Read more about how our sub-advisor, Wellington Management, plans to increase exposure to themes they believe could lead the next business cycle.
In our experience, recessions have been important catalysts for new thematic ideas, and the Coronavirus Recession of 2020 is no exception. As such, we are introducing several new themes sectors in the fund and expanding the scope of others in order to increase exposure to sectors we believe could lead the next business cycle.
One of the core philosophical beliefs of the Opportunistic Fixed Income team at Wellington is that a recession tends to wipe the slate clean, leading to new investment and consumption patterns that present themselves in a new set of compelling investment opportunities. We certainly did not expect the COVID-19 crisis to be the proximate cause for the recession we are currently experiencing, but its effects are likely going to alter the fixed income landscape for years to come. As liquidity has returned to fixed income markets and as volatility has subsided, we have taken the opportunity to reassess many of our key strategic sectors within the fund. As a reminder, strategic sectors are longer-term themes within the fund where allocations typically last between 1-5 years. This contrast with our market-neutral allocations which seek to generate returns from mispricings that last 1-3 months and our tactical positions which typically last less than one year. Early in a new business cycle, the fund tends to have most of its risk within the strategic sector component given compelling valuations in many fixed income assets. This cycle is no different and a larger portion of our risk will likely be coming from key strategic themes; while the return potential for the fund is higher in our opinion, it will likely mean that we will tend towards the higher end of our volatility target (1-1.5% over core fixed income) over the immediate term. Below are some more details on our key strategic sectors.
Activist governments were a theme in the fund prior to the COVID-19 crisis; yet we are still shocked by the aggressive and timely response from policy makers to the crisis on both the monetary and fiscal side.
The response from monetary authorities dwarfs any type of liquidity injections we saw in the Great Financial Crisis (GFC). In 2008, policymakers were largely behind the curve trying to put out liquidity fires as they materialized. However, because of experience gleaned from the GFC and the statutory ability to act, Central Banks were quick to identify and setup programs to alleviate market stress. At the same time, fiscal authorities have acted more aggressively than at any point since World War II.
In our view, policymakers are so much more aggressive in responding to this crisis, because of “lessons” they learned from the GFC. In the aftermath of the GFC, many economists were worried about two potential side effects. Firstly, that the large increase in government debt would create financing and solvency issues for governments, and secondly that the large increase in Central Bank balance sheets would increase inflation. Both worries turned out to be misplaced. Instead of bond yields rising to accommodate higher financing needs, bond yields collapsed to multicentury lows. Also, instead of causing inflation, disinflation reined over the post-crisis world.
This lack of negative consequences has caused policymakers to view little trade-off between fiscal and monetary coordination; ultimately leading to the Modern Monetary Theory. Central Bank independence is likely to become a thing of the past as the lines between fiscal and monetary policy may be blurred. Central bank actions may become much more closely aligned with the objectives of the government in power. The way we are investing in the theme within Activist governments is to focus on the assets that we think may be the beneficiary of the unintended consequences of this policy, namely Global Inflation-Linked bonds. However, we have also included assets that Central Banks will need to target in order to make sure their monetary policy is transmitted with rates at the zero-bound, namely agency mortgage-backed securities, investment grade corporates and municipal debt.
We think that policymakers are too cavalier in dismissing the trade-offs inherent in their policies. We believe that the macroeconomic experience following the GFC was truly unique, and instead we should heed the lessons of centuries of monetary-fiscal coordination. The GFC was a unique type of recession called a “Balance Sheet Recession” (BSR). In a BSR, various agents in the private sector are technically insolvent as their liabilities are greater than their assets, which have fallen precipitously in value. In a BSR, interest rates stay low, because there is little demand for new debt capital given the insolvency of the private and financial sector. This lack of demand for money ultimately is deflationary. Many policymakers mistakenly look at the disinflation following the GFC as evidence that money supply increases are not inflationary. We would argue that if Central Banks had not dramatically increased the money supply following the GFC, we would not have had disinflation but outright deflation.
The COVID-19 recession is not a BSR; in fact, balance sheets (particularly the U.S. household and financial sectors) looked quite healthy heading into this recession. The COVID-19 crisis is instead an income statement recession, a much more typical recession whereby a country’s income statement is temporarily affected by some factor, but lower interest rates and transfers from the government make policy multipliers much more effective.
