Fixed income: new opportunities 

Francesca Fabrizi meets Ahmed Talhaoui, Head of International Product Strategy for BlackRock's Global Fixed Income Group, to discuss how fixed income markets have evolved and what opportunities are available for pension funds to build robust portfolios

How have fixed income markets evolved since the financial crisis?

Ten years after the collapse of Lehman Brothers, many markets are reaching new heights and it's important to remember that, following the financial crisis, there was a massive liquidity injection from central banks that was co-ordinated, which basically served the financial systems and compressed interest rates.

But what is really fascinating is that we are now seeing a dislocation of central bank policies, a normalisation of interest rates especially in the US, which is going to change the valuation of fixed income markets going forward and also change how we should look at fixed income markets.

In addition to that you have volatility, which can be a good or a bad thing, but can definitely also create opportunities in fixed income markets.  This volatility is driven by geopolitical risk; we're talking a lot about also trade wars and other things that could influence markets.  Also, we see episodes of volatility in certain segments of the markets, such as emerging markets.

Last but not least we're seeing structural changes.  The disengagement of banks in Europe, for example, has led to interesting opportunities in private credit markets. 

All in all, things are changing in fixed income.  There are opportunities, there are dislocations and divergences that can be exploited by investors.

Which parts of the fixed income universe do you think are under-utilised?

What is important to remind our investors is that fixed income markets are big, bigger actually than stock markets.  Fixed income markets represent almost $100 trillion of assets.  Not all of these assets are directly investable but traditional indices only represent probably 50% to 60% of this pool of assets.

So, there are a lot of interesting segments with fixed income markets that investors don't necessarily look at. Specifically, I think it's important to look at the dynamics of emerging markets.  Emerging markets are growing structurally. There is right now $20 trillion of issuance that is coming from emerging markets.  It's a segment that is growing as an allocation for many institutional investors around the world.

We also see a definite increase in demand in private markets, private credit, and specifically mid-market loans in Europe.  That's a segment that willl continue to grow for the structural reasons that I've mentioned before.

But I would say that also lastly investors need to look at how to invest in these segments also.  Maybe the approach is also to look at how to approach these segments differently, how to invest outside of traditional benchmarks and that's something which is going to be very important and relevant going forward.

What types of opportunities available and how can they be accessed?

Fixed income markets are not just asset classes where investors expect to generate returns.  They are also a tool.  There is some sort of predictability in cash flows that is part of the fixed income markets which can be used to the advantage of investors.

Specifically, I think the idea is to use fixed income markets in the context of a broad allocation. So, for investors looking at de-risking a pension scheme you can used fixed income segments and a fixed income allocation to manage your risk, to add more predictability towards cash flows.

Specifically, with regard to investing in the less common segments of fixed income markets, it's important also to have an allocation that is more unconstrained in the sense that traditional benchmarks can lead into a narrow vision, a concentration into directional risk towards interest rates.  Having a more flexible and unconstrained approach enables investors to really take the opportunity of exploiting all the different segments that are available in the fixed income markets -high yield emerging markets, loans, private markets, credit broadly speaking and so on.

There are so many ways of diversifying your fixed income exposure.

How can allocations to this broader range of fixed income assets help build more robust and efficient portfolios?

Let's come back again to my point about the fact that fixed income markets can be seen as a tool in a toolbox which can enable you to hedge your liabilities by generating a predictable stream of cash flows and also to generate diversification with regard to equity risk, for example.  It’s well-known that in fixed income markets exposure to interest rates is one of the best hedges or best protection against an adverse move in equity markets.

Hence, I think specifically for investors who work in the context of pension fund management, we've been very successful in establishing a framework around liability-driven investments essentially focusing on matching liabilities in the future.  I think more and more we will talk about cash flow-driven investments where we're going to use this toolbox that is fixed income and by considering different segments, whether it's emerging markets or private markets or whatever, we're going to be able to build for our clients customised cash flow streams that are more predictable, more robust and that are going to help manage the volatility and the outcome for our clients.

How can fixed income allocations be optimised to ensure they meet the dual purpose of hedging liabilities as well as generating returns to improve funding?

Let's talk first about liability hedging.  Liability hedging is a science.  We know how to use a large range of products including interest rate derivative] such as swaps to match liabilities at different levels so, simple cash flow matching. We can also look at hedging inflation-related stream of cash flows and there innovation in this field in terms of, for example, even hedging certain risks such as mortality rates and so on.  The innovation is very constructive for our clients.

Then the idea of course on top of basically hedging the main risks and expected shortfalls is to be able to generate returns.  For us, the idea is that the generation of returns is almost to some extent de-correlated from the hedging.  The idea is to help our clients by adding sources of returns that would work independently from the liability hedging programme, but still be part of the integrated solutions.

On this specific topic there is obviously a lot of interest in developing absolute returns strategies and in fixed income markets these strategies tend to be focused also on capital preservation.  This is not a guarantee but this is really a very important part of the investment process.  Hence, you have this portable solution with a very systematic and robust liability hedging programme and the ability to add returns.

As mentioned before, absolute return strategies are a nice way of generating excess returns but then coming back to the concept of cash flow-driven investments, you can actually combine the liability hedging and the excess returns together by building this stream of cash flows leveraging the whole of the fixed income platform by mixing different sources of cash flows such as credit but also illiquid credit.

The illiquidity premium also is quite exciting in this context because for clients who have long-dated liabilities and no immediate need for liquidity, there is a very strong rationale behind taking some of these returns from the liquidity premium by looking at these sorts of asset classes.

Really, to summarise, liability hedging is a science and can be nicely combined with absolute return or can be part of an integrated cash flow-driven investment solution.