Q&A with Bob Michele – A review of 2017 and an outlook for 2018 in Fixed Income
2017 proved a challenging year for fixed income investors who had to move from contending with lethargic yields to a rate-rising environment. How did you stay ahead of the pack in that regard and what areas of the bond market did you tap to generate returns?
It may have seemed like we were poised for a challenging year for fixed income, though we haven’t seen any large market disruption or a dramatic move higher in rates. In our view, 2017 has actually surprised to the upside in terms of being a strong year for fixed income returns: US high yield has returned more than 7%, emerging markets debt indices are up double digits and even developed market government bonds have generated positive returns. However, these index-level returns mask some decent moves in individual companies or countries-meaning that employing a dynamic, flexible approach has been key to generating returns this year, both to capture the opportunities and also to avoid the risks. We’ve been actively rotating through idiosyncratic opportunities in the emerging markets space, and have also used the mantra “don’t fight the central banks” to take advantage of the ongoing search for yield by maintaining an allocation to high yield.
How does the previous 12 months compare to previous years as a fixed income manager – was it harder to find yield? Have you encountered a scenario like this before?
The past year reminds me of the 2004-2006 period: low volatility, credit spreads were narrowing and looked expensive, the global economy was reasonably healthy and the central banks were happy to sit back and let things run. This year, while it’s becoming increasingly difficult to find yield, there are still opportunities in the market. Take European banks as an example. European subordinated bank capital notes offer yields in the 4% to 6% range, and these are securities that essentially didn’t exist 5 or 10 years ago. So while yield opportunities may not be abundant, there are also new parts of the market worth exploring to generate attractive returns. One of the notable features of the fixed income market in 2017 compared to previous years is actually the lack of anything notable; it has been relatively “smooth sailing” across markets and sectors, highlighting the weight of central bank balance sheets.
What challenges or pitfalls did you face in 2017? How did you overcome them and how will you ensure you don’t get into the same situation again?
Coming into 2017, we expected a meaningful move higher in rates, particularly in the US, though admittedly these higher yields haven’t materialised. We attribute this to three factors: the more muted inflation environment compared to what was originally expected; the power of global central banks continuing to expand their balance sheets, which more than offset rate hikes from the Federal Reserve; and the lack of fiscal policy measures from the US administration. While the US rates market has not played out as we expected this year, our diversified approach to portfolio construction means that we’ve still been able to generate attractive returns through our allocations to the credit and emerging markets sectors. Going forward, we’re much more cognisant of the global monetary policy picture rather than getting too focused on any particular central bank, and we’re also closely tracking the point at which central bank balance sheets shift from expansionary territory to contractionary-and importantly when the market begins to price this in.
How do you expect 2018 to pan out and how have you positioned your portfolio to take advantage? I hear risk is being taken off the table in several funds, is that the same for you? Where is it being reallocated?
The key to 2018 will be central banks and the extent to which they continue to support bond markets through ultra-accommodative policies. For now, we continue to “follow the growth” and allocate to markets with solid fundamentals and attractive relative yields, such as high yield and emerging markets debt, as central banks still underpin the search for yield. However, we are mindful of a pending shift in this technical support and we will likely reduce risk at some point in 2018. As this shift is not imminent, we are not taking risk off yet and instead have used the dislocation in credit markets at the start of November as an opportunity to add risk, specifically in global high yield and European subordinated bank capital. 
Originally published by J.P. Morgan Asset Management