Limit Downside with Global Aggregate, Capture Upside with Convertibles
The dust from the US election has now settled and, although there are plenty of challenges in the pipeline, Joe Biden has claimed victory. The Democrats will probably not, however, have control of the Senate.
Markets have thrived from this outcome. Equities are higher, driven largely by the rebound in Tech stocks as the chance of aggressive new regulations falls away, with the VIX index of volatility actually falling back towards more normal levels. Fixed income markets across the credit spectrum have also rallied. It appears everyone has something to celebrate in the Panglossian world of markets.
Some of the move could be position-squaring and the unwinding of ‘blue wave trades.’ This has supported Treasuries, which had priced in rising issuance and economic reflation on the back of a large stimulus package, which now looks highly unlikely. It is a little less clear why risk assets have rallied so sharply. The limited ability of Congress to pass new legislation is certainly helpful to corporates, but economic stimulus for the US economy should have been more important.
There is most likely investor cash to allocate before year-end that was waiting for clarification of where the US stands politically. In the Q4 Bond Compass , we suggested government bonds as a hedge for uncertainty and they have performed well since it became clear that there would be no ‘blue wave.’ In our view, they remain the relatively safest option heading toward the year-end, but yields are low and the market is already priced for increased central bank buying and the potential for further interest rate cuts.
At the other end of the spectrum, credit (high yield in particular) has enjoyed a strong post-election rebound but the backdrop for risk assets remains uncertain. The re-emergence of the pandemic has shut large parts of Europe. To add to concerns, no trade deal has yet been agreed between the EU and UK – and the UK exits the single market at the end of the year. All of this may come to a head later in the year when thin markets could exaggerate market moves.
So there remain risks to navigate. One option to reduce exposure to event risk is a global aggregate bond fund. Such an exposure offers geographical dispersion and the high number of bonds should reduce volatility. At its core, Bloomberg Barclays Global Aggregate Bond Index has 53% of government debt, of which over 25% is US Treasuries. Unlike in Europe, where core yields are close to or at all-time lows, 10-year US Treasuries remain 5-10bp above their average yield since March and, as such, have space to rally if the pandemic becomes more acute. Also, around 10% of the index’s government exposure is to the European periphery, where spreads could continue to contract if the market remains in a yield-seeking mode. Expectations that the ECB will expand its bond buying in December should act as a backstop to prevent significant spread widening.
The Global Aggregate index has also shown a propensity to perform into the New Year, with average returns over the past five years of 0.6% in December and 0.9% in January. However, safety comes at a cost. While the index contains bonds that typically perform well in the event that the risk rally, such as Corporates (18.8%), CMBS (0.9%) and Sovereign debt (1.3%), all of which still have option-adjusted spreads of over 100bp, upside in a more durable risk-on rally will be limited.
The economic backdrop for this to occur may not look especially promising, but there is a risk that the election has given investors sufficient clarity that not much will change. The Democrats will not have the power to substantially change legislation and that suggests we will see a reversion to the investment themes that have dominated 2020. Given there may be cash to put to work, these themes may gain some momentum.
For fixed income, convertible bonds have been a top-performing strategy, with the Refinitiv Qualified Global Convertible Index having returned c. 22% year to date. There is exposure to equity upside, as a result of the optionality in convertibles, with the current delta levels suggesting the potential for strong participation in an equity rally. The convexity of a global convertible exposure can prove helpful as it will continue to benefit from the sectors that have been boosted by COVID-19 with a heavy allocation towards the new economy sectors (IT 27.4%, Electronics 7.2%, Telecoms 7.0% and Pharmaceuticals 7.0%).
While having the potential to capture upside, the index also retains defensive qualities. It is global and well diversified, and the overall quality of the index averages BB levels. Lastly, the asymmetry of a convertible’s payoff, with the bond floor, means downside risk is more limited than for equities, thus providing investors some peace of mind if the current risk-on phase loses steam.