Practical analysis for investment professionals
07 September 2016

What Is the Focus in Fixed Income? Exogenous or Endogenous Factors?

Is there any doubt that since the onset of the Great Recession fixed-income markets, issuers, regulators, and investors have put their attention squarely on exogenous factors?

First Place: Monetary Policy

Taking first prize in fixed-income celebrity are global central banks, especially the US Federal Reserve and the European Central Bank (ECB). Every player in fixed income obsesses about the doings of Janet Yellen and Mario Draghi like teenagers do with Taylor Swift and Justin Bieber.

So what is in fashion?

Currently it looks as if the Fed is set to part ways with its long-time “cut-rates-only” aesthetic, while the ECB is struggling to find its next direction: Does it stick with its unconventional interest rate policy or opt for a renewal of a more conventional approach? Fiscal disunity, Brexit, an immigrant crisis, a lack of vigorous economic growth, tepid demographics, and lingering hangover effects from the Great Recession debt-binge are likely to lead to “more of the same” monetary policy.

The loose money policies have contributed to more uncertainty than certainty, in my opinion. Every investor is patently aware of the big gray pachyderm in the room: Can the global economy stand on its own? Or is the new normal a form of socialist money formation? And last, but not least: Where is fiscal policy support? Answer: Its manufacture has been exported to China like most everything else. Elsewhere, gridlock has led to policy rust.

Second Place: Tepid Economic Growth

Taking the silver medal when it comes to capturing the attention of the fixed-income community is the anemic quality of economic growth in the globe’s major economies.

For those who long believed in a mechanical mental model that too much money must lead to too much inflation, too much unproductive economic growth, and ultimately to DISASTER! the current environment must be bizarre. Why? Because the mechanism just isn’t working like it used to.

So let’s assume that the mechanism is broken — that too much money leads to too much inflation. Does that make you feel any better? That is, do you believe that the economy is functioning as it should? Is demand for credit strong? Are businesses asking for debt capital to finance new high returns on capital projects? Not really.

Please also do not look at the underlying demographics of Europe, China, Japan, or any other of the traditional economic engines. If you do, you will see a future of low real economic growth on the horizon. And there aren’t many ways out of this pickle.

You might be among the thoughtful who say, “GDP per capita is what’s important.” Granted. But putting GDP on a relative basis (per capita) does not get you off the hook for all of those assets that exist on an absolute basis. Think: infrastructure and real estate built for a population of size x, that ends up being 0.8x.

Furthermore, how do we pay for the enormous Pension Party that sent out so many invitations in the past three generations? Ouch! Is there yield to be had for a pension trustee? Hah! The only solution is to increase your risk by dumbing down your credits. This is going to hurt! Right?

Third Place: Market Structure

Given the two preceding prize winners, is it any surprise that market structure in fixed income is fractured? It’s turning into the market equivalent of the Dead Sea: stranded, drying up, small, and very salty. Where’s the liquidity? Where is the scale? Corporate bond liquidity was never great, and now it is worse.

Attempts to improve liquidity by creating e-exchanges have largely failed. Efforts to develop standardized contracts to improve liquidity look far off. Outright purchases of bonds by central banks are likely eroding price discovery. And on and on. Even the market making in treasury securities looks bad with a major player, the Bank of Tokyo, quitting its Japanese government bonds (JGB) market making job, and a trade settlement company in the United States exiting to leave only one player standing.

Consolation Prize: Endogenous Factors

It is understandable that exogenous factors dominate fixed income, but a wise person — Robert Rubin, in case you were wondering — once said, “By definition the greatest risk is the one you didn’t account for.”

Hard to refute that logic. So what is not being planned for right now by a majority of fixed income investors? Endogenous factors.

When was the last time you sat down as a fixed-income analyst, PM, CIO, or asset allocator and spent the majority of your time considering the quality of the business models of your credits? Or whether or not your portfolio was diversified well enough? Or whether or not the asset allocation served your end clients’ needs? Or whether or not your trading desk is getting the best execution? Or whether or not your firm has communications good enough to ensure an appropriate response to the inevitable shift in the exogenous environment?

One thing you can do to help roll back some of the uncertainty of fixed-income investing is to make sure that you consider opinions other than your own. Want a great place to do this? CFA Institute Conference: Fixed-Income Management 2016 in Huntington Beach, California, 20–21 October. Sessions will include a presentation from Michael Pond, CFA, managing director and head of global inflation-linked research at Barclays; a look at emerging market debt with Kristin J. Ceva, CFA, managing principal at Payden & Rygel; and a discussion of quantitative approaches for a variety of fixed-income sectors led by Thomas B. Parker, CFA, managing director and chief investment officer of model-based fixed-income at BlackRock. This October you can, at least, see two kinds of ace wave surfers at work: ocean and fixed income.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/erhui1979

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

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