May 2021
Finding value in Fixed Income A Wealth DFM special supplement
Fixed Income ETFs LGIM's Howie Li challenges the myths
Is it time for an unconstrained approach to bond investing?
Will green gilts get the green light from investors?
For investment professionals Capital at risk Issued by Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority.
CONTENTS
May 2021 | WealthDFM
Finding value in fixed income securities An introduction to Wealth DFM’s special supplement on fixed income investing
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he Covid-19 pandemic and the impact of it continue to dominate the news headlines as well as the investment decisions taken by asset allocators and investment managers.
This special supplement from Wealth DFM Magazine seeks to gather expert opinion as to how fixed income securities can be used effectively to diversify the risks within investment portfolios during these challenging market conditions. We are currently seeing historically low interest rates as well as concerns about the threat of rising inflation and negative real returns. So, where can we find value in the
bond markets? What about the various myths around fixed interest ETFs? Should we be concerned about how we assess credit risks? What are green gilts? These are just some of the themes which are discussed in detail over the following pages. We thank all our contributors for sharing their insight with us and hope that you find it to be of use as well as of interest.
Sue Whitbread Editor Wealth DFM
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Will green gilts get the green light from investors?
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Is it time to embrace an unconstrained approach in corporate bond investing?
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Biden’s ambitious climate plans could transform the US bond market
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Fixed Income ETFs – challenging the myths
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Credit Spreads: the devil is in the details
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Italian bonds are in a ‘sweet spot’ but it won’t last
LGIM examines the differences between green gilts and traditional government bonds
Analysis from Mark Munro, Investment Director, Aberdeen Standard Investments
Kris Atkinson, Portfolio Manager, Fidelity International considers the opportunities for bond investors arising from the US’s plans to decarbonise the world’s largest economy
Wealth DFM talks to Howie Li, Head of ETFs at LGIM to discuss his views about some of the most commonly heard myths about fixed income exchange traded funds Holger Mertens, Head Portfolio Manager, Global Credit CFA at Nikko Asset Management assesses different definitions of the risk-free rate and different methods of calculating credit spreads
Aegon’s Henrik Tuch gives his reasons why he believes that it might be time to think again when it comes to Italian bonds
Designed by: Becky Oliver WealthDFM Magazine is published by IFA Magazine Publications Ltd, Tel: +44 (0) 1173 258328 3 Worcester Terrace, Clifton, Bristol BS8 3JW © 2021. All rights reserved ‘WealthDFM’ is a trademark of IFA Magazine Publications Limited. No part of this publication may be reproduced or stored in any printed or electronic retrieval system without
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prior permission. All material has been carefully checked for accuracy, but no responsibility can be accepted for inaccuracies. Wherever appropriate, independent research and where necessary legal advice should be sought before acting on any information contained in this publication. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. WealthDFM is for professional advisers only. Full details and eligibility at: www.wealthdfm.com
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LGIM
Will green gilts get the green light from investors? Are accusations of greenwashing well founded? Are they worth the “greenium”? As the UK Government looks to capitalise on the growing interest in sustainable investing, Legal & General Investment Management (LGIM) examine the differences between green gilts and the more traditional gilt-edged securities that we’re so familiar with.
WHAT ARE GREEN GILTS? At his ‘Future of the UK Financial Services Sector’ speech in Parliament on 9 November 2020, the Chancellor of the Exchequer announced that "to meet growing investor demand, the UK will, subject to market conditions, issue our first ever Sovereign Green Bond next year [2021]. This will be the first in a series of new issuances, as we look to build out a "green curve" over the coming years, to help
LGIM have been long-term advocates for integrating ESG (environment, social and governance) factors into their investment process
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fund projects to tackle climate change, finance muchneeded infrastructure investment, and create jobs across the country". It was subsequently announced in the Budget 2021 that the government will issue its first sovereign green bond - or green gilt - this summer, with a further issuance to follow later in 2021 as the UK looks to build out a "green curve". According to the UK Debt Management Office (DMO), planned green gilt issuance for the financial year will total a minimum of £15 billion. The green gilt framework, to be published in June, will detail the types of expenditures that will be financed to help meet the government's green objectives. LGIM have been long-term advocates for integrating ESG (environment, social and governance) factors into their investment process. They are also recognised by advisers as being strong supporters of fostering innovation
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LGIM
towards green growth and helping clients navigate this new market.
