The spread of Covid-19 and subsequent shutdown of economic activity in March has caused a spike in volatility and rise in economic uncertainty. Although market sentiment might be wavering as a result, this increase in volatility could also present opportunities for proactive investors.
Below are a few of the opportunities we see in the current market and actions investors could take to access them.
1. Long-dated corporate bonds look attractive, even if investors prefer not to add duration in a low rate environment
While interest rates have hit record lows in the last month, long-dated corporate bonds present an attractive opportunity. Investors looking to lock-in wider credit spreads without adding duration can consider utilizing interest rate derivatives1. Purchasing long-dated corporate securities and using interest rate swaps or futures to shorten overall duration allows investors to add exposure to attractive spread levels without taking on additional duration risk.
For demonstration purposes only, consider a hypothetical benchmark of existing investment grade long credit and long government indices, combined with existing interest rate swaps indices as footnoted below, to reduce the interest rate exposure to that of the Bloomberg Barclays Aggregate Index. As of April 23, the hypothetical benchmark would yield 3.2%, a 0.8% premium over the Bloomberg Barclays Aggregate index.2
In addition to locking in long corporate spreads at favorable levels, adding corporate exposure could be beneficial for liability driven investors with the goal of increasing their corporate bond exposure as funded status improves. Long-term demand is likely to outstrip supply in this area of the market, as the long corporate universe is about a third of the size of the investment grade market, with ∼$1.8TN of bonds outstanding versus the ∼$5.5TN of the overall market, per the table above. This is an important consideration for larger defined benefit plans, where building sizable long duration corporate bond exposure can be a significant undertaking.
As interest rates rise, investors can remove or reduce the exposure to interest rate swaps to gradually add back duration at more attractive levels. This structure allows investors to independently evaluate the decisions of adding exposure to credit spreads and interest rates, which were previously bundled in the purchase of corporate bonds.
Opportunity is most suitable for: Corporate defined benefit pension plans looking to lock in attractive corporate spread levels.
How to access? Via separate accounts with custom benchmarks that include both long duration fixed income and interest rate derivatives.
2. Think outside publicly traded markets and consider private fixed income
Investment grade private fixed income3 has proven to be a resilient asset class during economic downturns, providing diversification and the opportunity for excess returns relative to similarly rated public corporate bonds. Financial covenants and collateral that typically includes critical assets serve as lender protections during stressed scenarios, while small lender groups help lead to faster recoveries.
We continue to see attractive premiums for investors despite some slowdown in new issuance. Many issuers have looked to existing investors to facilitate quick transactions and avoid time and market risk. Information advantage, robust underwriting, structuring expertise and disciplined pricing are all key to an asset manager’s ability to seize opportunities presented in market dislocations and periods of price discovery. Additionally, managers should continue to be selective in this segment of the market and focus on issuers that have robust downside cushion, stable cash flows and limited funding needs.
Opportunity is most suitable for: Investors looking to add both additional yield and diversification versus public assets.
How to access? Include as part of the fixed income allocation, via separate accounts or other investment vehicles.
3. Follow the Fed – TALF 2020
On March 23, 2020, in an effort to re-energize the credit markets, the Federal Reserve and Treasury department jointly established the Term Asset-Backed Securities Loan Facility (TALF). TALF is designed to encourage investments in asset backed securities (ABS) by providing federal government loans to investors through the New York Federal Reserve.
The TALF was previously launched in 2009 during the last financial crisis to help support the flow of credit to consumers and businesses. The program was a success in helping capital markets return to normal. Participants in the TALF 2009 program experienced strong returns, with early participants typically seeing the greatest benefit, as initially high spreads tightened in line with the roll-out of the program.
We believe that the TALF 2020 program provides a similar opportunity for investors to achieve attractive risk adjusted investment returns. The window to access this program is short with an expected launch date in May and a scheduled end date of September 30, 2020.
Opportunity is most suitable for: Participants looking to opportunistically gain leveraged high-quality credit exposure with additional yield and a three-year time horizon.
How to access? The industry is offering this through a variety of investment vehicles.
4. Seek to exploit other dislocations in the securitized market
Initial market illiquidity and the subsequent liquidity injection had a significant impact on other areas of the fixed income markets beyond TALF, including the short dated securitized space. For example, commercial mortgage backed securities (CMBS) conduit credit spreads widened to about three times the levels of the 2016 sell-off, presenting a potentially attractive entry point for investors.
With stronger post Global Financial Crisis (GFC) underwriting standards, credit enhancement features such as over-collateralization and additional subordination, along with government support, we believe similar rated bonds today are likely to be of higher credit quality than ones issued pre-GFC. However, it’s still important for investors to carefully evaluate the investment, as specific subsectors such as hotels have seen their credit risk increase sharply. We have also seen similar dynamics in other pockets of the market, such as Market Place Lending (MPLs), where managers with capital to deploy have been investing in assets at attractive prices from distressed sellers in search of liquidity.
Opportunity is most suitable for: Investors with flexibility in their mandates to try to take advantage of market dislocation.
How to access? Allowing flexibility to invest within existing fixed income mandates or with dedicated separate account allocations.
Below are some actions investors may consider in order to prepare, evaluate and access opportunities that make sense for their long-term investment goals.
1. Work with consultants to identify opportunistic areas that fall outside the scope of existing relationships
Depending on the bounds of existing mandates, investors may be positioned to easily access some of these opportunities through their current relationships. Other opportunities may require more targeted allocation decisions through new managers.
