The time has come for quality FMPs
The time has come for quality FMPs
By Gerald Sinnasse, Fixed Income Portfolio Manager at SILEX
“Fixed Maturity Products are particularly relevant now due to the favourable economic environment for this type of vehicle. Let’s see how.”
An especially simple, transparent strategy
Lock-in a return at a specific time and for a set period of time; this is how you can describe, in just a few words, the main advantage of an FMP. The fund is invested in a diversified portfolio of sovereign and corporate bonds with no leverage, offering excellent visibility into future performance. In general, an FMP is more diversified than a basket of bonds, with its exposure to different countries and sectors varying a great deal, reducing its exposure to individual underwritings. Finally, as the fund approaches maturity, duration risk, credit risk and volatility decrease.
A current macroeconomic environment favourable to duration exposure
We are in the middle of one of the biggest interest rate and energy shocks of recent decades. Inflation has been the central issue since 2021 and has been causing the destruction of capital which we have experienced since the beginning of the year. Currently, the central scenario is a slowdown in growth while central banks remain under pressure to raise interest rates. Finally, the market has a very strong opinion concerning the Fed’s ability to raise rates for an extended period: in fact, the market is pricing-in interest rate rises until the first quarter of 2023, and then a cut!
In brief, the market’s sentiment is that an economic slowdown is fast approaching, which will bring inflation back to central bank targets.
Therefore, clearly, we find ourselves in a market environment in which caution must remain the rule; however, the market movement we have seen since the beginning of the year presents historic opportunities.
Duration exposure has become relevant again! In fact, Jérôme Powell’s commitment to fighting inflation is undisputable, even if – in his words – this will have a negative impact on growth and on the labour market. Therefore, lower expectations in terms of growth and inflation are leading to a quite logical appetite for duration.
As regards the credit segment, valuations have evolved dramatically since the beginning of the year. A BBB-rated European corporate bond with a typical maturity of 5Y is trading at its lowest level since 2012. Two characteristics stand out: firstly, spreads compressed during the first half of 2022 making individual underwritings of lower quality more expensive in relative terms. Secondly, the risk of default is asymmetric and increases exponentially as soon as you move towards the riskiest ratings.
Finally, the central macroeconomic scenario leads to favouring defensive sectors and avoids cyclical sectors. Nevertheless, the market has not yet allocated particularly high premiums to sectors which would suffer greatly in a scenario of severe economic slowdown.
Choosing the right positioning according to the current context
An FMP is therefore the ideal format in order to be positioned on bonds for the coming years: indeed, by carefully structuring the position and through diversification, moderate duration and credit risks can be borne.
A focus on BBB/BB bonds offers the best risk-adjusted return profile, with an attractive balance between credit risk and duration risk. The return on these bonds is well above A-rated bonds or even better, while the corresponding credit risk increase is very modest, especially in non-cyclical sectors. Finally, there is no need to move towards B+ or lower rated bonds, as volatility and credit risk increase faster than the associated returns.
As for fund maturity, too short a maturity does not bring sufficient return while too long a maturity offers little interest to an FMP. The 5-7Y niche, as well as having the benefit of involving a wide range of bonds, has an attractive ex-ante Sharpe Ratio.
Finally, emerging countries are facing some serious challenges: considering the strength of the dollar, the risk to energy prices, food inflation and, of course, geopolitical risks, it is prudent to wait a little longer, even though there might be some very interesting investment-grade areas today.