A BALANCED APPROACH When it comes to ‘green gilts’, LGIM believes that a balanced approach is necessary in order to understand how they could fit functionally into portfolios and where, as investors, additional comfort is needed about the ‘impact’ and ‘additionality’ of the bonds. In 2020, the group published a short piece on green gilts, addressing some of the key considerations. A lot has changed since then, including the Chancellor putting theory into practice by announcing the issuance of the first ever sovereign green bond to inaugurate a domestic green gilt market. On 27 January 2021 the UK DMO, on behalf of HM Treasury, announced that HSBC and J.P Morgan have been appointed as structuring advisers for the first issue of a green gilt. LGIM continues to engage proactively with the UK DMO, the Treasury, HSBC and J.P. Morgan and with industry working-parties to express its views on how these gilts should be put to market, taking into account the considerations outlined above. There are particular key areas of focused engagement with stakeholders, through which LGIM aims to align the issuance of green gilts with the needs of clients. These are as follows: 1. Green bonds – an ESG perspective As Anne-Marie Morris, Senior Solutions Strategy Manager, at LGIM explains “critically, we emphasise that the overall ESG risk exposure of the bond is the same when compared to the non-green counterpart – this is because the repayments of interest and principal are funded from the same balance sheet/cashflows of the issuer. “This therefore is relevant when considering the portfolio application with respect to pricing, liquidity and other instrument features. It is vital to analyse how the bond can improve the risk and return characteristics of the investor’s portfolio. It is equally
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May 2021 | WealthDFM
important to understand whether these bonds generate ‘ESG impact’ for investors. One criticism in the market of these bonds has been the degree to which they generate ‘additional’ impact above and beyond the use-of-proceeds for a ‘conventional bond. Accusations of greenwashing persist, and across sovereign and corporate issuers we have seen the full spectrum of quality and sophistication of sustainable bond frameworks. For example, some bonds have long ‘lookback’ periods, meaning green bond proceeds can be used to re-finance projects that have already been undertaken.” 2. Use of proceeds: clearly defined and ‘additional’ When it comes to working out how the green credentials of these are measured, LGIM believes that the use of proceeds should be clearly defined and relate demonstrably to the government’s overall strategy to achieve its climate objectives. Morris comments: “in our engagement with other investors, we have also agreed that it is critical to incorporate social considerations into the framework as part of the aspirations to achieve a ‘just’ transition. Furthermore, whilst the green gilt framework should allow flexibility for different types of spending, to avoid risks of greenwashing, we believe the government should ensure that the use of proceeds relate to projects that bring new environmental or social benefits, and avoid the use of these instruments as simple re-financing tools. In practice, this means that the government will need to identify a large enough stock of projects to allocate proceeds. This has been one limitation of the use-of-proceeds market that has also led to the development of the sustainability linked bond market (which provides greater flexibility with respect to the use of proceeds).” 3. Weighing up functionality without compromising on ‘impact’ A contentious issue with any green bond is weighing up portfolio functionality against ‘impact’. LGIM does not necessarily see the two as mutually exclusive concepts but the presence of a ‘greenium’, where green
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LGIM
bonds have traded at more expensive levels than their non-green counterparts, has posed a conundrum for investors. “The ‘greenium’ has fluctuated over time and is a function of demand and supply technicals” says Morris. “In Europe, for example, the ECB bond buying programme (which includes green bonds) has had a significant effect on market pricing. Investors also need to consider how other policies and regulations may influence additional demand and supply drivers. “Currently it is unclear how this dynamic will play out in sterling markets – corporate green bonds are still a very small part of the overall market. As stated above, we believe that the overall risk exposure remains the same despite the label, and
A contentious issue with any green bond is weighing up portfolio functionality against ‘impact’ therefore additional justification is necessary to qualify a ‘greenium’. For example, issuance at a new tenor point on the curve may increase functionality by enabling a better liability hedging profile for our defined benefit clients.” 4. Maturity: Align to strategic objectives “We have expressed a preference that the maturities of green gilts should be longer dated for two main reasons,” explains Morris:
whom are defined benefit pension schemes. It would allow clients to continue to invest in a way that aims to meet their long term liabilities and could increase their investment opportunity set. In addition, by issuing at such maturities, the proceeds would enable the financing of crucial longer term environmental and social projects with similar time horizons to the debt maturity. This could therefore be beneficial in terms of clarifying to investors how the projects relate to longer-term objectives of the government’s green strategy. It’s worth noting that, from our discussions, we understand the UK is unlikely to follow the German approach of twinned maturity bonds (i.e. issue a green gilt at the same maturity of a 'non-green' conventional gilt). It has also been expressed that over time the DMO hopes to build out a green gilt curve, therefore ensuring green gilts are issued at multiple maturities.”
FINAL THOUGHTS To conclude, LGIM will continue to be supportive of the government to catalyse a programme of green investment and help develop responsible investment initiatives to help meet the changing demands of its investor base.
For more information on LGIM ETFs and their fixed income range visit lgim.com/etffixedincome
“Firstly, we believe that issuing at longer-dated maturities could be a benefit to our investors, many of
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ASI
May 2021 | WealthDFM
An Unconstrained Approach? Is it time to embrace an unconstrained approach in corporate bond investing? By Mark Munro, Investment Director, Aberdeen Standard Investments
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he most interesting question now for fixed income investors is can bonds provide similar returns over the next five years to those of the previous five years? Potentially the biggest obstacle to achieving that is higher inflation, something that has not been high on anyone’s agenda since the global financial crisis. However, a strong economic rebound is now expected, helped by both supportive central bank stimulus and large fiscal spending at the same time. This is widely expected to put at least some upward pressure on prices, which has resulted in a sharp rise in core government bonds yields over recent months.
basis points compared to end 2020, to around 1.5% and 0.7% respectively. As bond prices move in the opposite direction, continued sustained yield rises would be problematic for both government and corporate bonds. So the outlook for inflation is very important. Our view is that inflation will likely rise in the short term as the economic recovery proceeds. However, the magnitude of rises should be constrained by the scarring of the pandemic, potentially higher unemployment and associated spare economic capacity. Furthermore, after an initial spurt, over the longer-term we think it’s quite likely that the structural drivers of low inflation will once again dominate.
