Ten things wrong with traditional fixed income

The majority of fixed income clients are invested in strategies that follow a traditional market-cap approach, which results in investors lending more to the issuers with the most debt.

By focusing instead on fundamentals for government and corporate issuers, bond investors are encouraged to think of themselves as lenders and prioritise a borrower’s capacity to repay their debts, rather than their capacity to borrow more.

With this in mind, here are 10 things that are wrong with the traditional approach to fixed income investing.

1. Debt bubble

History suggests investing in market indices leads you into the most levered borrowers and industries, often with disastrous consequences. As a sector gets unhealthier, it issues more debt and market indices own more of it. As conditions improve, investors divest. That is not a winning investment formula.

2. The year of the sheep

More money than ever is invested in fewer and more concentrated positions. Market-cap debt indices encourage this, so don’t be penned in.

3. Lending logic

Your mortgage application asks a lot of questions and fixed income investors need to apply the same rigour throughout their portfolio. By following market-cap indices and lending to whoever has borrowed the most, the majority of investors aren’t applying the basic lending logic their bank manager uses when lending to them.

4. Size doesn’t matter

Bigger is not necessarily better in bonds. Recent risk-off episodes have shown that even the largest borrowers are susceptible to illiquidity. Quality-driven diversification can act as a bulwark in such periods.

5. Balancing act

Fixed income investors have gorged on yield for a number of years, and bank capital cannot sustain returns indefinitely. Surely it is better to focus on ‘five-a-day’ credit metrics for corporates, rather than who issues the most paper.

6. Emerging markets

Why are traditional investors not investing in two of the largest economies in emerging markets? Both China and India are excluded from traditional indices on the grounds that they are difficult to access for investors. That doesn’t make their economies less relevant.

7. The price is right

Quantitative easing has inflated debt prices for most borrowers and not always the best ones. This increases the potential loss given a default, and market cap does not discriminate. It’s better to follow an index that takes into account a borrower’s fundamentals, not just the price.

8. Does the cap fit?

Issuer caps ignore the key drivers that govern a borrower’s ability and willingness to pay. Can an investor rely on active management in an illiquid asset class to resolve the issue? We think not.

9. Listening to Sirens

In Greek mythology, the hero Odysseus successfully navigates the allure of the Sirens’ song by strapping himself to the mast of his ship. But there may not be enough rope for investors to do the same when the next debt bubble bursts. It would be better to focus on quality-led diversification, low concentration and fundamental factors.

10. Common sense?

Would you rather lend more money to banks and insurers just because they need to borrow more? Or lend more to firms, such as retailers, who might not need your money but are more likely to pay you back?

Kevin Corrigan is head of fundamental fixed income at Lombard Odier Investment Managers