- By focusing on fundamental, long-term value, we believe we are able to identify when markets and securities are mispriced and to invest accordingly to benefit our clients.
- While some pricing anomalies can correct over relatively short periods, significant deviations from fair value can often take significant time to correct.
- Our confidence in our view of both fundamentals and valuations determines the proportionality of positions: the greater the confidence, the bigger the position.
- Our ability to add value for our clients has not been contingent on a specific market environment and we believe will not be compromised by the current low rates and unconventional central bank monetary policy.
More than a decade after the global financial crisis (GFC), policymakers continue struggling to catalyse their economies to expand beyond their anemic growth rates of recent years and to ensure that they can meet inflation targets. Investors have increasingly become conditioned to accept that a low interest rate environment will persist well into the new decade. With the secular headwinds from aging populations and high and rising debt burdens dragging on growth and inflation, such a scenario is hard to dispute. But does this mean that a long-term fundamental value-driven investment approach can remain appropriate for investors who seek attractive risk-adjusted returns from global bond markets? Based on our experience, which has stood the test of time for over almost half a century, Western Asset remains convinced that it does. Our conviction is anchored in the success of a proven investment style that allocates to securities priced below their fundamental fair value, especially when combined with diversified strategies that can reduce risk at the portfolio level.
The Western Asset Approach
By actively rotating across a broad range of sectors and markets as relative valuations change, we believe we can successfully augment returns from coupon income despite short-term capital market movements driven by market sentiment or non-economic participants. Value investing is by its nature defensive. The asymmetric risk of capital loss that bond investors face as yields have declined towards (or below) 0% argues strongly for constructing diversified portfolios with an emphasis on undervalued assets that can increase the probability of beating the market while limiting the risk of capital loss.
What Is Value Investing in Fixed-Income?
In his seminal work on value investing, renowned American investor Benjamin Graham posits that purchasing securities at a discount to their intrinsic value provides a “margin of safety” that can significantly limit losses from negative outcomes. Moreover, he believes that the concept is universal, applying across markets and through time.
It is this fundamental risk-mitigating concept that underpins Western Asset’s value-driven philosophy across our investment strategies. Bonds offer limited scope for capital gains but can be susceptible to significant losses. The cushion over the risk-free rate that bond yields offer is critical to successful bond investing. By being disciplined to invest only in securities that we estimate offer a yield cushion greater than that warranted by their fundamentals, we increase our ability to protect against price declines and to more fully participate in gains as prices return to our assessment of fair value.
Looking at each of the pillars of our philosophy, in turn, can shed light on the strength of our conviction in our ability to continue successfully to meet the test of time.
Long-Term Fundamental Value
Markets often misprice securities. Prices deviate from fundamental fair value, but consistently investing in undervalued securities increases the probability of delivering superior investment returns while reducing the risk of loss if your view is wrong.
There are three broad reasons why capital markets are not always efficient:
- “Fear and Greed” Psychology: Value investing is psychologically uncomfortable because it often means countering the consensus view. Investors often make investment decisions based on extrapolating shortterm price action and recent information. When the short-term fundamental news is good, markets tend to inflate prices beyond fundamental value when prices have been trending higher (“greed”). Conversely, when fundamentals appear to have worsened, the natural tendency is to sell even as prices are falling (“fear”). As prominent British investor John Templeton said, “To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.”
- “Non-Fundamental” Factors: Over short periods of time, markets move to levels that diverge from fundamental-driven factors such as geopolitics, supply/demand, market sentiment and liquidity. Increasingly market valuations have been driven by non-economic players such as central banks whose investment objectives are to stimulate economic growth or underpin financial stability rather than to maximize investor profits. However, to quote our CIO Ken Leech, “Central banks can win the battles but fundamentals win the wars”.
- Time Horizon: Investors who have short-term investment horizons are often forced to sell to comply with stop-loss or drawdown restrictions. These decisions tend to exaggerate price declines (or increases) in the short-term for reasons unrelated to fundamentals. As long-term investors we believe that, over time, prices adjust to reflect inflation, credit quality fundamentals and liquidity conditions. While some pricing anomalies can correct over relatively short periods, significant deviations from fair value can often take significant time to correct; after the GFC, corporate bond spreads took many years to return to levels closer to fair value.
We can systematically identify mispricings. We identify and capitalize on markets and securities that are mispriced by using disciplined and rigorous analysis, comparing fundamental fair values estimated by our macroeconomic and credit research teams to market pricing.