STRUCTURAL DRIVERS WILL DOMINATE
AN UNCONSTRAINED APPROACH
In the case of both the 10 –year US treasuries and 10-year UK gilts, yields have jumped by more than 60
Having said that, we would agree with the Bank of England governor’s recent assessment that inflation
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risks are now ‘increasingly two-sided’. In this context, the likelihood of the whole bond spectrum doing quite as well as in the past 5-10 years seems less likely. With the debate around inflation risks increasing, volatility in both core yields and spreads is also likely to rise.
We would agree with the Bank of England governor’s recent assessment that inflation risks are now ‘increasingly two-sided’
ASI
We think this will call for a much more selective and flexible approach to bond investing. For corporate bond investors, an unconstrained approach to investing is more likely to successfully navigate challenges. One example of unconstrained investing and highly relevant to inflation is duration, or interest rate sensitivity. Most credit indices have quite high duration, which is fine when inflation is low and yields falling. However, the flipside of this is greater vulnerability to higher inflation and rising yields. Unconstrained approaches are typically more defensive in this respect as they tend to have lower duration. Furthermore they have much greater flexibility to dial down duration if needed.
Source: BAML indices, JP Morgan indices for Emerging Markets Bloomberg, as of 16.03.2021 * Yield to Worst (YTW) Please note where indices are not labelled as “£” we have adjusted the YTW for projected FX hedging costs.
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ASI
Another aspect of an unconstrained approach and an expansion of the investable universe is the ability to look in more places for the most attractive/best value investments. This can include Investment Grade, High Yield, emerging markets, subordinated financial debt and securitised debt markets. In turn, this supports a ‘high conviction’ approach. In the context of the generalised strong recovery in credit spreads, this ability to look more widely gains added importance. Beyond duration adjustment, unconstrained credit investors tend to have many more tools at their disposal to cope with potential inflationary threats. For example, there is normally scope to increase
Beyond duration adjustment, unconstrained credit investors tend to have many more tools at their disposal to cope with potential inflationary threats exposure to lower rated credits and subordinated debt, which typically tend to be more immune to rising inflation. In addition, an unconstrained approach usually means the ability to invest in floating rate bonds, where any upward moves in interest rates triggers compensating upward adjustments in coupon payments. Needless to say, judgement and selectivity would be very important in such cases because moving down in ratings and
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different bond structures brings additional risks. Other strategies that can be explored for inflation protection include inflation swaps and real yields. Beyond duration adjustment, unconstrained credit
FOCUS ON TOTAL RETURN
To conclude, an environment of rising inflation, or even just rising inflation expectations, usually implies increased yield volatility. This calls for a more flexible approach to bond investing. An unconstrained investing approach that focuses on total return has produced strong returns in the past and is well equipped for differing economic conditions. More specifically, an expanded investable universe provides more tools to defend against rising inflation and for mitigating downside risks more broadly. At the same time, an unconstrained approach is more suited for investing tactically and selecting high conviction investments. ABOUT MARK MUNRO Mark Munro is an Investment Director at Aberdeen Standard Investments. Mark is a Portfolio Manager in ASI’s Credit team for Sterling Investment Grade Credit Funds and is also the manager of the Total Return Credit and Ethical Bond funds. Mark joined in 2013 from Scottish Widows Investments Partnership where he worked as an Investment Manager on the Corporate Bond Team, with responsibility for Sterling and Euro credit funds. Mark is a CFA charterholder and has a Bachelor of Law (LLB) from the University of Edinburgh.
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FIDELITY INTERNATIONAL
Biden’s ambitious
climate plans could transform the US bond market Following April’s global climate summit, Kris Atkinson, Portfolio Manager, Fidelity International considers the opportunities for bond investors arising from the US’s plans to decarbonise the world’s largest economy.
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he announcement by President Biden on April 22nd of a target to halve US greenhouse gas emissions by 2030 (from 2005 levels) and his announcement in March “to create millions of good jobs" in clean energy, electrified transport and general decarbonisation will generate opportunities for bond investors and transform the US bond market. In line with the new target and its ‘American Jobs Plan’ (AJP), the US government aims to spend over $2 trillion this decade on infrastructure projects. These are broadly defined as activity related to carbon emissions reduction, climate change resilience and ensuring inclusive growth and social equity during the low-carbon transition. This could lead to the following changes for US bondholders.
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1. GREEN/SUSTAINABLE BOND MARKET COMES OF AGE The green bond market has grown rapidly since the Paris Agreement was signed in 2015, but still accounts for just 1 per cent of global developed market debt. The US has fewer issuers than the size of its economy should warrant. But the proposed $2 trillion of spending, aimed squarely at improving environmental and social sustainability, opens the door for a significant increase in US green government bond issuance (or ’Greasuries’ pending a better title), and sustainable bonds generally. Companies seeking additional funding as they build utility infrastructure or capacity for zero-carbon transport will add to this green fiscal boost. Some portion (likely most) will be funded through the debt markets, and much of it will be issued in a green, social or sustainable format.
