In any economic system, the fixed-income market plays an essential role as one of the principal ways of financing enterprise (be it corporate or sovereign). Research shows that at the end of 2010, the global bond market had amounts outstanding of over US$95 trillion (to put that in context, the World Bank reported the total value of global economic output to be US$65 trillion in the same year). For investors, fixed-income markets play a critical role both in generating return- and hedging risk.
To learn more about this, we speak to Mr. Krishna Memani, Director of Fixed Income, SVP and Portfolio Manager at Oppenheimer Funds, which are reported to have in excess of $150 billion under management.
Q: Given the crises we’ve experienced, what are your sentiments on the risks and opportunities of holding US, UK and European Government Debt?
Krishna Memani: The true risk with all of these securities is the fact that real-yields are actually negative. Thinking about it in terms of whether you will get paid on them is not a big issue- even if you have drama like the US debt ceiling debate- eventually you will get through it and these countries are in a position to lever up their balance sheets some more if that’s what they need to do… So I don’t think this is an issue of ability or willingness to pay, it’s really that you are getting negative real returns.
The opportunities would be if you thought, in a reasonable and probable scenario, that [an event would occur] that would allow you could make a lot of money… but this is very difficult to see when two year and five year rates are at 29 basis points in the US and sub 119/120 basis points on five years. The only value that government paper provides you at this point is, basically, the fact that if everything goes to “hell in a handbasket” that you have some assets of value.
Q: For fixed income investors, what are your views on emerging market government debt, and developed country corporate paper?
Krishna Memani: I would put emerging market paper and corporate paper in one giant category. The value in fixed-income markets at the moment is in credit instruments (corporate and emerging market). We think both of those sectors offer different amounts of value for various reasons. As far as the developed market corporate credit sectors are concerned, the default rates given the cash and profitability levels, and liquidity levels in the market, are relatively low and the spreads in the market provide more than ample compensation for any default risk embedded in those securities. That said, the sector is going to be reasonably volatile because economic picture is volatile. While default risk is low, overall volatility risk is reasonably high. We do, though, like them for one simple reason- they provide you with some income cushion relative to government bonds. In a really bad outcome for bonds- so if rates rise meaningfully- corporate bonds (because in that scenario the economy is doing better and hence spreads would tighten) would cushion the downside in case we started moving towards risk.
Q: How can investors use fixed-income markets to protect against inflation?
Krishna Memani: Looking at the bond market to provide you protection from inflation is a fools game. Our CIO loves to say that, “TIPS are for chumps…” TIPS are a real-rate instrument, and the driver for the performance of TIPS (which people cite very often) is that real rates have collapsed- so TIPS have rallied.
If you are really worried about inflation- you have to buy stocks. Trying to hedge that exposure in the bond market, unless you buy TIPS and hold for twenty years, will not provide you with the protection you are looking for.
Q: How can investors trust asset backed instruments when the value of the underlying asset cannot be reliably determined or relied on?
Krishna Memani: There ought to be a risk premium built on top of whatever default level or loss level analysis you do for these instruments. Let’s take a non-agency residential mortgage backed security- quintessentially exhibiting the characteristics of not knowing the ‘true value’ of that security. We compute some level of default and losses because of those defaults- and perform IRR calculations to create yields and then we haircut it some more because, in truth, we have no idea!
There is a risk premium you ought to assign to your valuations because the environment is so uncertain. In certain parts of the markets- such as high quality non-agency securities, you can come to the conclusion that even after computing reasonable risk premium, you have some excess return left into it whereas in other assets you may not feel as comfortable.
So what does this mean for investors?
While the ‘function’ per-say of fixed-income markets is not under question, investors and risk-managers are certainly facing a changing landscape with regards what instruments they use to generate return and protect against risk. The valuation of ‘classic’ risk-free instruments is now under increased scrutiny, while the second tier of fixed-income instruments (corporate and emerging market) are now offering greater value, and lower risk than ever before.