An inevitable consequence of investing in financial markets is making a mistake; dissect any investor’s career and you will uncover a litany of errors. For a recent Citywire event our CEO Mark Holman was asked to reflect on some of the common mistakes made by fixed-income investors (you can find a recording of the event here ) and the lessons to be drawn. Accordingly, here are four lessons we view as the most pertinent for bond managers.
1. Don't Sacrifice Liquidity for Yield Too Cheaply
One mistake a bond investor may make is failing to recognise the inherent trade-off between liquidity and yield. Everyday bond managers are confronted with a plethora of different bonds from issuers – some are bigger, some older, in various currencies, various maturities all at different yields. The sheer number of options available means it is very easy to favour one over another based on the one metric that bond managers thirst for: yield.
A higher-yielding bond, all things being equal, should bring greater total returns and possibly the opportunity for spread compression (and profit) is higher than another with similar characteristics. The bond, therefore, may be considered a better relative value than alternatives. One plausible reason for that discount might be a lower level of liquidity. Consequently, should a period of market distress arise, an investor could find themselves in the unfortunate position of retaining a bond that is rapidly losing value and the price of selling, if forced, may be considerably higher than any yield pick-up the investor gained by initially investing in the higher-yielding instrument.
Therefore, investors should carefully balance how much they are receiving from a higher-yielding position against the potential for losses due to illiquidity. In other words, the lesson to learn is don't sacrifice liquidity for yield too cheaply.
2. Don't Excuse Mission Creep
The second lesson for bond investors is, don't try to rationalise mission creep, especially when it comes to short term positions; a great deal of short-term trades can become ineffective long-term positions if not dealt with appropriately.
If we suppose a bond investor views an upcoming event as a potential threat to their positioning, they may attempt to hedge their portfolio with another position. The event passes, and the hedge works, but to the investor maintaining the hedge seems like a good idea in the aftermath. Do you maintain the position or remove it? Conversely, if the hedge doesn't work, there is a temptation to keep the hedge because of the possibility that it works in the future.
As a rule, during our collective years managing bond portfolios, we at TwentyFour have found that discipline is a virtue when it comes to short-term trades. For example, during the latter weeks of 2016, the Italian government held a referendum to alter parts of the country's constitution to reform the composition and powers of the Italian parliament and the division of power between the State and regions.
At the time, market participants regarded the failure of the reform agenda as a clear risk with the potential to exacerbate an already febrile political atmosphere in Italy and potentially introducing volatility to broader debt markets, just like Brexit did earlier that year. The referendum failed to pass, it should have been the source of further volatility, but the reaction from risk markets was surprisingly muted. The hedge had made no money.
In the aftermath, we could easily have found post hoc rationalisations to justify maintaining the position. In fact, the Italian political scene remained relatively tense for some time afterwards. Yet, the lesson on offer was that the appetite for risk was strong and markets would be underpinned by a new "buy the dip" mentality.
On paper, our hedge should have made money because of the referendum's failure. Had we maintained the hedge, we would have lost money, despite putting it on for the right reason. The lesson? We took the hedge off as it did not work despite the realisation of the adverse event; why would it work in the future when it was clear that the market was so resilient? The referendum turned out to be the first buy signal for risk in a very strong Q1 2017.
3. Sizing Positions is Just as Important as Sourcing an Idea
When a bond manager opts to allocate to a particular sector or issue, a key consideration is the optimal size of the position in their portfolio. For example, when a bond manager encounters a very attractive bond that passes through the credit selection process, how significant a position should that bond command in a portfolio?
At first sight, the potential investment might fulfil every characteristic the manager is seeking for the portfolio; good credit quality, a healthy yield, the correct maturity profile, and a profile that complements overall portfolio construction. The overwhelming temptation for the manager is to allocate more rather than less.
However, the higher the yield, the higher the potential volatility, and if an investor over allocates, they will find themselves with potentially more risk than desired. Therefore, investors should consider the potential volatility of an instrument as a crucial driver of sizing. Ratings, historical volatility of the borrower's other bonds, or the sector will give vital clues about how much volatility that bond might bring with it. Quite often, ironically, the bonds that instinctively are most attractive are the ones you should keep to small doses.
4. Don’t Get Wedded to Your View
Being married to your view is also a bit like mission creep. Essentially, it occurs when investors find new reasons to stick with old views even when the old reason has elapsed, or even worse, found to be wrong.
Despite sounding like a mistake that is easy to avoid, managers can find themselves reading third party research that supports their view rather than focussing on research that consistently challenges it. The supporting research gives them comfort at a time when they should be contemplating change.
We have all heard the term that "the trend is your friend", but trends change, markets change, and therefore so must our views.
Therefore, when establishing a position or a view, it is worthwhile contemplating under what circumstances might you change your view, and if so, what you would do otherwise. This keeps your mind open to change that will inevitably happen.
At TwentyFour, we have collectively garnered more experience than any of us would care to admit. While not wholly inoculating a portfolio (we ae not clairvoyant), the lessons that come from experience can help ensure investors minimise the severity of any unforced error and provide the best returns possible.