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FIDELITY INTERNATIONAL
Meanwhile, across the Atlantic, the European Union is due to launch its €800bn Next Generation EU programme designed to rebuild economies after Covid-19, of which a third could be financed using green bonds. Increased supply would bring sustainable finance fully into mainstream debt investing and ease the current imbalance of high investor demand and limited green and sustainable supply, potentially making these kinds of bonds cheaper and more liquid.
2. EVOLUTION IN CREDIT RISK FOR DIFFERENT SECTORS The US spending plan is likely to reduce credit risk in beneficiary sectors while increasing it in sectors that lose out from this transformation, offering opportunities for
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active credit managers to add value. However, shifts in the cost of capital for different sectors could be rapid and therefore require close monitoring.
3. CHANGING M&A TARGETS FOR LEGACY FIRMS A merger is not always good news for corporate bondholders, as the new company’s credit quality will depend on the relative credit strengths of the target and the acquiror as well as the funding mechanism. In the past, legacy fossil fuel industries have adopted different strategic responses to the shifting energy complex, split broadly down geographic lines. US oil majors have sought to capitalise on the depressed valuations of US oil and shale producers to pick up cheap resources (such as
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FIDELITY INTERNATIONAL
Chevron’s acquisition of Noble), while the European oil majors, driven by a much greater regulatory and investor focus on decarbonising, have paid full valuations for clean energy assets and infrastructure. Now, however, that picture could change as US energy companies are encouraged to invest in clean energy. Ultimately, we see the lines between utility and oil companies blurring as clean hydrogen, produced by renewable electricity, replaces hydrocarbons in the energy value chain. Both strategic approaches will present opportunities for credit investors, since they typically involve companies with strong credit ratings acquiring weaker ones. Bondholders in target entities will benefit from capital gains as credit risk reduces. However, identifying which targets will be the subject of a bid that increases credit value, rather than one that proves dilutive, will require careful due diligence.
BOND INVESTORS MUST PICK THEIR MOMENTS Unlike equities where early entry to broad secular trades captures maximum upside, bond investors tend to benefit from waiting for the investment phase and funding of growth as the trade gathers pace. Leverage tends to peak and spreads to be at their widest (due to elevated levels of bond issuance) when a company is investing in new business opportunities that have yet to generate strong cashflows. This creates attractive entry points for investors who believe the market’s perception of a company’s risk will prove to be incorrect. We may therefore prefer to take an underweight position in certain sectors likely to see a big pick-up in bond supply, in anticipation of increasing our holdings as the supply peaks. Other areas will benefit from a lowering of credit risks as stranded asset risks reduce or demand patterns become more predictable. In the context of increased climate-related spending, we are taking a close interest in the following areas where we expect credit dynamics to evolve. Utilities: The most obvious beneficiary of the AJP will be the utilities sector, given the ambitious Clean Energy Standard designed to deliver carbon free electricity by
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2035 and a carbon neutral economy by 2050. The emphasis on ’Clean Energy Standard’ rather than ’Renewable Portfolio Standard’ allows nuclear power generation to be in the mix, as well as wind and solar. This push for clean energy should benefit established renewable developers and nuclear operators, while the tax incentives for 20GW high voltage transmission lines will benefit transmission system operators. Despite an absence of detail on how the fiscal boost will be implemented, we expect opportunities in the renewable-rich Midwest for companies that are developing clean energy sources and providing grid connectivity. This should also lead to greater electrification overall which, alongside increasing takeup of electric vehicles, could boost investor demand for copper and aluminium producers who supply the raw materials for wires and auto parts. Clean hydrogen and carbon capture: President Biden’s plan to fund clean hydrogen demonstration plants at existing carbon emitting locations wherever possible should help preserve jobs in those communities and generate bipartisan support in Congress. Industrial gas companies should benefit from greater hydrogen production, while refineries may also prove to be unlikely winners if they can pivot to producing ‘blue’ hydrogen from natural gas, using carbon capture and storage, and receive enhanced tax credits. Climate resilience: Biden proposes to make the electric grid, food systems and urban infrastructure, including hospitals and transport, more resilient to climate disaster. Buildings will be made more energy efficient with $213bn of funding to "produce, preserve and retrofit" around two million affordable and sustainable homes. A separate sum will be dedicated to building or modernising staterun schools, childcare facilities, hospitals and federal buildings, mainly through improving energy efficiency. This could benefit a broad range of sectors from utilities to building materials to engineering and technology. Digital inclusion: Access to digital services is also part of the plan. Around $100bn has been earmarked for increasing broadband access for 30 million households, ensuring the whole country can benefit from being online. Congress also recently enacted the CHIPS
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FIDELITY INTERNATIONAL
May 2021 | WealthDFM
(Create Helpful Incentives to Produce Semiconductors) America Act, which seeks to incentivise firms to increase domestic semiconductor manufacturing operations at a time of global chip shortages. These two policy measures imply a range of benefits for US tech firms, though the rollout of 5G and faster broadband will not automatically boost incumbents. Nonetheless, technology remains key to economic growth and the low-carbon transition. In this context, providers of semiconductor equipment and 5G infrastructure and tech suppliers to the clean energy (smart meters, battery walls) and industrial automation (robotics, EVs) sectors may offer potential opportunities.
