The formula for fixed-income safety
Bolstering defenses in a world awash with risk
The past months of turbulence in fixed-income markets have had a significant impact on investors’ mindsets. Where an allocation to bonds was traditionally seen as a place of calm that moderated the sometimes volatile swings in equities, recently bonds themselves have been a source of trouble. New questions emerge as the familiar, benevolent tailwind of gently falling risk-free rates is replaced by the prospect of a Treasury yield chart that moves up and to the right, presenting investors with lurching volatility. In such an environment, where do investors look for safety?
We see safety in accordance with three criteria, a safe investment should be able to provide: (1) real value, after inflation; (2) substantial insulation against potential loss; and (3) an ample degree of liquidity. Let us discuss these three elements in turn.
Holding real value
Holding real value is an important aspect of investment safety in 2022. While cash maintains nominal value, inflation reduces purchasing power and effectively results in real losses for cash. Even government bonds and GICs in the current environment offer a high probability of negative real returns, given yields well below inflation. We consider two prime methods of ensuring real return:
- One way is to own an asset of sufficient scarcity that a decrease in the purchasing power of money translates fairly directly to an increase in price of the asset. And, while most fixed income securities do not provide this feature, many do. Here we consider real return bonds, Treasury inflation-protected securities (TIPS), and certain convertible securities tied to scarce business assets.
- The other way to ensure real return is to own an asset with a yield comfortably above the rate of inflation. The higher the yield, as adjusted for default probability, the safer the bond is, in our view. Given the recent back-up in yields, the bond market has actually begun to price in an increasingly positive real return for corporate credit. But delivering that return requires careful attention to issuers and the drivers of potential default.
Insulation against potential loss
Insulation against potential loss of capital is the second dimension of safety. It is one thing to own a security priced to deliver a high yield, and another thing to successfully realize the yield and return of principal. Insulation against loss is the result of backing by business assets that are worth unquestionably more than an entity’s liabilities. In this regard, safety doesn’t stem from a rating but from a valuation. And the degree of safety? Well, that directly reports to the amount of excess value that covers a bond.
While sometimes a public market valuation can indicate a sizeable buffer against loss, it is also important to underscore here the importance of independent valuation. A market cap can provide a clue towards the fair value that underpins a credit valuation, but we feel more confident when our independent analysis supports the idea that a company has many times its debt in fairly valued business assets.
Liquidity is the third and final aspect of safety. It is fine to have assets that are secured by value and that have real-return characteristics, but if they cannot be sold in a pinch, how can investors truly have confidence in their safety? At Penderfund, we consider a number of factors in assessing liquidity. Issue size is important, as is a history of trading and the magnitude of spread between bid and offer. However, there are also elements of form of security, and the population of other owners that contribute to our understanding of a security’s liquidity. It is hard to put a finger on the exact boundary between “most liquid” and “less liquid,” but when liquidity is not there it is very much evident.
Safety isn’t everything for investors, and it is certainly different from growth, which some people also need. But we believe it is useful for investors to understand the new dimensions of safety in a world now awash in risk. Our formula is simple:
Safety = Real Value + Insulation Against Loss + Liquidity
Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – March 2022. Used with permission.
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