Changing dynamics in global fixed income markets call for rigorous fundamental research

Published on September 9, 2014 by Dinesh Saboo

Headlines over the past few months indicate that a majority of large investment banks have reported huge losses in their fixed income business. Fixed income trading units of most investment banks have been suffering from lower volumes amid low volatility.

The key question that concerns market participants is whether this is a permanent change driven by a post-recession regulatory regime or a temporary phase that will gradually conclude as the era of quantitative easing slowly comes to an end.

While one can argue whether old times will return in this business, it is interesting to note that the change looks more of a structural shift (driven more by regulatory aspects gaining traction, particularly after the 2008 crisis) rather than a cyclical or a temporary phase (although cyclicality did play some role in the recent downturn in fixed income businesses of banks). The trend may improve once market issues gradually settle down; however, a significant reversal in the so-called new trend in FICC appears unlikely.

While reduction in market volatilities may be good news for risk-averse investors, the biggest cause of worry in the future for banks will likely be a decline in the trading of hedging instruments, which boom mainly during higher volatilities. This also reduces arbitrage opportunities and limits the number of big participants in fixed income markets. While this trend will likely vary from region to region (depending on the local bond market, regulatory regimes, investors’ risk appetite and relative market attractiveness), a common trend we have noticed particularly during the past few months is that during times of shock or negative news concerning a junk bond with weak fundamentals, a situation arises wherein there are absolutely no buyers, only sellers. In other words, the liquidity of a bond and its sensitivity to external market conditions and credit quality become of utmost importance in not only trading in plain vanilla products, treasuries and bonds but also in credit derivatives markets. No portfolio manager would like to hold his/her money in products/instruments wherein he/she is left at the mercy of markets. Hence, rigorous fundamental research (particularly, on high-yield credits) and a thorough understanding of market sentiments are required to formulate clear entry and exit strategies with well articulated stop-losses.

Overall, market dynamics are changing and so are ways to deal with these markets. Companies will continue to issue debt to optimise their debt structure. Similarly, deleveraging will also continue to be a key theme during increasing macro uncertainties. Given the ongoing structural shift, portfolio managers will have to work on their active management strategies to generate higher alpha while avoiding exposure to extremely sensitive products. While we note that the high-yield asset class has continued to command respect, and investors are trading through beta/indexing or other duration matching strategies, we believe “risk of default” and “liquidity” are core issues of this asset class and should not be compromised under any circumstances. Further, as the primary issuances in the high yield category continue to register a healthy growth due to high appetite for yield, investors need to be extremely cautious and selective in their investments with a thorough understanding of downside risks. Overall, we believe that trading ideas and strategies, which are backed by solid fundamental research will continue to yield higher risk-adjusted returns for the portfolio managers and other market participants.

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