CONCLUSION The size of the green/sustainable bond market looks set to explode under new US political leadership on climate change, and these fiscal measures will bring winners and losers. Working out which firms will benefit and when to invest in them will be central to generating long-term value for bond investors. ABOUT KRIS ATKINSON Kris Atkinson is Portfolio Manager of Fidelity’s Global Corporate Bond, Sustainable Reduced Carbon Bond and Global Hybrids portfolios and is Co-Manager of Fidelity Money Builder Income and Short Dated Corporate Bond strategy. Kris joined Fidelity in 2000 as a Research Associate, became a Credit Analyst in 2001 and was promoted to a Senior Credit Analyst position in 2010. During this time he covered a variety of sectors across Investment Grade, High Yield and Emerging markets including European utilities, consumer / retail, pharmaceutical, global energy and basic materials. He became a Portfolio Manager in 2013 and is a key member of the Core Investment Grade strategy team. Kris has an MA Economics from the University of Cambridge.
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LGIM
WealthDFM | May 2021
Fixed income ETFs -
challenging the myths Wealth DFM talks to Howie Li, Head of ETFs at Legal & General Investment Management (LGIM) to discover his view about some of the most commonly heard myths about fixed income ETFs
WDFM: ARE FIXED INCOME ETFS DANGEROUS? DON’T THEY POSE LIQUIDITY PROBLEMS AND CAN THEY REALLY BE TRUSTED IN CRISES? HL: No, I don't see fixed income ETFs as dangerous. What we should do is take one step back and remember that Exchange Traded Funds (ETFs) are a form of mutual fund. It is basically a mutual fund that happens to be listed and that is able to provide a pricing throughout the entire day. So, a fund manager managing a portfolio of bonds in the traditional mutual fund, an unlisted one, is doing the exact same thing as in the ETF structure. What really matters is how the portfolio itself is constructed. The so-called ‘danger’ that everyone talks about in the market revolves around liquidity. To answer that question, if we rewind to 2020 and look at how some of the bond markets behaved back in March and April, everyone faced the same kind of liquidity issues or concerns as every single bond
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manager did. All the ETFs continued to trade during that period and all ETFs continued to have prices. There have been papers released since to highlight the important role of ETFs, which is the ability to give real time, transparent pricing on the value of transacting in those bonds. I think that's been a very good experience. If we look back at last year we can show that ETFs did exactly what they were supposed to do, give investors diversified access to a portfolio of bonds and the prices were very clear and transparent throughout the day. Investors could buy throughout the day on a daily basis. So a huge amount of flexibility was afforded to fixed income ETFs on top of what investors normally experienced in other mutual funds.
WDFM: SO WHEN PEOPLE WORRY ABOUT WHETHER THEY CAN BE TRUSTED IN A CRISIS, THEN YOU FEEL FAIRLY CONFIDENT THAT THEY CAN?
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LGIM
HL: Yes I do. I used that example from last year because I think many people would call the Covid-19 pandemic and lockdown a crisis. And there were a lot of bonds selling off and the bond spreads were actually increasing. So whether you're a fund manager of an ETF or you're a bond manager buying individual bonds, buying or selling, you face these spreads. I think what's been really encouraging is that the ETF essentially highlighted this knowledge and this insight for everyone to see, hat was happening in the bond market, the spreads were widening and actually the ETF prices were just reflecting that.
WDFM: AREN’T FIXED INCOME ETFS COMMODITISED PRODUCTS? HOW CAN YOU ADD VALUE EXCEPT THROUGH LOWER FEES? HL: It depends on how you look at it. The fixed income market, when it comes to ETFs, is definitely less developed than in equities. Some would say, well, some equity ETFs are commoditised. But I would only say that that's the case when you look at traditional benchmarks on the equity side, it tends to be so-called market cap benchmarks where there are perhaps in the UK market a number of FTSE 100 trackers. Now, in the last five or so years, there has been much more developments in how portfolios are put together in ETFs. Both smart beta and an increase in the active focus of ETFs have been on the rise. And we at LGIM certainly take a very active view in terms of designing investment strategies which are very much focused on how investors think now and into the future. So when we look at the bond lens itself, you might ask, are they commoditised? There are probably some products that multiple managers or multiple ETF issuers are issuing and tracking the same thing. So to that extent, perhaps you can call that commoditised because investors have choice and it is therefore down to pricing. The bond market is being shaped very differently. The concerns of investors which are being highlighted are around things like liquidity. Also around being able to buy and sell and there's a lot of value that's sometimes lost if you're buying and selling all at the same time in a crowded market.
