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Credit Suisse's Gadsby: time to rethink fixed income

Credit Suisse's Gadsby:  time to rethink fixed income

Credit Suisse bond fund selector Omar Gadsby tells Angus Foote what fixed income portfolios will look like in the future.

Brace yourselves, bond investors. You might think that after all the market upheavals of the past 18 months you’re due a quiet period, but no such luck.

It’s not just governments and policies that are changing – the economic backdrop means that your allocations need to change too and that process is far from over.

So the question is: what will bond portfolios look like in future? And what changes will fund selectors have to implement to get there?

As head of fixed income and multi asset class fund selection at Credit Suisse in Zurich, Omar Gadsby is one of the most influential bond fund analysts in Europe. If his vision of the future is accurate, professional investors need to re-think their whole approach to bond strategies.

The biggest part of the assets that Gadsby oversees is advisory money in client portfolios. Gadsby sees his role as identifying and then solving the big problems that investors face. At the heart of the current conundrum for bond investors, of course, is the low yield world we’ve moved into.

What’s going on in the market?

‘We’re a bit less negative than we were just 12months ago, but still negative,’ says Gadsby. ‘Wehave a bund yield at 30 basis points, the majorityof one to seven years in the bund term structure,negative, so that’s a real challenge.

‘There is a 27-year high in the spread between 10-year US treasuries and 10-year bunds. That presents an interesting scenario because we haven’t experienced this degree of spread differential for two decades, and someone’s wrong.’

There are different ways in which this could play out. US yields could go higher, based on strong employment figures and robust growth, or European yields could be pushed up by a recovery in the region’s major economies and favourable election results.

‘Euro government bonds look vulnerable. There is growth and the beginnings of recovery in Europe, as well as evidence of inflation bottoming and potentially some signs of increasing inflation. That suggests the euro government term structure may be wrong,’ Gadsby says.

‘One of our biggest problems right now is our huge exposure to euro aggregate bond funds. These funds typically have an average credit quality of A, but the bund yield is at 30 basis points and those funds yield just 40 basis points above the bund.

So, they’re yielding 70 basis points, way below 1% and they have seven years’ duration. As I look at bond markets around the world, the euro investment grade and euro aggregate cohort is where I see potential risk and we will address that over the coming quarters as we reposition our euro portfolios.

‘Developed government bond markets are clearly moving in different directions, and for the first time in many years they’re out of sync. Relative value trades are back. Maybe you want to be long US, short Europe. That could work,’ he says.

An important part of Gadsby’s role is to be a ‘thought leader’ in the private bank in terms of how clients position their portfolios. ‘I need to see the problems on the horizon and start to shape our portfolios for those types of developments.

‘Emerging market debt was a really good example of that. I embraced short duration strategies at an early stage and they’ve worked well for us. Our clients need income, and it’s produced one of the best risk-adjusted sources of income in the bond markets.’

The hunt for good risk-adjusted sources of income has also taken him into senior loans, catastrophe bonds and insurance-linked securities.

‘We’ve been forced to think innovatively and to talk to our clients about the fixed income return, which historically has been driven by coupon, with some modest capital appreciation. It was important to start thinking about an alternative: well you could build a part of your total return from a combination of carry and capital gain.

‘And that’s where long/short strategies became more important to us, as these products can generate capital gain from owning a credit default swap, and currencies, both on the long and the short side. Then they can generate a total return which is less dependent on just that carry or income component.’

The need for innovation

Investors focused on the steady stream of racy thematic launches in the equity world are often inclined to view bonds as a more boring, conservative asset class. But Gadsby is adamant that if you’re looking for real inventiveness, fixed income is where it’s at.

‘This is the asset class that has experienced the most innovation in the last two decades,’ he says. ‘In developed markets there was huge growth in corporate bond issuance in the 1990s. Then credit derivatives became a big feature of that market, pre and post-crisis.

‘We had credit default swaps in the early 2000s when it was an over-the-counter market, then post-crisis it became a fully-clearable market, both on single-name and index credit default swaps, so you didn’t need to express your opinion in a bond any more, you could use a credit derivative to do that,’ he says.

Then there’s emerging markets, where, back in 2000, the hard currency market was bigger than the local currency one. By 2007, just pre-crisis, many emerging market countries started to benefit from commodity inflows so they retired dollar debt and issued local debt.

This meant the local market became twice the size of the hard currency one. ‘This resulted in more innovation to capture local currency funds and more regional funds such as Asia RMB, RMB investment grade, RMB high yield, and now total return in EM debt.

‘In euro high yield, we had the crisis, and overnight, 20% of the European high yield market became bank debt. That’s been refinanced in the last eight years as contingent convertible bonds. So you have the birth of the CoCo, and that’s a sector we really like. Innovation in fixed income is ongoing, and it’s led to a substantial growth in products.’

But is such innovation always a good thing? I met up with Omar Gadsby in January, just as many of us were getting back into full swing after a seasonal lay-off. But the holiday had not been all relaxation for him – he spent the Christmas break pondering a question posed by his management, one which many fund selectors are currently confronting: ‘how do you justify what you do?’ He’s thought it through and his answer is clear.

Over the last five years he’s seen a 50% increase in the number of fixed income funds just on the online platform. ‘That’s a huge number, and with that rise we’ve also had the first decile, and the 10th decile, increasing materially.

'The dispersion of returns in the first and 10th decile has increased by more than 60%. So that means a lot more bad funds. I’ve consistently delivered in that top quartile, and that’s where we focus. So the growing dispersion of returns is a justification for the selector, particularly in fixed income.

