Tale of two assets
The debate over active versus passive investing never seems to grow old and that’s true as the late cycle lingers and a widening range of disruptions looms over global capital markets, most recently with the coronavirus outbreak. While the natural desire for lower costs has attracted more investors to passives, we believe the case for active management in fixed income outweighs that in equities no matter where we are in the cycle due to distinct differences in the nature of the two underlying markets.
To start, the benchmarks representing each asset class vary significantly. Most equity indices are made up of stocks weighted proportionally to their market capitalisation, while bond indices give higher weights to the companies with the most debt. As active managers, we are able to venture away from the benchmark in search of undervalued quality credit issued by companies that have a strong balance sheet or deleveraging, not companies with the largest amount of debt. Our in-house credit team and independent analysis are crucial to identifying value and this is especially important in fixed income given the many different structures of debt. Fixed income indices also tend to be larger than equity indices: for example, the number of bonds in the Bloomberg Barclays Euro Aggregate Corporate Index is in excess of 2,850. This makes full scale replication of bond index expensive and very challenging due to liquidity constraints of individual bonds.
The active advantage
The risk mitigation advantages of active fixed income funds cannot be underestimated, particularly in this lower for longer environment where companies have increased their leverage. Our internal credit research capability allows us to look at the underlying credit fundamentals of each name we invest in rather than relying on external agencies. This helps us to identify companies that might be on a trajectory to increase leverage or names that might have deteriorating business fundamentals. Usually a passive investment grade bond tracker wouldn’t be selling its holding until downgraded to junk (aka fallen angel) by ratings agencies and when it exits the respective IG bond index. Such forced selling on downgrades can cause near term price dips (spread widening) because of these market dynamics. As active managers, we have the flexibility to look at such fallen angels and decide on a course of action on the basis of underlying credit fundamentals rather than just an external credit rating.
While risk mitigation helps us in avoiding pitfalls, actively scanning the market for opportunities is what helps us to generate superior returns for our clients. Last year, for example, we bought BBB-rated Fidelity Information Services (FIS), the US-based global provider of banking and payments technology, which issued a multi-tranche deal across sterling, euros and US dollars. FIS came to the market to raise money for its Worldpay acquisition, making them the market leader in payment processing worldwide. Given the momentum of cashless transactions, we believe this is a relatively low risk and high growth business. Also, the acquisition was not a fully debt-funded deal but rather a mix of c.90% stock and c.10% cash. As with any acquisition, this deal has its own execution risks but on balance we felt the returns offered by the bond compensates us for the risks involved.
We are always eyeing ever-changing pockets of opportunities like this and are happy to look down the lower end of the rating spectrum for companies that in our opinion have proved to be deleveraging and engaged in credit-friendly policies. Our recent purchase of the subordinated Stanley Black & Decker bond is a pertinent example.
Fixed income benchmarks have become riskier with time. The graph below shows that over the past decade the duration of Bloomberg Barclays Global Aggregate Bond Index has increased from 5.71 years to 7.32 years while yields have dropped from 2.92% to 1.29%. During the same period, the number of BBBs in fixed income indices has increased. For example, the number of BBBs in the Global Aggregate Bond Index now has gone up to c. 15% of the index vs c. 5% at the beginning of this decade. Hence, passive fund investors are taking on more interest rate risk and credit risk for lower yields. In our view, the advantage of active management is this ability and flexibility to manage interest rate and credit risks.
The idiosyncrasy involved around the timing of bond inclusion into indices offers unique opportunities as an active manager. Usually a new issue does not get included into the bond index if it does not settle at the end of the month. So, if a new issue is priced attractively at a discount, as active managers, we can look in the primary market to capture this discount. One such example was the BRK 2.375 39 (Berkshire Hathaway) bond issued in GBP last year. The bond was priced at 98.435 in the middle of June 2019 but because it was issued cheap it rallied post issuance and by the time it was included in the indices it was trading around 102.5 cash price. Hence, as a passive investor one would have lost around 4% of price appreciation that this new issue generated over that two week period. This is not an outlier and as an active manager we are always looking for such opportunities.
Looking ahead, an active approach that discriminates between highly indebted companies will be even more critical if the much-talked about downside risks and recessionary fears do materialise in 2020. Indeed, should the coronavirus outbreak become more of a medium to long-term risk, active fixed income management that is focused on quality from the start will pay off and potentially lead to enhanced returns and lower volatility.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors. No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness. The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice. This document is issued for information only by Canada Life Investments. This document does not constitute a direct offer to anyone, or a solicitation by anyone, to subscribe for shares or buy units in fund(s). Subscription for shares and buying units in the fund(s) must only be made on the basis on the latest Prospectus and the Key Investor Information Document (KIID) available at www.canadalifeinvestments.com.
Canada Life Investments is the brand for investment management activities undertaken by Canada Life Asset Management Limited, Canada Life Limited and Canada Life European Real Estate Limited. Canada Life Asset Management Limited (no. 03846821), Canada Life Limited (no.00973271) and Canada Life European Real Estate Limited (no. 03846823) are all registered in England and the registered office for all three entities is Canada Life Place, Potters Bar, Hertfordshire EN6 5BA. Canada Life Asset Management is authorised and regulated by the Financial Conduct Authority. Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
CLI01571 Expiry 28/02/21