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We're taking a strategic approach and recognising those risks and designing strategies that specifically avoid the crowds, taking into account an enhanced level of liquidity. We’re making sure the portfolio itself has overall increase in its liquidity profile. Also, importantly, more and more investors are actually looking at sustainable investing and ESG as an important part that's reshaping how they build their portfolio. That's the active design view that we've taken in order to build a strategy in the way that we have because there aren't any products that are similar in the market which do exactly the same thing. I would say some ETFs are not commoditised, wheras where there's lots of choice tracking exactly the same thing, these are perhaps commoditised. But I think we're still at an early stage of fixed income ETFs and there's a lot more to consider compared to equities.
WDFM: SO IT’S ABOUT ADDING VALUE, IT IS NOT JUST ABOUT LOWER FEES. YOU’RE SAYING THAT THERE ARE OTHER DIMENSIONS THAT LGIM CAN BRING TO THE PROCESS TO SUPPORT THE WAY THAT YOU MANAGE THE ETFS? HL: Yes, absolutely. And that's a big question for
investors - is it all about fees? By chasing the lowest cost product, does that mean that they're missing out value somewhere else? We're confident that our fixed income range of products are competitively priced, very close to some of the pricing that we see in the market, in the so-called ‘commoditised’ fixed income type ETFs. However, we think that now is the time really to think about where the future allocation of capital is going.
At LGIM, we have the benefit and experience of tracking indices for a long time, we know that value can sometimes be lost when everyone tries to buy and sell at the same time
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LGIM
And as I mentioned, we touched on making sure that portfolios are aligned to certain ESG considerations. We also think this is time to ensure that your holdings have a higher liquidity threshold so that you know that the portfolio is holding more liquid bonds. The most important thing to consider is value. At LGIM, we have the benefit and experience of tracking indices for a long time, we know that value can sometimes be lost when everyone tries to buy and sell at the same time. That experience allows us to say, hold on to bonds a little bit longer than the rest of the market would and capture any reversion in prices. By designing a product in this way, we can incorporate any potential of that increasing in value in the long term, and this is something that we've proven across all of our index investments. So, it's an opportunity to think about how we invest today, but actually recognise that there are ways to do it still in a low cost manner, recognising how we can manage the risks from ESG and liquidity, while also adding value based on our experience at LGIM.
WDFM: DOES ESG MATTER IN FIXED INCOME? HL: That’s such a great question. I’d say that investors are increasingly thinking about sustainable investing and about ESG but probably that thought starts on the equity side first. When you start thinking about a portfolio, many investors and their advisers will blend a portfolio of both equities and bonds. If you're going to take a sustainable view on investing as well as an ESG view, then it's actually quite important to look across your entire portfolio because otherwise you'd have some contradiction in there. You take a view on equities, but you don't take that view on fixed income. So if we consider why investors are thinking about ESG, sometimes it’s regulatory driven, sometimes a client might want to prioritise environmental, social or even governance factors.
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I’d say that investors are increasingly thinking about sustainable investing and about ESG but probably that thought starts on the equity side first But what's more important is taking into consideration the global position, and we are encouraged to think about these measures as there are regulations pushing us towards that. We also have to recognise that the future allocation of capital is likely to be prioritised in and into those areas. So the questions for investors would then be, do you want to be missing out on that? In terms of bond investing, having the focus - alongside your equities to say this is a paradigm shift and we should probably align and position our portfolio in the same way. I think this is actually a very important consideration for all investors and their advisers. That's why for us, we very much feel that going forward, ESG will be completely integrated into all investments. We're currently going through a process where some investors are perhaps more advanced in that approach than others. If we’d had this conversation two or three years ago, I think there would be much less discussion around ESG or sustainable investing. Whereas in most conversations we have with clients today this topic is raised and if not actively seeking it, clients are looking to transition their portfolios that way and need guidance and explanations around the potential impact. It’s a really exciting place to be at the moment because of that transition, because of the viewpoint and the perspective that investors are taking.
WDFM: WHEN IT COMES TO SO CALLED ‘GREEN BONDS’, ARE THEY REALLY GREEN? DO YOU THINK THEY’RE JUST A FAD?
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LGIM
HL: Whether it's driven by governments or the social, environmental side of it, there are indeed more green bonds that are being issued. It's very important to do our due diligence as to who's issuing that green bond and what they're issuing for. For investors to walk into this with limited knowledge, they may end up with the vast majority still towards green projects. I think that's probably where you've got to take a view. Do you want to invest and research every single issue or actually work with partners who have the necessary experience or work with certain within industry standards, such as the Climate Bonds Initiative that really starts to certify and classify some of these green bonds? That's certainly the approach that we've taken when it comes to green bond investing. We prioritise the investments towards ones which have actually gone through the certification process from the Climate Bonds Initiative. So, when you ask whether these investments are actually moving towards green projects, having a certification process and prioritising those issues is definitely a step in that direction.
WDFM: WHAT DO INVESTORS NEED TO KNOW ABOUT CHINA BONDS?
