Going a step further, I prefer to use fundamental research as an “Alpha chaser.” Time should be best used on researching excess return opportunities. By using third-party research as a monitoring tool of rather efficiently priced issuer debt, in-house research is best used to hunt for mispriced issuers and bonds because of unique or legacy covenant language, deal size, sponsorship, availability, ratings implications, company management, etc. Portfolio construction and sector allocations in combination with focused bottoms up security selection with disciplined trading strategies have proven to deliver outperformance in a repeatable, high-capacity way.
Hortz: How important do you feel that a trading perspective—keeping a trained eye on the daily dynamics of markets—needs to be added to core, long-term investment approaches?
Duch: A lot depends on the expectations for an investor’s bond allocation. A lot of investors think about bonds only as hedges to their equity positions. They may own large, middle, and small caps, growth and value, international or EAFE, emerging markets, and a country specific strategy like Japan, China. But when it comes to bonds, they own a fund or ETF based on the Bloomberg Barclays US Aggregate Index, which is nearly 75% U.S. Treasuries, Government Related, and Securitized. This bond index has increased the exposure to government debt, extended duration and reduced yield because of record new debt issuance, something that should continue in treasuries. Investors may have a very diversified equity portfolio but a concentrated bond portfolio that drags performance or is intended to act as a hedge to the equities. Our belief is that investors can get better returns than what the Bloomberg Barclays US Aggregate Bond Index gives them. We believe investors should reduce their Aggregate Index exposure and utilize active strategies that potentially offer better risk/reward returns.
Bond indices are weighted by qualifying debt outstanding by issuers. Unlike market value weighted equity indices where prices can keep rising (i.e., FAANG stocks), the more debt an issuer incurs that becomes a larger part of an index is not always a good thing. Active managers can avoid troubled debt-heavy issuers, reduce duration based on interest rate outlooks, and do relative value analysis that turns bond allocations into a source of Alpha, not a possible drag on the rest of the allocated portfolio.
Hortz: From your specific perspective, how do you see the current lay of the land in the fixed income markets?
Duch: This is always a loaded question because if you want to feel horrible about the future economy, a bond manager can help you get there with their often defensive views of the world! I try to be balanced as best I can but when the math does not work, though, it is always hard to just hope things work out.
There are two major themes driving fixed income markets right now, 1) inflation concerns and 2) government debt supply. Spread products like high-quality securitized and investment-grade corporate debt trade tight and often move in tandem with treasuries. Where inflation shows up is anyone’s guess, i.e., concentrated in raw materials and commodities, weaker dollar, transitory, broad but momentary spike, etc. but we do know money supply continues to increase and huge amounts of treasury debt are outstanding and will be issued. How the interest rate curve adjusts and the effects of higher rates have real impacts on the economy and risk valuations.
In other words, supply concerns can push rates to a point that tightens liquidity in the real economy thus blunting inflation concerns. There is a long history of interest rates rising to only reverse their movement to come back down a bit as they do the Federal Reserve’s tightening ahead of schedule. There is a lot of leverage on consumer and corporate balance sheets so rising rates certainly impact things.
Be nimble and liquid because money has poured into illiquid investments the last few years. If something looks cheap when liquidity is at an all-time high, imagine how cheap it looks when liquidity tightens! Move up in quality if the give-up is historically tight. Treasuries are approaching yields that could pressure High Yield bond intermediate maturities and dividend paying stocks.
Hortz: Any other thoughts or recommendations for advisors to consider for their clients’ fixed income portfolios and portfolio construction in our current investment environment?
Duch: As shared earlier, bond investing is often nuanced based on price, capital structure, covenants, liquidity, maturity, etc. so taking a fundamental research, equity liquidity driven approach to bond investing can lead to underperformance. Bond investing is about loss assumptions, security, and asset valuations to receive coupons and principal. Equity investing is generally a subordinated perpetual security driven by growth and income with decimal point bid/offer liquidity.
With all of this in mind, it is no wonder most active bond managers beat their passive ETF counterparts. However, a lot of bond ETFs get inflows because there is an assumption that all ETFs are to be in a wealth advisor’s model or solution product because of a low fee. I maintain low fees only matter if it makes the difference in net performance.
Active management costs a bit more than passive ETF strategies but if the result is increased net performance to the investor, it is worth it. It takes a professional bond manager to see and access better risk-adjusted return opportunities. We are happy to work with wealth advisors to find solutions to their fixed income needs that offer greater value to their clients than a passive ETF product or laddering bonds. We invite you to learn more about our firm and Channel Short Duration Income Fund on this link.
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