
Invesco Euro Short Term Bond Strategy Insights
Luke Greenwood. Co-Head Global Investment Grade, Invesco Fixed Income and Lyndon Man. Co-Head Global Investment Grade, Invesco Fixed Income.
Global markets during January and February were broadly uneventful as participants assessed the opportunities for the year ahead after an extremely rewarding 2019. This relative calm abruptly ended as March arrived and the first quarter of 2020 will be remembered by several unwelcome records relating to unprecedented moves within financial markets.
The ferocity of the global sell off was bought about by the uncertainty created by the rapid spread of Covid-19 combined with the oil price shock, two largely unforeseen events. This saw investors’ primary goal instantly switch to capital preservation and a flight to quality.
Performance
For the first quarter of 2020 the strategy underperformed its benchmark.
Attribution:
- The main driver of the strategies relative underperformance versus benchmark was the overweight to investment grade corporate bonds. The spread widening, predominantly in March, was compounded by the aggressive bear flattening of credit curves. This underperformance of short maturity credit versus longer maturities was a result of the liquidity squeeze on the broader investment grade corporate bond market. The strategy was long credit protection (using crossover CDS) which was originally implemented to hedge the higher beta credits within the portfolio and provided some respite
- We were active in duration to help insulate the strategy from the broad risk aversion. Specifically, we were up to 0.4 years long US duration in the 5 year part of the curve. In Europe we added Italian government 4 week bills when yields became dislocated, and also some Portuguese government bonds which are set to benefit from the ECB’s Quantitative Easing (QE) program. Overall, duration helped to offset some of the underperformance from corporate bonds
- The strategy is 100% currency hedged under normal market conditions. However, in order to act as a hedge during the volatility the strategy has had a small allocation to JPY versus USD. This has slightly detracted from relative performance as US dollar funding shortages resulted in dollar strength against most currency pairs. We maintain this position should risk off sentiment cause a flight to JPY
Strategy
Despite the underperformance, the strategy was positioned with a more conservative stance going into the volatility, primarily due to tighter valuations and several tail risk events not fully resolved in our opinion (Brexit, US-China trade and the US Presidential Election). This more conservative stance meant the strategy was long liquidity (approximately 8% cash), flat peripheral spreads and we had also reduced spread duration.
To this point, within the corporate exposure we continue to focus on high quality corporates, all of which are underwritten by our global credit research team. Given the recent oil price shock, it is also worth noting that the strategy only has around 2% of exposure to Energy.
Unfortunately, in times of market distress like we have seen throughout March, short dated, high grade credit (which makes up a large portion of the spread risk in the strategy) is actively traded and marked wider which weighs on this part of the market.
The main reason is that as strategies endure outflows, in particular corporate bond funds, one of the only areas of decent liquidity is in high grade paper as investment banks are reluctant/not permitted to take large positions of higher beta risk onto their books. In addition, these liquidity constraints have been exacerbated by the operational issues caused by traders having to work from home.
As a result, we have seen an underperformance in names that should be a safer haven in these times distress. It is key to remember though that these recent losses are mark to market, not realised and we anticipate that as soon as normality begins to return to markets, as outflows stabilise and the myriad of global QE policies start to take effect, we expect to see a sharp reversion of the spread widening experienced. Of course, the time horizon of this is clearly unknown at this stage.
On a more positive note, the ECB’s pandemic emergency purchase programme purchases will not count towards the 33% sovereign issuer limit which should help peripheral spreads.
Additionally, toward the end of March and into April, liquidity began to return to the market as outflows stabilised. The primary market has been extremely buoyant both in Europe and the US and we have seen investment grade corporate bonds perform well into quarter end.
Looking ahead
The recent volatility has not altered our longer-term view, though of course the weakness in credit markets has made valuations much more attractive. If anything, the reaction function of governments and central banks globally has increased our conviction that government yields across the region will remain lower for longer, with shorter dated bonds in Europe well anchored by extremely loose ECB policy.
Within the corporate bond market, technicals had turned negative as investors sought safe haven assets, though this is a trend we believe will reverse in the near term as the ECB’s increased monetary support kicks in and headlines around the spread of the virus continue to improve.
We continue to ensure the strategy has sufficient liquidity. In addition, where appropriate we have been capitalising on the surge in primary market supply. The objective being to selectively add some high-quality credit bonds at spread levels not seen since the Global Financial Crisis (GFC).
However, it is extremely important to note that we continue to focus on minimising idiosyncratic risk within the strategy, both from a corporate and government perspective.
To help us mitigate the risk of a downgrades occurring within the strategy, our team of Global Credit Research analysts continue to work around the clock to update their ‘Downgrade Candidate Monitor’ as the situation evolves. This is in place to give portfolio manager’s advanced warning of potentially weakening credits.
To this point, Covid-19 has caused a sharp collapse in both trade and service sectors (especially the latter) which will result in a material hit to companies’ liquidity in the short term. We expect corporate fundamentals to deteriorate as a result, with greatest pressure on industrial and cyclical firms alongside the leisure and travel industries.
Bank regulation has been temporarily relaxed and balance sheets are much stronger versus 2008/09, albeit loan loss provisioning will increase as the SME market feels the greatest pressure on funding lines. At current valuations, this credit deterioration is being priced in.
We continue to be active in duration, primarily moving long versus the benchmark during periods of risk off to try and help insulate the strategy and reduce drawdown. With regard to European peripheral government bond positioning, we remain cautious on Italy given the increased levels of borrowing caused by Covid-19, combined with the potential for political instability and anti-euro rhetoric. Instead, we prefer Portugal, Spain and Ireland and believe they are best placed to benefit from the ECB’s purchases leading to a compression in spreads versus German bunds.
Active risk in the form of tracking error has material increased, which has been driven by higher levels of market volatility rather than a change of strategy. Despite the ongoing growth shocks globally, we continue to overweight high quality corporate bonds given the supportive central bank and government policy. This is a well diversified allocation by both by name and maturity to enhance the yield of the strategy (currently 1.4% in euros) and roll down profile.
Investment risks
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Important information
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Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.