Picton Mahoney head of fixed income outlines where the asset class sits going into a year where many predict bonds to perform well
After two years of negative performance and uncharacteristically high volatility, 2023 ended with a rally in bonds. Yields fell and prices rose on the promise of interest rate cuts by the US Federal Reserve, likely to come later this year. Analysts expect cuts and the bond market has been touted as more attractive now than in prior years. Many asset managers have shifted into slight overweights in fixed income, or at least back to the 60/40 equity/bond split that had largely failed to deliver during 2022 and 2023.
Advisors are now looking for opportunities on the bond market. As they do so, Phil Mesman believes that the right allocation is key. The head of fixed income at Picton Mahoney Asset Management believes there is enough uncertainty still out there to justify active management. As portfolio managers and advisors make key choices around duration and sector allocation, Mesman believes they also need to consider a key concept in fixed income investing: the margin of safety.
“We want investors to focus on the safety margin with respect to duration positioning. In other words, have a view of where you want to be on the curve with respect to government bonds,” Mesman says. “Given the rally that occurred in late 2023, the back end of the curve was becoming much more challenging from a risk-reward perspective, which leads to that safety margin consideration.”
Mesman’s view is that investors became too optimistic at the end of 2023 and thinks the rally ran too far on the 10-year US treasury bond. In 2024 so far we’ve seen some selling off in the 10-year, which is in line with what Mesman and his team expected for the long end of the yield curve. He says that the safety margin — how much value you can lose on a bond before you fall below a break-even point — on the US 10-year is only around 56 basis points. On the three-year bond, given its higher yield, the margin of safety is 228 basis points. Mesman believes that the three-to-five-year section of the yield curve offers the best margin of safety when it comes to government bonds.
While there has been some selling off on the long end of the yield curve so far in 2024, Mesman does not see a return to the volatility we saw while rates were increasing. The uncertainty on the bond market now is largely a question of when central bank rate cuts will actually come.
He notes, as well, that we are seeing additional supply coming onto the market in the form of both government bonds and investment grade credit. That could pose some headwinds for bond investors in the short-term as well.
Mesman is most constructive on the corporate bond market, with the caveat that it is currently expensive. Some parts of the credit market, he says, offer attractive yields for their prices, somewhere between five and eight per cent. At those yields he thinks credit could prove more attractive than having to make a call on the duration of government bonds. However, he notes that the spreads can be tight on some of these products. Because of those tight spreads, Mesman says an active approach can help in credit markets. Actively selecting winners and losers, he believes, is key to success in an expensive market like credit.
In terms of Picton Mahoney’s active credit strategy, Mesman says that he thinks financials, especially hybrid capital structure financials, are quite attractive. His team practices event-driven credit investing, capturing opportunities from special situations. He sees M&A volume picking up which may offer specific opportunities that an active manager can snap up.
On both the government bond and corporate credit side of the fixed income market, Mesman sees an opportunity for advisors to differentiate themselves and drive value for their clients. The money that had been parked in GICs and cash products last year may do well in an asset class that remains promising, provided advisors pay attention to the details.
“What I say to clients is, review your current fixed income positioning, what do you own, where’s your beta, and have a view on rates and credit…and rethink and rebalanced based on your desired comfort level position,” Mesman says. “Take what you currently own, factor in your views on rate and credit, and then rebalance.”