May 2021 | WealthDFM
taken care of by investment or asset managers like us. We deal with the custody accounts, with the currency element etc. So if as an investor you have GBP or US dollars, all you have to do is invest in that currency and we will take care of the exposure to the Chinese markets. When you look at the yield profile, but also the return from the Chinese markets, you can see that that's where the interesting element comes as it relates to bringing diversification and yield into a bond portfolio. I think that's why we're seeing that growing interest in adding Chinese bonds into the market. I suppose just taking even a further step back from a macro lens, we all see that actually the Chinese economy continues to grow as it has been over the last 10 years. And there are many people who will continue to believe and focus on the fact that that economy will only get bigger over time. So it's really about positioning your global portfolio to increase your exposure towards the global economy, and China is very much a part of that.
For more information on LGIM ETFs and their fixed income range visit lgim.com/etffixedincome
HL: Chinese bonds have got a lot of focus over the last
year or two. That’s because if you look at traditional benchmarks, they previously sat outside of the emerging markets framework, or at least certainly the major ones that most investors focused on.
The Chinese bonds are now starting to be added into that emerging markets standard portfolio. What that means is that there's increased interest in having that allocation to China when you're looking at emerging market bonds. The other observation around Chinese bonds is that for a lot of people, if you were to try to buy that bond directly, it's not that straightforward. You need to have local subcustody accounts to manage to hold Chinese bonds and also management of the local currency aspect as some of it is restricted. Putting it together into a fund, a liquid investment, like an ETF, means that any problems are
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ABOUT HOWIE LI – HEAD OF ETFS Howie leads the development and growth of the ETF business. Howie joined the investment manager from ETF Securities after the successful acquisition of the Canvas ETF business which completed in March 2018. During his time at ETF Securities for almost 10 years, Howie was most recently the CEO of Canvas after holding other positions including Head of Legal and Co-Head of Canvas. Prior to that, Howie trained and worked at Simmons & Simmons in London advising the hedge fund industry. Howie holds a LLB from the University of Leeds and is a qualified solicitor in England and Wales.
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WealthDFM | May 2021
NIKKO AM
Credit spreads explained:
The devil is in the details
By Holger Mertens, Head Portfolio Manager, Global Credit, CFA
F
or corporate bond investors one of the most important points of discussion is spreads. Spreads are the industry term for the risk premium an investor aims to earn in the corporate bond market. It is the difference between the yield a bond is promising and the risk-free rate. If spreads are narrowing it is positive for investors as the price of the corporate bond will increase; likewise, a widening leads to a lower bond price. Although the concept sounds simple, the devil is in the details, as investors have different definitions of a risk-free rate and different methods of calculating credit spreads. For example, in the US market investors compare corporate bond yields to the yield of the closest “onthe-run” US Treasury bond. This approach is a common market practice but has several flaws. Firstly, the maturity of the corporate bond might be different to the Treasury bond and this difference in maturity will impact the calculated spread. The maturity mismatch
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makes it difficult to use the spread for relative value analysis, i.e. a credit spread comparison between two telecom companies. The difference between spreads might not only be due to a deviation in credit quality but also by the way the spread is calculated. The second flaw comes from the fact that corporate and government bonds might have different coupons. Even if both bonds have the same maturity or investors use an interpolated government bond curve1, we would still have a mismatch in duration and convexity. In the European corporate bond market, a different benchmark is used to evaluate credit quality: the I-Spread (Interpolated Spread). To derive the I-Spread, investors calculate the difference between a bond yield and the corresponding point on an interpolated swap curve. But similar to the US market example discussed above, the I-Spread is not a flawless measure of credit quality. First of all, whether the swap curve can be used as an indicator
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NIKKO AM
May 2021 | WealthDFM
of the risk-free rate is questionable as it also reflects the counter-party risk of dealing with the banking sector. In addition, it only measures the distance between a bond yield and the corresponding point on the interpolated swap curve. This simplification leads to the shape of the yield curve not being recognised in the calculation of the spread. The criticism of these widely used spread measures beckons the question: are there better ways to assess credit quality? The ASW spread (asset swap spread) and the Z-spread/OAS-spread are, in our opinion, better ways of measuring credit quality. The ASW spread assumes a combination between a cash bond and an interest rate swap. The spread represents the difference between the present value of a bond cash flow, discounted using a swap zero curve2, and its market price. The ASW represents a good way to evaluate credit quality with one caveat, it only works when bonds are trading close to par. Applying it to bonds trading at a significant discount or premium would lead to an incorrect outcome. Therefore, most corporate bond investors now prefer the Z-spread (zero-volatility spread) which is not impacted by the bond’s price. The Z-spread is the basis point spread that needs to be added to either a swap zero or government bond zero curve, such that the
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WealthDFM | May 2021
NIKKO AM
sum of the corporate bond’s discounted cash flows equals its current market price. The Z-spread is not just using the YTM (yield to maturity) to discount, but also includes the term structure of the bond market. Sometimes investors also use a derivative of the Z-spread to measure the credit risk premium, the OAS-spread (option adjusted spread). The OASspread equals the Z-spread plus or minus the value of embedded bond options, i.e. make- whole call (MWC) (Chart 1). Option pricing models are used to derive the value of the embedded options.
