Coupons today and yesterday
Before the 2008 crash, government and corporate bond yields provided a steady source of real income and positive investment returns. Coupon cash flow and a secular downward trend in interest rates, meant that negative returns were fleeting, often masked by carry in all but the riskiest credits and longest-dated bonds.Today, there is less coupon cash flow to buffer capital volatility and capital returns are arguably a more important component of total return and far more apparent in the return profile of fixed-income assets. Equally lower coupons mean higher duration and consequently greater sensitivity to valuation changes.
A systematic approach
Despite such a low-return environment, fixed income still has a place in a portfolio, providing income, capital protection, and often negative correlation with equity investments. So more than at any point in the recent past, there is value in looking for a systematic approach to finding relative capital upside and minimising unwarranted capital risk for fixed-income allocations.
Ten years ago, coupons were 6% or more and despite four consecutive years of negative price returns, they delivered positive total returns. A yield rise of 0.5% in a 6% interest-rate environment would represent a change of 3%, or just 50% of income returns, with returns in the region of 3%. Compare this with a similar rise at rates of 0.5% on 4%.In the US today (due to greater duration in the equivalent index as a result of lower average coupons), the same 0.5% move would have a 3.5% impact, or 87% of the income of 4%. Given this kind of effect, being able to exploit mispricing, avoid unnecessary downside capital risk, and lock in capital returns is more important than ever.
Returns in practice
Imagine it was possible to find a portfolio which offered a very modest 20bps discount on the average index for the equivalent rating and duration and that this discount was realised – it would generate an excess return of 0.7%, or 140% of the total today (versus just 27% ten years ago).
Income returns are falling with coupons and no longer provide the buffer they used to
Even if this repricing was not achieved, an additional 20bps represents yield in excess of the benchmark. If you could identify these bonds, lock in the capital gains, and rotate into something cheaper, then returns could be compounded.
Equally, bonds which trade at even greater discounts potentially have greater capital upside, indeed a bond trade at 50bps cheap could provide almost as much capital return as the income it generates.
Screening for discounts
The intention of our relative model is to systematically screen bonds that are discounted, tell us when that discount has gone, and that it is time to lock in capital.In a low-yield world there is a temptation to simply move into more risky credits to boost yields, but these bonds can be exposed to greater cyclical risk. Understanding the potential impact on capital returns and correlation is key for investors who hunt for yield.
Navigating this successfully can help deliver significant outperformance with respect to capital, but it might force an investor to stray from the original asset-allocation objectives of their portfolio.
We believe our relative value approach not only provides a systematic way to enhance returns in a low-yield environment but also offers style diversification versus a pure yield-orientated approach.
Links to fund pages
• New Capital Global Value Credit Fund
• New Capital Wealthy Nations Bond Fund
• New Capital Asia Value Credit Fund
• New Capital Euro Value Credit Fund
• Institutional strategies
For more information on the relationship between duration and relative value, read our whitepaper A Theory of Relativity.
• Read New Capital Wealthy Nations Bond Fund, New Capital Euro Value Credit Fund and New Capital Asia Value Credit Fund.
• Explore our asset allocation in fixed income in 5. Navigating credit risk for better gains.
• Explore the impact of duration on generating capital returns in 4. Long haul or short stay? Duration uncovered.