at the beginning of 2016 have since stabilised. Regulatory authorities have reduced pressure on issuers by adopting a pragmatic approach, halting new regulatory projects and introducing technical changes to give subordinated debt holders improved visibility on coupon payments. Elsewhere, the ECB's pursuit of accommodating monetary policy is now being conducted through new Long Term Refinancing Operations (LTRO) with less onerous conditions for Europe’s banks. Lastly, results for the first half of 2016 showed that banks were able to defend profitability in today’s deflationary environment while continuing to reinforce solvency ratiosp>

With interest rates so low and investors searching for yield, subordinated debt is capable of generating particularly attractive yields. The segment is benefiting from the introduction of new regulations for banks and insurance companies. Issuing companies are still improving the size and quality of their capital structure to meet recent regulatory requirements. This has led them to issue new quasi-equity instruments to replace previous instruments by calling them early, for example. These reforms have helped banks and insurance companies to improve their capital bases, their solvency and their liquidity. Following a very choppy start to 2016, CoCos are undervalued and also offer attractive investment opportunities.

Given financial bond specifics, investing in the sector requires investors to be selective and to diversify. Julien de Saussure and Benjamine Nicklaus, who manage the Edmond de Rothschild Signatures Financial Bonds fund, have developed an active and opportunistic approach to investing at every level in a financial institution’s capital structure.

Selective opportunities in emerging country debt

A selective approach to emerging country debt is an interesting way of diversifying a bond portfolio. Since the Brexit vote, the segment has once again been seeing massive inflows. As a result, the proportion of emerging country debt in global funds hit a four-year high in August. This has, however, increased risk - spreads have plummeted for example - so investors should tread carefully. Elsewhere, China's debt and its property sector, a major contributor to GDP, are still sources of concern. Nevertheless, emerging country fundamentals are today more robust, notably as concerns foreign exchange reserves and debt-to-GDP ratios.

Investing in emerging debt necessitates a flexible and opportunistic approach as well as the capacity to take contrarian positions. Selectivity and idiosyncratic risk-taking are essential if investors wish to tap into opportunities in debt issued by emerging countries like Venezuela. The country has the world’s biggest oil reserves and low external debt levels. Brazil, a country which is also undergoing serious political change, is one of our biggest investment convictions because it has some very appealing valuations.

Romain Bordenave and Jean-Jacques Durand, who run Edmond de Rothschild Fund Emerging Bonds, have adopted a discretionary management approach to give full rein to their convictions. This allows them to move significantly away from their benchmark so as to seek performance in countries and instruments that strike them as the most attractive. The fund is structurally invested in hard currency sovereign and quasi-sovereign debt, a segment which ensures broad diversification.

1 Subordinated debt is reimbursed after senior debt when a company is liquidated. It is consequently riskier than senior debt but generally has a better yield. Tier 1, Tier 2 and Tier 3 debt are examples of subordinated debt.
2 CoCos (Contingent convertibles) have fixed or perpetual maturities which may absorb some of a company’s losses or be converted into equity when the issuing company’s capital falls below a predefined threshold.

Edmond de Rothschild Fund Emerging Bonds is a sub fund of the Luxembourg regulated SICAV which is approved by the CSSF and approved for marketing in France, Luxembourg, Spain, Austria, Switzerland, Germany, Finland, United-Kingdom, Italy, Netherland and Taïwan.

September 2016. This document is non-binding and its content is exclusively for information purpose.

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