Participation in TALF 2020 or the addition of investment grade private fixed income might require that investors add a new portfolio to their asset line up. Investors looking to exploit wide credit spreads or attractive securitized pricing can do so in a limited way through existing mandates, or in a more substantial way through opportunistic asset allocation. Investors should carefully consider the most efficient way to target these market dislocations and work with their consultants and existing managers where possible to put the necessary structure in place. For example, while a dedicated securitized allocation might not be appropriate for every investor, extending existing fixed income managers some scope beyond traditional benchmarks may allow them to take advantage of both the current and future market dislocations.
2. Review investment guidelines and Investment Management Agreements with consultants and asset managers to identify any restrictions on asset classes, use of derivatives or rigid leverage definitions
Most institutional asset holders such as pensions, endowments and foundations have long time horizons and a deliberate decision-making process that focuses on long-term asset allocation. As opportunities arise that fall outside the scope of existing mandates, the time required for investment committees to convene and update documents can compress the already narrow window to take advantage of them.
Reviewing plan documents in the near term and broadening the definitions of eligible investments can put investors in a position to act more swiftly to a changing market. Building in flexibility for active managers will also allow them greater freedom to express their highest conviction ideas within the portfolio. For example, ratings related guidelines might be reviewed to ensure there is no forced selling in an illiquid market. Additionally, opportunities such as TALF might fall within existing portfolio restrictions on leverage despite being boxed-in by high quality, low risk assets. Investors may want to review leverage specifications to ensure they are able to access such opportunities.
3. Ensure managers have dry powder to put to work by being creative about asset allocations and rebalancing activity
Many investors don’t have a large pool of undeployed cash on the sidelines and raising cash to reallocate between asset classes can be a lengthy process. One option to consider is freeing up cash by utilizing derivatives in areas where they can easily be used to maintain existing asset class exposures.
For instance, when rebalancing back to equities investors may want to consider using derivatives to achieve the equity exposure, allowing them to maintain an allocation to cash either directly or within their fixed income portfolios. This approach allows investors to have dry powder ready for deployment in dislocated fixed income markets while not reducing equity exposure or creating a large cash drag.
Successfully navigating turbulent markets depends on two important factors: investors and asset managers recognizing opportunities and also being ready and able to act upon them. We believe that tactically taking advantage of short-term market dislocations should complement, support and advance long-term investment goals.
1The use of derivatives may expose a portfolio to risks that differ, and may be possibly greater than, the risks that would be generally associated with investing in fixed income assets. These risks include, but are not limited to: i) the lack of availability of a liquid market at the time that the portfolio may want to unwind a derivative contract; ii) the possibility that the portfolio may not be able to realize value from any derivatives contract if the contract counterparty cannot fulfill its obligations under the contract; and iii) the possibility that the portfolio could experience a loss of all or part of any margin, cash or securities, on deposit with that counterparty if that counterparty goes bankrupt. There is the possibility of deterioration in the functioning or liquidity of the market for derivative instruments which may decrease the value of the derivatives instruments, thereby decreasing the value of the portfolio. Under certain circumstances, the portfolio may be unable to close out derivative contracts in a timely manner or realize values that reflect the fair market values of those investments. The posting of derivative collateral and margin could result in liquidity demands for the portfolio. The portfolio will need to hold ample eligible collateral and margin to satisfy collateral requirements. Derivative contracts may include the use of leverage. Derivative collateral may not be sufficient to close out the portfolio’s obligations under its derivative contracts.
2For illustrative purposes only. Hypothetical benchmark represented by a 75/25 blend of Bloomberg Barclays Long Credit and Long Government indices. Pay fixed swaps consists of a 25/75 blend of Bloomberg Barclays 10 and 30 year swap indices. An investor may not invest directly in an index.
3Investment grade credit ratings of our private placements portfolio are based on a proprietary, internal credit rating methodology that was developed using both externally-purchased and internally developed models. This methodology is reviewed regularly. More details can be shared upon request. There is no guarantee that the same rating(s) would be assigned to portfolio asset(s) if they were independently rated by a major credit ratings organization.
This document is intended for institutional investors only. The information in this document is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this presentation.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.
The use of derivatives may expose the portfolio to risks that differ, and may be possibly greater than, the risks that would be generally associated with investing in fixed income assets. These risks include, but are not limited to: i) the lack of availability of a liquid market at the time that the portfolio may want to unwind a derivative contract; ii) the possibility that the portfolio may not be able to realize value from any derivatives contract if the contract counterparty cannot fulfill its obligations under the contract; and iii) the possibility that the portfolio could experience a loss of all or part of any margin, cash or securities, on deposit with that counterparty if that counterparty goes bankrupt. There is the possibility of deterioration in the functioning or liquidity of the market for derivative instruments which may decrease the value of the derivatives instruments, thereby decreasing the value of the portfolio. Under certain circumstances, the portfolio may be unable to close out derivative contracts in a timely manner or realize values that reflect the fair market values of those investments. The posting of derivative collateral and margin could result in liquidity demands for the portfolio. The portfolio will need to hold ample eligible collateral and margin to satisfy collateral requirements. Derivative contracts may include the use of leverage. Derivative collateral may not be sufficient to close out the portfolio’s obligations under its derivative contracts.
Investment grade credit ratings of our private placements portfolio are based on a proprietary, internal credit rating methodology that was developed using both externally-purchased and internally developed models. This methodology is reviewed regularly. More details can be shared upon request. There is no guarantee that the same rating(s) would be assigned to portfolio asset(s) if they were independently rated by a major credit ratings organization.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of December 31, 2019. Unless otherwise noted, all references to “$” are in U.S. dollars.
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