What drives performance in fixed income, and how are assets faring?

Andrew Cheeseman: The problem is when a class gets oversold – high-yield bonds were worth the risk a few years ago but they then become flavour of the day and risk starts to outweigh return. Emerging market debt is another example where it became popular and was talked up as markets started to move in the wrong direction. Markets can change very quickly nowadays and this can present problems to trustees with long-term strategies.

Nicola Ralston: Do you think there is somewhere that is attractive now then?

Cheeseman: I must admit that is our major problem, and it is a problem whether it be fixed interest or growth assets. We are diversifying our asset allocation not necessarily to create greater yield or protect our downside but because of the uncertainties regarding the markets.

Jeremy Cave: It is a low-yield world.

Dan James: What about if we have a repricing of asset classes like emerging markets? You have had a 150-plus basis-point widening in some of those spreads; they now look to represent value again because you are being rewarded for that risk you are potentially taking.

Cave: Emerging markets are an interesting case in point, particularly the local markets. Because most investors view the emerging markets as a single asset class, one tends to see subscriptions or redemptions from the whole universe of markets. Investor flows have certainly been very positive into emerging markets, and yet when volatility increases we observe client redemptions, particularly if funds have a high level of retail investors, which then forces fund managers to sell assets, even those they consider attractive. This indiscriminate selling, forced by redemptions, can create opportunities for other investors. It may well be logical to sell those markets in which fundamentals are deteriorating, such as Turkish bonds, because rates are going to go up by several hundred basis points.

But is it right to sell your Mexican bonds while policy there is sound and the outlook is very positive? Nonetheless, because funds provide investors with liquidity, a sudden increase in redemptions forces the manager to sell, thereby giving rise to these dislocations and opportunities.

Ralston: Yes, you have to sell your Mexican bonds even if you do not want to.

Cave: You get dislocations that then allow others to pick off markets that have [become] unnecessarily or inappropriately cheap. And that is the situation now for some local markets.

Ed Britton: Multi-asset funds tend to have a long-term objective of, for example, Libor plus 4 per cent or something close to what equities give you in the long term, and not obsess on the benchmark. But you have to be aware that if high-yield, loans and emerging markets are only going to give you 1 -2 per cent next year, then with the best will in the world your fund is not going to do that much better than that. So one actually has to use two measuring rods here.

Richard Ryan: There are certain issuers from the bottom up in both investment grade and in high-yield which do represent interesting opportunities where the credits are not liked or they are misunderstood, and these assets will always exist. Furthermore, there are individual opportunities in some commercial real estate asset-backed securities, and leveraged loans. We still see traditional bank funding as being partially broken and, to date, private markets have stepped into the breach, but public bond markets are waking up.

This is creating some pricing tension between private lending and public bond markets. You can get spreads of hundreds of basis points for investment grade opportunities in these marketplaces because very few will venture there, so it is a question of looking around, ignoring the labels, and instead analysing the individual opportunities and saying, ‘This is why I own this particular bond.’

Britton: The theme that we think is driving all that is the broken bank market that you mentioned. The banks are still pulling out, shrinking their balance sheets and that is driving an awful lot of value opportunities still. It is in the area of lending to small companies still, it is lending in the real estate market.

Ralston: Do you mean direct lending?

Britton: Yes the direct lending initiatives that a number of people are doing. There is social housing. There are a lot of places where credit was freely available and is now not, and so there is an excess premium for [the investor] to step in and take.

James: That is attractive as long as you have a real asset to back it.

Cheeseman: For me, it is a little bit like Greeks and gifts. I can have absolute trust in my manager to explain the concept but by the time we have received some of these products that are being offered, it has been through so many hands that nobody really knows what is happening. Although I must be careful not to compare this to the subprime fiasco, I would suggest that although the risk versus return may appear attractive, I just never see the research to the level that I need in order to feel totally secure. Supposedly they are backed up with suitable assets but we do not know that, and we are just relying on somebody who is not the manager who is much further down the food chain.

James: We obviously package up loans ourselves to either commercial real estate or infrastructure, which is a big area that people are moving into. And obviously you need a specialised manager to look at and source the underlying property, but you are buying real bricks and mortar and you have a direct line over those – it is not just a case of having a synthetic view of something. And it is the synthetic views, perhaps, where the concerns lie.

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