In corporate bonds this means combining a thorough fundamental credit review with a robust quantitative relative value analysis, irrespective of the phase of the interest rate or credit cycle. This allows us to identify issues which are mispriced relative to their creditworthiness.
In government and currency markets, we assess current and prospective trends in macroeconomic factors such as growth, inflation, domestic and external balances and political governance. Moreover, we analyse central banks’ stated policy objectives for an indication of future borrowing costs. Since the banking system is an important conduit for the transmission of monetary policy, we will also carefully monitor trends in the supply of and demand for credit through data on monetary aggregates. This analysis and comparisons with historical valuations help us assess fair value for the expected path of short-term interest rates as well as for the shape of the yield curves. Over the longer term, Western Asset believes that the main drivers of government bond valuations are growth and inflation, with inflation being a more dominant driver of longer-dated bond yields. We believe that currency valuations over the long term will be driven by growth and interest rate differentials, and by trends in relative competitiveness.
Our portfolios emphasize our highest convictions. The greater the difference between our view of fair value and markets’ pricing of a security, the bigger the potential position we can take. Our confidence in our view of fundamentals determines the proportionality of positions: the greater the confidence, the bigger the position.
Multiple Diversified Strategies
We seek diversified sources of returns. Our objective is to meet or exceed our investors’ performance objectives within their tolerances for risk. By diversifying investments across interest rate duration, yield curve, sector allocation, security selection, country and currency strategies, that all offer value but do not all benefit from the same market environment, we increase our chances of meeting our performance goals. Moreover, with no one strategy dominating performance we reduce risk and dampen volatility.
In fixed-income, diversification is harder to achieve than it is in equities, and correlations tend to be high, especially in credit and other spread products. This makes diversifying portfolios with strategies that are reliably negatively correlated in a risk-off environment crucial to reducing portfolio risk.
Market Inefficiencies in a Low Rate Environment
Perhaps the best known example of where non-fundamental factors led to a dramatic shift in market pricing is the so-called “taper tantrum” in the latter half of 2013 shortly after the then Federal Reserve (Fed) Chair Ben Bernanke stated that the Federal Open Market Committee (FOMC) was considering reducing the size of asset purchases over the following months. Despite Bernanke’s subsequent attempts to reassure markets that decisions about bond purchases were distinct from those on interest rates, investors started to price in policy rate hikes with 5-year US Treasury (UST) yields rising over 120 basis points between May and September. Western Asset’s view over this period was that the FOMC was very unlikely to increase policy rates as US domestic economic fundamentals didn’t warrant it.
The market dislocations resulting from the taper tantrum episode provided Western Asset with an opportunity to look through short-term noise and position portfolios to reflect our long-term fundamental views. Long duration positions in USTs, and in particular our bias to be overweight the long end of the yield curve, subsequently performed very strongly in 2014 as the market reassessed its view on Fed policy and ongoing weak inflation to be more in line with Western Asset’s view.
In 2018, emerging markets (EM) were severely challenged by the perfect storm of rising US rates, a strong US dollar, weak European and Chinese growth, higher oil prices and a looming trade war. With inflation rates in EM remaining subdued, central banks had substantial scope to loosen monetary policy. This was not reflected in real yield differentials with developed markets at 10-year wides, presenting a strong valuation opportunity for capital gains in 2019.
With the 2016 Brexit referendum, UK banks suddenly found themselves exposed to a world of materially higher political risk, combined with elevated economic uncertainty and lower interest rates. UK bank spreads widened materially when compared with their European and US peers. Against this backdrop, the UK banks continued to strengthen their balance sheets and the onerous stress tests by the Bank of England further highlighted the resilience of their credit fundamentals. As a result, we saw the widening of UK bank spreads in 2016 as an opportunity driven by our fundamental assessment.
Western Asset’s Value Approach: It Works
We can demonstrate that our ability to add value is not contingent on a specific market environment and not compromised by the current low rate and unconventional monetary policy stance of some central banks.
Exhibit 7 shows the attribution across a number of key return drivers for our global full discretion portfolios. The 10-year period shown spans a number of distinct monetary policy regimes including the US Fed’s zero interest rate policy (ZIRP) and quantitative easing (QE) (2009-2014), US Fed rate “normalization” (2016-2018), European negative rates (2014-2019) and Bank of Japan QE, and yield curve control policies (2013-2019). Throughout this 10-year period, our global aggregate portfolios were able to generate positive excess returns from different sources.
Importantly, sources of return vary, and this is testimony to our value-based approach to sector rotation and our active management style, with no single source of return dominating.
View the Performance and Risk Disclosure.