According to a report by Lobard Odier, most investors in fixed income products stick to strategies that follow a traditional approach based on market capitalization. This leads them to lend more money to issuers with the highest debt. By focusing instead on the fundamentals of government and corporate issuers, bond investors are encouraged to think of themselves as lenders, and to prioritize the ability to repay debts, rather than the ability to borrow larger amounts. With that said, here are ten common mistakes of the traditional fixed income investing approach:
1. “THE DEBT BUBBLE…”
History shows us that investing in market indices leads to the most leveraged debtors and sectors, often with disastrous consequences. Raise your hand if you thought that September 2008, with the collapse of Lehman, was a good time to have 56% of your corporate bond portfolio committed to financials. As an industry becomes less healthy, it issues more debt and market indexes own more of that debt. As conditions improve, investors divest. This is not a winning investment formula.
2. “THE YEAR OF THE SHEEP”
Today, more than ever, money is invested in fewer, more concentrated locations. Debt ratios based on market capitalization encourage this trend. Don't get caught up in this logic.
3. “WHAT WOULD YOUR BANK MANAGER DO?”
The mortgage loan application form asks a lot of questions. Fixed income investors should apply the same rigor across the portfolio. By relying on market cap ratios and lending to whoever has borrowed the most, most investors don't apply the basic logic their bank manager follows when deciding whether to lend.
4. “SIZE DOESN'T MATTER”
Bigger isn't necessarily better when it comes to bonds. Recent episodes of risk aversion have shown that even the largest lenders are sensitive to illiquidity. In times like these, quality-oriented diversification can serve as a barrier.
5. "A BALANCED DIET HELPS TO LIVE LONGER"
Bond investors have been bingeing on yields for many years. The steep sugar spike of high yields, peripheral debt and bank capital cannot sustain yields indefinitely. Better to focus on more balanced parameters for measuring corporate credit, rather than looking at who issues the most paper: better five portions of fruit and vegetables a day than an excessive feast.
6. “THINKING ABOUT EMERGING MARKETS WITHOUT CHINA AND INDIA IS LIKE WASHING WITHOUT SOAP AND WATER
Why aren't traditional investors investing in two of the biggest emerging market economies? Both China and India are traditionally excluded from mainstream indices, on the grounds that they are difficult for investors to access. But that doesn't make their economies any less important.
7. "THE PRICE IS RIGHT"
Quantitative easing has inflated debt prices for most borrowers, not always the best. This increases the potential loss in the event of default and the market capitalization does not discriminate. Better to follow an index that takes into account the fundamentals of a debtor, and not just the price.
8. “IS THE CAPITALIZATION CORRECT?"
Issuer capitalizations ignore the fundamental drivers that determine an obligor's ability and willingness to pay. Can an investor rely on active management in an illiquid asset class to solve the problem? We believe not.
9. “LISTEN TO THE SIRENS”
In Greek mythology, the hero Odysseus manages to save himself from the call of the siren song by tying himself to the mast of his ship. There may not be enough string for all investors to do the same when the next bubble bursts. Better therefore to focus on a diversification based on quality, low concentration and fundamental factors.
10. “COMMON SENSE?”
Would you give more money to banks and insurers just because they need to borrow more money? Thus ending up with a portfolio completely misaligned with the real world? Or would you rather give more money to companies, such as retailers, who may not need your money but are more likely to pay you back.
