Hollywood loves a good "standoff," that moment when actors face each other with guns drawn, waiting for someone to make a move. The standoff between Congress and the White House over the debt ceiling, however, is hardly welcome news for fixed income investors who are already swimming against a rising tide of factors that make investing increasingly challenging.
Whether it’s ten straight interest rate increases pushing rates to a 16-year high, persistent inflation, bank failures or the war in Ukraine, investors face an abundance of hazards that highlight the critical need for fixed income investors to take a nimble approach. While markets are often efficient, times like these expose a number of select areas within the bond market that exhibit less efficient behavior. Investors taking a value oriented bond management approach may find ways to exploit the inefficiencies.
While traditional bond management generally focuses on macroeconomic, interest rate forecasting, yield curve forecasts and sector expectations, value oriented bond management, as we define it, is an approach to bond selection and management whereby a unique value opportunity related to a particular bond issuer or issue is identified.
The concept behind this issuer and issue focused approach is to not only identify an inherent underlying value, but to also identify a catalyst that might result in realization of that value—in other words, a “bottom up” analysis with a value focused perspective. While inputs and events will vary, the process of analysis involved in value oriented bond investing may be repeatable.
Value oriented bond management focuses on potential exploitation of a variety of perceived market inefficiencies, which can create value.
Credit upgrades are a common element in many value oriented bond portfolios. An investor identifies an issuer or issue that may improve in credit quality which, in turn, may result in a reduction in the yield required by investors to own it. This reduction in yield creates issue-specific gains that are independent of overall market performance. When pursuing a credit upgrade, it’s critical to identify the most effective issue in the capital structure to utilize. In our view this is typically the longest duration security in the issuer’s capital structure.
Market themes are a second inefficiency where opportunities can arise and are generally developed from research or recognition of a situation where similar or common characteristics exist among multiple bond issuers or issues.
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Recurring themes tend to exist for a long time and may be almost permanent market features. This could include charter “arbitrage” and small cap/liquidity opportunities, which are explained in more detail below. These opportunities persist due to enduring market limitations and inefficiencies.
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Opportunistic themes tend to have a shorter life that may only exist for months. Examples of this might be high coupon bond tenders and selected industries subject to merger and acquisition. For industries prone to merger and acquisition activity, investors need to identify lower quality issuers that may be acquired by higher quality issuers, potentially realizing an increase in credit rating as a result.
Small Cap or Low liquidity opportunities can arise for several reasons. Small cap bond issues often have an illiquidity premium and there may be fewer competing investors because of limited information flow and/or limited ability to interpret available information. A quick to market approach may be beneficial when an information advantage is perceived, as other investors will “catch up” and reduce inefficiency. Examples include companies that are underrated due to size but hold prospects for growth or the probability of a takeover by larger, higher quality issuers, or a situation where a company has the possibility of self-liquidity, which could result in the capitalization of the acquired illiquidity premium.
Special situations, as we define them, involve unique, non-traditional fixed income or fixed income like opportunities. Special situations could have elements of credit quality uncertainty, lower liquidity, unusual covenants and/or complex structure. Special situations could also involve market inefficiencies resulting from charter restrictions or firm culture.
Competitor constraints may occur for many reasons. For instance, some smaller investors may not commit resources to credit analysis or other elements of value oriented bond investing. At the same time, some opportunities may not be considered feasible by larger investors with many billions of dollars under management.
In conclusion, value oriented bond management seeks to exploit perceived market inefficiencies and identify individual issue or issuer-specific opportunities in an attempt to add value. This bottom-up, value oriented process can be considered as an alternative or complement to traditional bond management, which focuses on top-down factors like interest rate movements, duration management, and economic forecasting.
Jerry Paul, CFA, is Senior Vice President of Fixed Income and serves as Portfolio Manager of the ICON Flexible Bond Fund and Co-Portfolio Manager of the ICON Equity Income Fund. He is also a member of the ICON Investment Committee. Mr. Paul was named Morningstar’s Fixed Income Manager of the Year for 1999 while he managed high yield bonds for INVESCO. Mr. Paul’s professional investment experience includes over forty years in fixed income portfolio management and research.
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