Balancing Objectives: How We Preserve Capital While Generating Income

by: Brandywine Global Investment Management
Summary

Since income generation and capital preservation should be pursued in tandem, we are exploring these topics in complementary posts.

We previously covered how global investors can find attractive yields by citing prior examples of income-generating opportunities, such as the European Sovereign Debt Crisis and collapse in crude oil prices.

In this piece, we outline why capital preservation should encompass a top-down macroeconomic investment approach to identify uncorrelated, higher-yielding opportunities - which are often excluded from benchmarks and indices.

By Brian L. Kloss, JD, CPA

A Global Opportunity Set

We think capital preservation starts with the investable universe, so the broader the opportunity set, the higher the potential for identifying mispriced securities that could produce strong, risk-adjusted, uncorrelated returns. Starting with a global opportunity set of sovereign bonds and corporate credit is engrained in our process, primarily because we want to diversify exposure across different business cycles and macro environments. Having the flexibility to invest in both credit and fixed income has a few implications. For example, investors should be keenly aware of the limitation benchmark construction presents. Having a flexible, benchmark agnostic approach can offer a level of freedom in portfolio construction that in turn becomes a building block for uncorrelated returns. The global bond universe is as vast as the name implies, so let's look at spreads across credit markets to identify where the relative value could be and how this could produce an uncorrelated returns stream.

If you read Gary's blog, you'll notice that he featured a similar chart in his piece. Chart 1 here differs because it evaluates spreads across the entire global credit market, whereas Gary's featured spreads across the credit-quality spectrum of the U.S. energy sector. Nevertheless, both charts are a starting point to signal where potential value may be in these markets.

Based on Chart 1, it's evident that U.S. corporate spreads have compressed significantly, thanks in large part to the first-quarter rally. Yet, it doesn't mean the U.S. market should be ignored, as investment-grade corporate credit could serve as a source of high-quality duration in a risk-off period - an observation we will address later in this blog. Although it's not shown in this chart, the same could be said for U.S. Treasuries, which have provided relative value versus German Bunds and French OATs and served as a source of high-quality duration. Furthermore, a strategic allocation to U.S. high yield corporate bonds, particularly better-quality BB-rated bond, could benefit from extra innings in the domestic credit cycle. These U.S. positions create a nice cushion to explore high-income-generating opportunities in other segments of the global credit market. They also highlight how flexibility can uncover multiple investment opportunities even within one country.

The spreads on euro- and sterling-denominated corporate debt obviously look attractive, but further macroeconomic evaluation is needed, as eurozone growth is flagging, the European Central Bank is in a dovish holding pattern, and Brexit remains unresolved. Before allocating to a seemingly attractive segment like the European credit market, it is therefore important to understand macroeconomic headwinds and tailwinds as well as liquidity at the sector and security level and the impact of currencies on valuation.

Duration Management

A moment ago, we mentioned how U.S. Treasuries could be a source of high-quality duration. Chart 2 below shows how we have tactically increased our exposure to long-dated developed market sovereign bonds through the end of 2015 into 2016, which was a particularly volatile time for financial markets.

We believe the relationship between flexibility and capital preservation also pertains to active duration management. Weakening global growth became a concern after the Federal Reserve (Fed) raised interest rates for the first time since the financial crisis at its December 2015 meeting. We responded by:

  1. Adding a significant source of high-quality duration through an allocation to U.S. Treasuries and core European sovereign bonds.
  2. Initiating long positions in interest-rate futures as additional protection.
  3. Balancing this risk-off hedge with high-income-generating opportunities within the U.S. energy sector - as you may recall from Gary's blog.

Once the Fed backed off its cadence of rate hikes in 2016, we lowered that high-quality sovereign duration given the price risk these assets posed. Overall, the chart shows how in prolonged risk-on environments, we will typically concentrate positions that offer the greatest value at the respective country's point in the business cycle and shorten duration in these periods as well.

Conclusion

When investing in global fixed income, we believe in the importance of analyzing company, sector, credit quality, country, and macroeconomic fundamentals. Context matters, especially when balancing complementary objectives like capital preservation and income generation. Ultimately, we think maintaining flexibility in order to navigate a complex investment backdrop should allow you to reach a far better outcome.