Focusing in on risk and return asymmetry
Given the continued uncertainty facing markets, as well as significant trading costs as liquidity has tightened, we are not making large directional bets at this stage. But as with any periods of volatility, let alone one this extreme, opportunities and dislocations are beginning to emerge. We are focusing our attention on areas with attractive risk and return asymmetry. One example of this is a shift from Master Limited Partnerships (MLPs) into US dollar denominated emerging markets debt. In recent years, the composition of the emerging markets hard currency universe has evolved to include a higher allocation to oil exporting countries, and this has resulted in a more meaningful oil beta than in the past. MLPs also have a high oil beta, and both assets have corrected meaningfully during the recent oil selloff, but we see emerging markets hard currency debt offering mean reversion qualities, better downside protection, as well as upside participation when the oil price eventually recovers.
Where are the opportunities?
We are also seeing value begin to emerge in corporate bonds as spreads have widened meaningfully. While we think the barrier to adding US high yield is quite high at present, we have higher conviction in the prospects for US investment grade fixed income. We have seen significant indiscriminate selling that has led to more attractive valuations, and this selloff has hit even those corporates with strong balance sheets and cashflows. Many companies are facing or will be facing significant threats to cashflow sustainability, and dividend cuts are to be expected in such an environment, but this does not necessarily mean poor management decisions or a business in decline as in normal circumstances. That said, given our cautious approach and broad mandate, we prefer to gain exposure to those quality businesses higher up their capital structure, and it is worth remembering that bondholders are always paid first. Until we see a meaningful turnaround in the economic backdrop, our preference is likely to remain for debt over equity securities. The strategy is also holding one of its highest ever levels in cash, which includes an allocation to money market securities and shorter dated corporate bonds. This offers low risk and high liquidity, as well as sacrificing less yield than holding outright cash or many developed market government bonds.
These things take time
It is likely to be some time before we know the scale of economic damage of the polices taken to stem the spread of the virus, or if the very large fiscal responses globally will be enough. When the growth rate of the virus slows, we will be looking to short term money markets, safe-haven currencies and commodity prices for signs of stabilisation. We are not seeing that yet. While market volatility remains elevated, we prefer to closely monitor developments and remain cautious, while incrementally adding to areas of conviction offering strong risk-adjusted returns.
