Michael Elsworth, Manager, Fixed Income, Lonsec
Managers within the Unconstrained Bonds and Specialised Income sectors have been shifting their portfolios in response to the uncertain economic backdrop. Many Government Bonds and Investment Grade Credit securities, the traditional ballasts of fixed income portfolios, are trading at historically tight credit spreads – which does not bode well for forward-looking returns.
This has prompted some managers to pivot toward the Securitised sectors, such as Mortgage or Asset-Backed Securities (MBS/ABS – both public & private), as well as High-Yield Credit, which are still offering diversification, enhanced yield and a more attractive risk-return profile.
Valuation challenge
Government Bonds and Investment Grade Credit have long been considered the foundation of conservative fixed income portfolios. Despite rate cuts by global central banks, yields on these securities remain compressed relative to historical averages. Additionally, most benchmarks only capture a narrow subset of fixed income markets – predominantly Government Bonds, Investment Grade Credit and Agency MBS – and do not include sectors such as High-Yield Credit, Non-Agency MBS and Leveraged Loans. As a result, index strategies have exacerbated the valuation in some of these lower yielding securities, particularly in the more indebted issuers.
Unconstrained bonds and specialised income strategies
Unlike traditional benchmark-aware strategies, Unconstrained Bonds and Specialised Income strategies are typically managed against a cash benchmark and designed to generate positive returns regardless of market direction. Some mandates allow managers to take long and short positions, adjust duration using derivatives and allocate capital across a broader spectrum of fixed income sectors, such as Structured Credit, Emerging Market Debt and Currencies.
The increased flexibility is particularly appealing in today’s uncertain economic environment. Stubborn inflation, geopolitical tensions and fiscal imbalances have contributed to heightened volatility. Given this backdrop, the ability to shift quickly between defensive and opportunistic positioning can be a distinct advantage.
Securitised debt – A rich opportunity set
Securitised debt, particularly Agency and Non-Agency Mortgage-Backed Securities (MBS), Asset Backed Securities (ABS) and Commercial MBS, have been key areas of focus across Unconstrained Bonds and Specialised Income managers. These securities offer attractive yields and are generally less correlated with traditional fixed income sectors.
US Agency MBS benefits from an implicit government backing, while offering both lower credit risk and yield pick-up relative to Investment Grade Credit. While Non-agency MBS and ABS carry greater credit risk, they also offer higher yields and are often backed by diversified pools of consumer loans, auto loans or credit card receivables. These instruments can be particularly attractive in environments where the consumer sector remains resilient and underwriting standards are strong.
The opportunity in private ABS
Lending by managed funds to asset-backed warehouse facilities is a niche but growing area undertaken by ‘traditional’ fixed income and credit funds as well as specialist private credit managers. Lending to an asset-backed warehouse is a type of credit line extended to lenders (like fintechs, specialty finance companies, mortgage and auto loan providers) to temporarily finance a pool of loans or receivables prior to securitisation or sale. Some non-bank lenders include Pepper Money, RedZed, Mortgage House, Automotive Financial Services, Allied Credit, Wisr and OptiPay.
Prior to the GFC, banks were willing to fund the senior and mezzanine tranches of warehouses. However, since then it has become uneconomic for banks to fund anything other than the senior tranche due to additional capital requirements. This left a structural gap in funding for the mezzanine tranche and alternative lenders have stepped in to fill the void. Private warehouses provide an attractive premium over public markets due to their illiquidity and complexity. All things being equal, any fund lending to private warehouses assumes more liquidity risk in exchange for additional returns.
The funding arrangements are typically individually negotiated, so private markets transactions rather than public in nature. While this does not mean a fund would be unable to liquidate if required to meet redemptions, there is a far more limited number of buyers, which increases the chances of needing to sell at a loss or temporarily suspend redemptions (depending on liquidity terms).
In addition to assessing the strength of originators and underlying loan pools, there are several aspects of a private warehouse that lenders must understand and negotiate to protect their own interests and the interests of investors. To make certain there is adequate compensation for the risks taken, mezzanine lenders must understand the rights of both senior and mezzanine lenders and what senior lenders can agree to without mezzanine consent. Lenders should also understand what enforcement rights they have if a warehouse is not performing as expected.
High-yield credit – Yield enhancement with tactical risk
High-Yield Credit has been gaining the attention of many Specialised Income managers for their higher yields relative to investment grade credit. While spreads have narrowed over the past 12 months, they still offer a material premium over Investment Grade Credit. Importantly, managers have observed improvements in credit fundamentals within the High Yield sector, with many issuers demonstrating conservative balance sheet management and strong cash flows. The expansion of private debt markets has also removed some of the riskier issuers from the sector.
Pleasingly, managers have not been indiscriminately chasing higher yields, with most opportunistically allocating to mispriced securities, avoiding sectors with deteriorating credit outlooks or using credit derivatives such as CDS to hedge downside risk. This cautious approach has allowed managers to capture the upside of High Yield Bonds without exposing portfolios to excessive drawdowns, particularly during periods of market stress.
Conclusion
In a world where traditional fixed income strategies are constrained by valuation and economic uncertainty, flexibility, selectivity and active management become critical.
Unconstrained Bonds and Specialised Income strategies, with their more flexible portfolio guidelines and ability to dynamically allocate across fixed income sectors, are well-positioned to navigate this backdrop. By embracing Securitised debt and High Yield Bonds, managers have been able to not only enhance portfolio returns but also build resilience against the uncertain market backdrop.
As the fixed income universe continues to evolve, the ability for managers to adapt will become critical. For investors seeking income, diversification and downside protection, Unconstrained Bonds and Specialised Income strategies may offer a compelling path forward.
Important Information: This article has been produced by Lonsec Research Pty Ltd ABN 11 151 658 561, AFSL No. 421445 (Lonsec). Generation Development Group Limited ABN 90 087 334 370 is the parent company of Lonsec Research.
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