We believe that ultimately a higher degree of monetary and fiscal coordination may manifest itself into higher inflation expectations and lower real yields globally. We want to make an important distinction between inflation and inflation expectations. We view the severe demand shock from COVID-19 as disinflationary and it is likely we will see core CPI at very low levels for the foreseeable future. However, inflation-linked bonds only price inflation over the very long-term and inflation expectations can deviate substantially from realized inflation. For example, from 2009-2011, we also had coordinated monetary and fiscal policy: inflation expectations in the U.S. traded at ~3% relative to core CPI falling below 1% at the end of 2010.
Admittedly, our view of higher inflation expectations depends on a weaker U.S. dollar environment. There are some reasons for optimism that this could finally materialize. The U.S. has been far more aggressive on both the fiscal and monetary side than any other country in the G-20. At the same time, the U.S. is starting with a net international investment position (NIIP) of ~-50% of GDP. The highly negative NIIP means that half of U.S. assets are owned externally; this is one of the reasons we do not think the Fed will want to repeat the dollar shortage that the world experienced in March. During that time, non-U.S. holders wanted to hold USD cash, so they were forced to sell USD-assets to raise this, exacerbating negative price action in U.S. fixed income and equities. If the Fed wants its monetary policy to be effective and ease financial conditions, it cannot allow a dollar funding squeeze to materialize again and must resume its role as central banker and liquidity provider to the world.
However, we are not only focused on Global Inflation-linked bonds, but also other sectors within U.S. fixed income that we think may directly benefit from the Federal Reserve’s efforts to ease financial conditions at the zero-bound: particularly agency MBS, Investment Grade corporate and municipal debt. We added to Agency Mortgages in March when investors started to question the efficacy of Fed purchases and liquidity. While Agency MBS yields are at all-time lows, the gap between where individuals can borrow and where Agency MBS trades is close to all-time highs. It is unlikely that the Fed can step back from the mortgage market until this spread compresses and their purchases feed-through directly to homeowners.
We were a bit surprised that the Federal Reserve was so quick to utilize its 13.3 powers and directly purchase Investment Grade corporate bonds and municipal debt. Policymakers were disappointed following the GFC that their capital injections into the financial system led to very little direct lending as the banks hoarded cash. The Fed is trying to bypass that problem entirely by directly financing companies and municipalities. We certainly do not want to fight the Fed and would highlight that many revenue-based tax-exempt bonds are still trading at historic yield ratios and spreads to Treasuries.
While our Activist Governments theme is aimed at purchasing assets we think will directly benefit from
policymakers’ actions, our TALF trickle-down theme is based on sectors that we think may inadvertently benefit from Fed policy. The TALF program was established by the Fed in March that enables investors to access non-recourse leverage from the Fed to purchase mostly new-issue AAA-rated ABS securities. The lending and leverage terms are quite generous depending on the collateral and not surprisingly several asset management firms have raised TALF-funds to make use of the Fed program. However, this program has and may likely continue to create TALF haves vs. have nots. It is likely that the amount of capital raised for AAA assets will squeeze out return potential from non-levered accounts. Within TALF sectors like credit cards, auto and student loans, spread ratios are already increasing between lower-rated tranches that are not TALF-eligible and the AAA classes.
One sector that has been left out from the TALF program completely is mortgage-backed securities that have some form of credit risk. Spreads on these sectors remain well wide of historic levels and AAA CMBS spreads. One could argue that commercial-mortgage backed securities should be the most susceptible to the COVID-19 crisis given the high retail and hotel collateral in the deals as well as office properties that will certainly see some demand destruction as more companies allow flexible work arrangements. Yet, seasoned CMBS AAA bonds are allowed as part of TALF and not surprisingly, spreads in this space are quickly rallying to pre-COVID levels.
We believe we will find more total return potential for unlevered investors within the sectors that TALF has left behind. It is notable that consumers entered the COVID-19 crisis in a much better position than they had entered the GFC. Financial obligations to disposable income and household liabilities to assets are close to 40-year lows. Additionally, the CARES act offers substantial income support to workers hit in the most directly affected sectors by COVID-19.
The four R’s are driving unique opportunities in credit markets in the post_Covid-19 economy: Recession, Ratings constrained owners (IG, CLOs), Redemptions and Restructurings.
While overall credit beta looks attractive, we would highlight that COVID-19 has caused significant dispersion between sectors. “High-quality” high yield bonds have not really offered much value relative to history. So how is an investor to navigate a complicated COVID-induced credit environment?