It is also important to remember that some spread measures are more preferable than others. We favour the use of the ASW-spread or the Z-spread/OASspread to assess credit risk. ABOUT HOLGER MERTENS, CFA: Holger joined Nikko Asset Management in July 2015 to manage the development of the firm's Global Credit capabilities. Prior to Nikko AM, Holger worked at Lazard Asset Management and held a variety of roles based in both Frankfurt and London and was Lead Portfolio Manager for their European Corporate Bond Portfolio. Before Lazard, he worked for Deka Investment Management where he was a Fund Manager/Analyst in Corporate Bonds.
Chart 1: Z spread and OAS
Holger began his career at DG Bank as a Fixed Income Trade and Sales assistant. He holds a Masters in Business Management and Economics from the Frankfurt School of Finance & Management and is a CFA® Charterholder.
Source: Nikko AM
Regardless of the spread used to compare two bonds or to analyse price moves in the corporate bond market, it is important to be consistent with the spread being used and to be aware of potential flaws.
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1 Interpolated Government Bond Curve: Interpolated refers to the methods used to create new estimated data points between known data points on a graph. “On the run” Treasury bond yields will be used to create an interpolated curve and estimate theoretical yield level for maturities in between to Treasury bonds.
A swap zero curve assumes that all bonds on the curve have a zero coupon. The assumption is used to overcome the problem of duration and convexity miss match which was discussed earlier
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AEGON AM
May 2021 | WealthDFM
Italian bonds are in a
‘sweet spot’ for investment, but it won’t last Investors might want to think again when it comes to Italian bonds as coronavirus turns conventional thinking on Italian debt on its head says Hendrik Tuch, Head of Fixed Income NL at Aegon Asset Management
T
uch cites two reasons for this recent reversal in conventional thinking around Italian bonds, calling the coronavirus crisis a “blessing in disguise” for the country’s finances.
“First, the recent appointment of Italy’s new prime minister, Mario Draghi, and his government bring stability to a historically volatile country,” says Tuch. “As an economist with an impressive resume, Draghi has already gained the confidence of investors. For example, ‘The Draghi effect’ is helping demand for Italian bonds—even allowing the country to cut yields while still selling the full amount of debt it wanted in the most recent new debt offerings after Draghi took office.”
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COVID RESCUE PROGRAMS The second reason Tuch explains, is down to the EU’s coronavirus financial rescue programs that have given Italian bonds an added appeal which has yet to wear off. “When the ECB introduced the Pandemic Emergency Purchase Programme (PEPP) this time last year in response to the global pandemic, it was an
As an economist with an impressive resume, Draghi has already gained the confidence of investors
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WealthDFM | May 2021
AEGON AM
unprecedented stimulus with no limits on policy. Initially, the bond-buying program heavily weighted its purchases toward Italy. “Since August, that has tapered off with signs of the crisis phase coming to an end with the introduction of several successful vaccines. But thus far, Italian government bonds have been able to sustain their appeal.”
CAUTION LONGER TERM Tuch cautions however that this “sweet spot” won’t last long-term as coronavirus support recedes and politics comes back into the frame. “It is nothing new to point out that the low Italian sovereign bond yields and spreads are not made in Rome but in Brussels and Frankfurt, which is the main issue for the longer-term outlook on Italian sovereign bonds.
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Before Covid-19, the ECB was reluctant to add to its sovereign bond purchases; however, the pandemic turned everything on its head “Before Covid-19, the ECB was reluctant to add to its sovereign bond purchases; however, the pandemic turned everything on its head. On top of the ECB buying program, the Italian government can expect payments from the EU Recovery Fund for up to 12% of its GDP from Brussels in the next few years. The country is also able to refinance debt at much lower yields because of the ECB, so the coronavirus crisis has been somewhat of a blessing in disguise for Italy.
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AEGON AM
“In two years’ time or less, however, we believe the situation will become more uncertain as we face new elections and, by that time, the ECB will have pulled back some or all of its buying. Longer term we are therefore a bit more cautious, as we need to see structural changes to be implemented to boost growth prospects for Italy. With a rating that is very close to sub-investment grade, we still consider Italian government bonds as a tactical asset to hold rather than a long-term buy. “The implicit assumption is that Draghi manages to keep his government together for this period, which should be possible considering the broad support team-Draghi has received also within Italy. According to polls, over 60% of Italians view his appointment as positive news, which bodes well for his current mandate. “Market sentiment can also change on a dime for these bonds, so we are cautiously optimistic. Right now, Italian bonds are in a sweet spot, but their longer-term
WealthDFM.com
May 2021 | WealthDFM
outlook is still very uncertain. Changes in the political, economic, or health situations will be important factors in altering the outlook and can send momentum in a different direction.” ABOUT HENDRIK TUCH Hendrik Tuch, CFA is Head of NL Fixed Income. Hendrik joined Aegon Asset Management in 2011 as senior portfolio manager. In his role he is responsible for all sovereign bond portfolios, the money market funds and discretionary fixed income portfolios. Prior to his arrival at Aegon Asset Management, he worked as senior portfolio manager Euro Government Bonds at F&C since 2007. He holds an MSc in Economics from Erasmus University Rotterdam and is a CFA charter holder. For more information visit www.aegonam.com
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