Whatever scenario is contemplated, it is critical that fixed-income portfolios are diversified by duration, instrument, geography, issuer type, industry, sector and currency. This is acutely important during times of market stress, when correlations can become distorted and an entire asset class can become tainted by irrational selling (for example, leveraged loans during the fourth quarter of 2008). It is also important that each individual area within fixed income is itself diversified, and within the stressed and distressed credit area it is possible to build a portfolio that evolves with the opportunity set taking advantage of the many bites of the apple that are likely to present themselves sequentially.
For example investing today in performing stressed credits, as well as specific cash-pay instruments such as U.S. agency-backed residential mortgage POs (principal-only) will provide a current yield that is attractive in the current environment and should perform well in a deflationary scenario characterized by low interest rates. If the environment remains deflationary some defaults will ensue, but the low interest rates should motivate some borrowers to refinance, thus accelerating discount accretion on the POs. If the environment turns inflationary, the price appreciation based on stronger prospects should boost returns on many leveraged loans. Looking further out, over the course of 2010, we expect to find pockets of inflation hedging protection in credits tied to commercial real estate assets, as those assets fall into the hands of secured creditors.
So we believe that adding a stressed/distressed component to a core fixed income portfolio serves a valuable role in making that portfolio all-weather given the current uncertainty regarding the course of the coming few years.
The inflation hedge component in a credit portfolio is based on fundamental properties rather than an explicit hedge to a specified liability stream, which tends to be prohibitively expensive if obtained through derivative overlays or other immunization strategies. It also does not come at the expense of current yield, unlike TIPS. The only price implicit in using the distressed component of a fixed-income portfolio to combat inflation is time horizon, the effort required in careful manager selection and potential mark-to-market volatility, particularly if the secondary markets seize up again for technical reasons or general risk aversion.
The stressed/distressed opportunity is a medium to long term one. Institutional investors who see it as such and choose very carefully the stewards to guide them should reap multiyear rewards that are well worth the wait.
Aoifinn Devitt is principal; Elizabeth Carey, director; and Richard Lewy, adviser, at Clontarf Capital, London.