Our approach is to divide dislocated credit into 3 different buckets:
It is getting much harder for global asset allocators to find core government bond markets that can actively hedge equity drawdowns. Given the low level of yields, many government bond markets failed to rally in the face of the largest equity drawdown since the GFC.
Given a higher starting point for yields, U.S. bond markets did a better job of protecting equity funds in March, but there are reasons to believe that this is unlikely to be the case in the next large equity downturn. The net amount of U.S. fixed income issuance dwarfs the supply we have ever seen and the annual amount of domestic U.S. savings. If this supply is not met by adequate demand, yields may rise until they compensate investors for this.
The two sources where this demand could come from are the Federal Reserve or externally. There is no question that the Fed will monetize most of the increase in net issuance, which should provide some cap on how high U.S. yields can go. However, as we saw post-GFC, a very active Fed trapped at the zero-bound tends to steepen the yield curve. Foreign investors are the other potential source of demand for higher U.S. fixed income issuance, and non-U.S. investors are the now the largest holders of U.S. fixed income.
One of the main reasons that global investors have accumulated U.S. fixed income assets and kept yields low is that gross national savings rates have risen over the past few decades due to aging demographics. Gross National Savings is a macroeconomic identity, which is equal to a country’s Gross Domestic Income – consumption – government savings and the current account. While the demographic trend towards higher savings may not subside over the secular horizon, governments globally are likely going to be dissaving at the fastest pace since World War II, dwarfing the decrease in consumption from the COVID-19 crisis. This decrease in savings globally, means the source of external demand for U.S. fixed income will likely be lower than it has been historically. Moreover, the composition of the current foreign holdings of U.S. Treasuries is a function of past U.S. multilateral foreign policies, which today are becoming less relevant as the U.S. administration adopts a more isolationist approach.
As a result of this backdrop, we have had to expand our search for the best sources of duration to hedge the credit exposure in the fund. In looking for attractive duration markets, we tend to focus on countries with the following characteristics:
This has led us to a few countries like Korea, China and Australia where yields have significantly underperformed U.S. Treasuries and can offer investors total return as well as a potential hedge for credit risk.
The last theme in the fund is an existing theme called EM opportunities, which mainly consists of EM local debt and select Emerging Market High Yield issuers. The premise behind the theme is that declining inflation in EM countries would be a tailwind for EM local rates, their respective currencies as well as their solvency. The decline in EM inflation has continued despite the recent currency volatility with EM inflation at record lows; local yields are also at record lows.
However, this decline in inflation has yet to manifest itself into higher valuations for emerging market foreign exchange with EM FX trading 17% below its long-term average.
Additionally, despite more direct support from multi-national organizations, Emerging Market High Yieldsovereign spreads continue to underperform U.S. high yield creating compelling total return opportunities, and more stable currencies would tend to benefit these spread sectors considerably.
The outlook for the global cycle and forward-looking returns for fixed income assets has not been this uncertain since the global financial crisis. We have re-positioned the fund adding new thematic allocations to capture new investment and consumption patterns that we expect to develop as we emerge from recession.
The areas we find most compelling and have added new allocations in the fund are those that will benefit most from 1) open-ended fiscal policy back-stopped by central banks, 2) structured credit assets supported by a stronger than expected U.S. consumer and a search for yield, 3) idiosyncratic industry leader, infrastructure and covid impacted dislocated credit opportunities offering compelling valuations to their fundamentals and 4) high quality sovereign exposure in countries with more sustainable fiscal trajectories.
Note: On May 24, 2019 the Sun Life Opportunistic Fixed Income Pool, previously the Sun Life Multi-Strategy Target Return Fund, changed its name and underwent a change in investment objective. Performance prior to this date relates to the Fund’s previous investment mandate and may differ substantially from the future performance under its new mandate.
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Sun Life Global Investments is a trade name of SLGI Asset Management Inc., Sun Life Assurance Company of Canada, and Sun Life Financial Trust Inc., all of which are members of the Sun Life group of companies.
SLGI Asset Management Inc. is the investment manager of the Sun Life family of mutual funds; Sun Life Assurance Company of Canada is the issuer of guaranteed insurance contracts including Annuities, and Segregated Funds. Sun Life Financial Trust Inc. is the issuer of Guaranteed Investment Certificates.
