Panellists:
- Ms Tanya Sanwal, managing director, investment product & fund strategies, Wellington Management
- Mr Samuel Rhee, chairman & chief investment officer, Endowus
Moderator: Genevieve Cua, wealth editor, The Business Times
Appetite for income in portfolios remains intense, even as challenges in the investment backdrop grow. Rising interest rates and higher inflation are raising questions about the fixed income asset class. Yet there are opportunities within fixed income, and credit in particular is worth a closer look. Our panellists explain.
Within the fixed income spectrum, credit investing is a viable option. What does it mean to invest in credits, and how does it differ from equity investing?
Mr Rhee: Investing in credit involves buying a bond that periodically pays out coupons for regular income and pays back the principal at maturity. The relatively lower risk and lower volatility, along with the offer of fixed income, are key characteristics of investing in bonds for income generation.
This is different from investing in equities, and receiving dividends paid out by companies – dividends are not fixed but are a variable amount or percentage of the share price. Dividends can be skipped or lowered. By contrast, coupon payments for bonds are meant to be guaranteed and if the company does not pay, they are in default. Additionally, equity prices are generally more volatile than bond prices; expectations of growth and earnings can change and affect stock prices, as well as dividends. Bond price changes can also be negative sometimes, but they typically move much less than equities.
Ms Sanwal: We have observed that investors are typically drawn to equities as they follow these markets, and many of the names might already be familiar to them. Further, there can be more upside in equities over the long term, albeit typically with more volatility.
Comparatively, credit markets are more complex. Within the fixed income market, there are multiple subsectors. There are investment-grade credit, high-yield credit, emerging market credit and more. It begs the question: What within the credit universe should I buy? Moreover, some parts of the markets are less well known than others, like bank loans, and so that complexity does cause some investor reluctance.
That said, we believe credit should remain a core allocation in an investment portfolio, as it can serve as a stable portfolio anchor. Credit has the potential to provide a higher level of income over the longer term with much less volatility relative to equities – where income can fluctuate, and capital appreciation can be very dependent on the economic environment – and a better drawdown profile. For investors looking to derisk from equities or who are less keen on lower-yielding government bonds, credit is a solid medium, as it can provide more stability regarding income and risk.
In credit investing, investors typically are drawn by the headline yield, but yield alone may not tell the whole story. What risks are typically implied in higher yields, and how can these risks be overcome?
Mr Rhee: Yields on bonds are largely determined by the market, and reflect the company's creditworthiness – the likelihood of default, as often indicated by the issuer's credit rating – and the quality of the earnings stream, which would then impact its ability to keep paying out coupons. They also reflect other factors such as market interest rates, macro conditions, and the asset class or sector that the issuer of the bond is in.
Taken together, the range of the bond yield will depend on the type of issuer (such as a government or a corporate), where the issuer is based (for example, in emerging or developed markets), and the strength of the issuer's credit rating.
There is a direct correlation between risk and return in all financial assets – this is no different for bonds. A bond with a higher yield generally has higher risk embedded than a bond with a lower yield. However, unlike equities, there are greater opportunities to deliver better-than-broad market returns in fixed income through active trading, with the best fund managers tasked to manage risks better and to seek opportunities to capture higher returns over time.
A fund manager’s responsibility is to do the necessary fundamental research on both the macroeconomic environment and to run an analysis of specific securities and how their performances stack against industry peers, so as to avoid downgrades and defaults, and to generate above-market returns for investors.
Ms Sanwal: Investors should keep in mind that a higher yield does not always mean higher return. Yield is just one component of total return. It is equally, if not more, important that investors pick the right bond, so they don’t run the risk of losing their principal investment. In other words, investors should make sure that the likelihood of the bond defaulting is remote.
Risk management is essentially about stress-testing the portfolio, not just for a base case but for a wide range of scenarios, including any downside risks that may impact returns. It is easy to get seduced by headline yields – the key is to look under the hood: Stay focused on the total return of the strategy and ensure that the manager isn’t stretching to the point that it might actually compromise capital.
Investors increasingly want to invest in line with their values. How can they build a reliable income stream via credit investing, while still investing responsibly?
Mr Rhee: There has been an increasing response and appetite for value-driven investing as expressed in environmental, social and governance (ESG) investing. One upside to the growing trend towards investing based on ESG considerations is that now you don't have to choose between sustainability and your financial goal. Many funds now factor ESG as a necessary risk management enhancement to address the evolving global systemic risks stemming from ESG issues.
This is true for many income-oriented funds. While the fund managers’ main mandate is to deliver the financial objective with regular income, they apply negative exclusion of controversial ESG names and sectors, and incorporate ESG considerations in their investment research process. By allocating assets to such funds, investors can achieve the income objective while staying true to their values.
Ms Sanwal: Often, investors believe they must compromise income and returns when making an ESG-labelled investment. However, when using a robust and well-integrated ESG investment process that leverages the right tools, data and bottom-up ESG research, the investment universe remains considerably broad, without meaningfully impacting investment returns.
We take numerous actions to amplify outcomes positively through our ESG integration. For example, we avoid investing in issuers that have concerning ESG values. Exclusion means prohibiting investments in any issuers with more than 25 per cent of revenue derived from related business in fossil fuels, conventional weapons, tobacco and cannabis. Second, we engage with issuers to help them drive improvements to their ESG trajectory.
Third, we adopt a “leaders and improvers” approach, where we not only incorporate the current ESG score into our investment framework but also assess where management teams are genuinely trying to improve their sustainability, governance and environmental strategies to improve ESG scores in the future. Very often, the market may be underpricing the ESG improvement path for a particular issuer. Active managers with deep ESG research can add value to investment returns through this forward-looking lens as well.
How are credit issuers impacted by rising interest rates and inflation? How can investors mitigate these risks?
Mr Rhee: Inflation and interest rates go hand in hand as central bank short-term interest rate policy is driven by inflationary trends. Further, short-term interest rates and the overall macro outlook have an impact on long-term yield. Generally, rising inflation precedes rising interest rates, which negatively affect bond prices in the short term, but can lead to higher interest rates and higher yield – and the ability to generate higher income.
Higher rates typically lead to higher income generation once initial market dislocations smooth over. Active fund managers are often able to a) buy oversold bonds on the back of knee-jerk selling by other market participants, b) hold current bonds to maturity while avoiding default, and/or c) reinvest proceeds into newly issued bonds offering higher yields.
Ms Sanwal: We have to acknowledge investor concern over interest rates, inflation risk and the impact of these on returns across asset classes – both equities and bonds. However, it’s important to note that the underlying environment matters. If interest rates are rising in the context of strong growth, that can be a positive for credit strategies, as the spread component can offset the impact of near-term rate increases – preserving total return.
The concern currently is that interest rates could go up while underlying growth is weak, which, in the near term, can be a headwind for fixed income assets. In this scenario, two things matter.
The first is managing the near-term risk through portfolio construction. For example, by reducing duration or by exposing the portfolio to sectors that can do well through rising rates, like floating-rate sectors or inflation-protected instruments, such as inflation-linked bonds. There are segments of the market that have lower sensitivity to rising rates, and active managers can cushion the near-term impact of rising rates on portfolios through a variety of levers.
Secondly, from a longer-term perspective, higher rates may be good for total returns as yields are higher. As such, over a three to five-year horizon, the portfolio may still generate a positive return. In addition, while markets have significantly repriced expectations of central bank rate increases, should economic growth deteriorate, central banks could slow the tightening process.
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