‘A lot of these new strategies are not working and they’re in the 10th decile. So being able to protect client money and not participate in those products is more important than capturing the upside,’ he says.

The solution

To get clients the returns they need, but to do so in the right way, Gadsby brings us back to one of his main themes: the focus on emerging markets.

‘One of my big strategic objectives is increasing clients’ exposure to emerging market debt.’

Emerging markets, he reiterates, represent around 5% of total debt outstanding in the world but deliver over 50% of global growth. ‘There’s an imbalance there, right? Emerging markets have historically been associated with high volatility, and that’s why the weights have been quite low.

Our strategic asset allocation for the fixed income component captures 5-8% emerging market debt. I think that’s the fundamental problem. We have a majority of the OECD countries with negative interest rates or very low interest rates, and high debt to GDP. But you’re not being compensated for that risk, so how do we solve this?

‘To build an emerging market portfolio you should always have your core/satellite. But the historical core was made up of what I call “market value” benchmarks, which are not efficient at all.

'For hard currency it’s the EMBI Global Diversified. That index is horrible, it’s the old Brady Bond index, and the top 10 issuers represent over 50% of the market cap, so you’re investing in 10 countries, right?

But this index has over 60 countries. It’s a bad index. ‘The GBI EM Local Currency index is even worse, the top seven countries represent 70% of that index. So these are the historical core exposures. That’s wrong. Those old benchmarks should not be core.

‘My message is that you keep the core-satellite structure, but change the core. The new core is more defensive and we try to keep volatility at around 5 to 6%. How do we achieve the new core? With short duration EM debt, total return EM debt strategies, and then I surround that new core with high conviction satellites. Take an Indonesia bond fund and a frontier bond fund, for example.

‘When you have this structure, you can go to a client who has euro investment grade exposure yielding 70 basis points and say: “Look, you have a product in your portfolio yielding 70 bps, from a wide range of highly indebted countries, and seven years of duration. Why not capture a defensive emerging market exposure yielding 3%?”

That message, he believes, is strong enough to get where he wants to be in terms of the overall client allocation – a strategic asset allocation that is closer to 15% than 5%. But changing deeply entrenched mind sets is never easy.

‘It takes years of communication, because you never get conviction for funds until you have three years’ track record. My frontier fund finally has five years so people think: “Oh, frontier markets actually can deliver a return, it’s not scary.” It just takes time, but that’s the problem I want to solve,’ he says.

Picking the right managers

The eventual formula for cracking this conundrum is likely to include a mix of well-known managers and specialist boutiques.

‘Increasingly I’m observing something of a barbell, where I have some big managers to provide my asset allocation building block exposures, together with an increasing population of boutique specialist managers. In the latter I can get direct lending, long/short credit, high yield. I can get emerging markets in a variety of strategies,’ Gadsby says.

While boutiques often create a bigger buzz among fund analysts, if you’re on the hunt for innovative ideas then new approaches from established managers can be just as valuable as exotic new finds.

At the same time, selectors who can’t find enough new ideas coming down the provider pipeline are now more likely to bring their own ideas to the table.

Gadsby sees idea-generation as a two-way street, although he doesn’t always get what he needs. And he has very clear ideas about what he wants from a fund manager.

‘I tell asset managers what I need. I’m engaging in that discussion now. I’m trying to fix a problem where I have euro aggregate benchmark exposure in traditional bonds and I need to shift that into products that deliver average investment grade credit quality, but where I get yield that’s closer to the duration or exceeding the duration.’

But for this key allocation it’s unlikely he’ll be using boutique managers he’s only just discovered. ‘I must have evidence that they’ve made money before. I develop long relationships with my asset managers and then I ask them: “Think about this, come back to me with an idea.” Because I already know that they can manage money.’

Fresh ideas to fill the gaps

Right now he’s looking for infrastructure solutions. President Trump has vowed to spend billions on infrastructure in the US, so Gadsby wants a liquid infrastructure solution.

His approach has been to ask his big, trusted asset managers what they can do in this area. The strategies on offer tend to be illiquid and hard to access for private clients, requiring a capital call. A liquid portfolio of bonds from infrastructure-related companies seems surprisingly hard to find.

‘I have been in this business for 20 years and I have a bias towards working with teams and processes that I know. For example, we’re positive on European financials, we see a steeper yield curve, banks are going to start to make money.

There was a problem in the financial sector, the balance sheets were repaired but then there was just no profit. Now we’re moving into a period where we have, across Europe, an average core tier 1 ratio of 13%. That’s double the capital that we had during the crisis.

‘Banks are well-capitalised and now we’re seeing the final piece of the puzzle coming together where they can start to make some money, and profitability improves.

'Then we invest across the entire bank capital structure, from senior debt down to subordinated bonds, to CoCos. I have managers who have been investing in this sector for decades, and I know where I need to go,’ Gadsby says.

So boiling down all the problems facing fixed income selectors as they respond to a new environment, to put it simply, is emerging market debt the answer? Well, yes – although of course it’s not quite that simple.

‘I think you have to go beyond the developed world and reduce exposure there, that’s very clear. You have to go sensibly into emerging markets,’ Gadsby says.

‘And you have to embrace innovation and consider asset classes that offer fixed income-like returns, but are not historically associated with it.’

Sorry, bond fund selectors: the bad news is there’s a lot more work to be done. The good news is: that’s why you’re needed.

This article originally appeared in the March edition of Citywire Selector magazine.

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