The Perils of Inflexible, Formulaic Investing


June 24, 2019 [benchmark agnostic, passive vs active investing, dividends]
Charles Roth

As downward pressure on negative bond yields builds, a flexible approach helps in the search for attractive, relative values.


In Alpha and the Paradox of Skill, authors Michael Mauboussin and Dan Callahan found “a positive correlation between the breadth of opportunities and the dispersion of fund returns.”1 That effectively means “flexibility and a benchmark agnostic approach can allow fund managers to go where the value is, which in practice leads to a broader breadth of opportunities,”as Thornburg Portfolio Specialist Danan Kirby explains.

A real-world example can illustrate nicely, particularly at a time when market expectations of monetary easing have quickly enveloped the U.S. Federal Reserve, European Central Bank officials have declared readiness to resume asset purchases or slash rates even deeper, and half a dozen other central banks in Asia have already cut them.

Across the ratings spectrum, corporate credit spreads have compressed sharply. The amount of negative-yielding debt in JPMorgan’s Global Aggregate Bond Index jumped from 18% last October to roughly 25% at the end of March; European sovereign debt sporting sub-zero yields accounted for nearly 40% of Eurozone indices.

That certainly doesn’t make it easy for passive bond funds, “which have to buy formulaically, no matter the yield,” notes Thornburg Chief Investment Officer Brian McMahon. “If the index is X% German government bonds, which carry negative yields out to about 15 years, they need to be that percentage, too, whether they like the yields or not.” In a new Q&A, McMahon notes some investors may think “some disaster is looming” and seek to hide out in bonds that they are actually paying to hold. But that’s a real cost “non-thinking” passive investors in funds following those benchmarks bear.

A flexible, benchmark agnostic approach can take many forms, particularly in hybrid stock/bond strategies that can invest all along a firm’s capital structure. For example, U.S. pipeline companies sold off with energy prices in mid-2014. Slews of “Master Limited Partnerships” subsequently cut their dividends. Switching from their equity to their debt instruments made for a fruitful trade.

“Dividend cuts are always a bad thing if you're a stockholder but quite a good thing if you're a bondholder because more cash will be allocated to shoring up credit characteristics,” McMahon says. “Over the years, we've seen that dividend cuts are often a signal to buy the bonds of a company that appears to be prioritizing upgrading its credit quality. That’s because it usually comes at a time when investors are questioning the company’s credit quality and its yields are high, at least relative to where they could be if the firm would just allocate more cash to debt servicing. We like to buy bonds of companies that come to that crossroads, and decide they're going to repair their credit ratings and remove doubts about their credit worthiness.”

Much of the bond universe has become pricey, with negative real rates prevailing in much of the world. Yet inflows into bond funds continue to surge. The week to June 5 marked “the biggest inflows to investment grade bond funds ever,” at $12.3 billion, while government bond funds saw the second largest inflows ever,” at $8.9 billion, Bank of America/Merrill Lynch reported.

“Markets face issues involving market segmentation, home bias, and central bank intervention,” Kirby says. “All of which results in relative value discrepancies, which create opportunities for investors able to navigate between them.”


1. Alpha and the Paradox of Skill, Michael Mauboussin and Dan Callahan, Credit Suisse, July 2013

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