Seeking returns - wherever they are

Our active approach dictates that, sometimes, finding the best opportunities for our clients means having to go beyond traditional benchmarks.

At Invesco, we will only invest our clients’ money when we think we are being adequately compensated for doing so. From experience, we know that bond markets can temporarily present significant imbalances of risk and reward, which can be exploited. These imbalances are not confined to one particular market.

Investment opportunities can therefore be increased by not managing our funds within the constraints of a benchmark. While the core of the fund will always be focused on its underlying market, mis-pricings can, where appropriate, be exploited wherever we identify them.

For example, some of the building blocks of our long-term performance track record have been financial capital, hybrids, peripheral European sovereigns and US corporate bonds. In many cases, these instruments are not found within the underlying index that comparable funds are typically managed against.

Subordinated financials

In the aftermath of the global financial crisis, we saw value in subordinated bank debt. We built substantial positions in the subordinated debt of nationally important banks – those we felt too important to be allowed to fail.

These positions were not widely held in indices and were avoided by many of our peers. Careful analysis and effective trading allowed us to add positions in which we had high conviction. These bonds were at very high yields and often priced at large discounts to par.

The bonds went on to recover, as we believed they would, adding strong returns for our investors. At this point, we were able to take profits and reduce some of the higher beta names in favour of core holdings.

As other opportunities have come along, for example, during periods of volatility in 2016 and more recently during the pandemic, we have added exposure. Today, this area of the market continues to offer an attractive yield premium and remains a core holding across many of our strategies.

Hybrids

The low level of bond yields in recent years has meant that we have increasingly needed to look beyond the plain vanilla bond market to satisfy the demand for income. One area of the market that has helped fulfil this objective is the hybrid bond sector.

Hybrids combine one or more of the characteristics of bonds and equities, with the exact combination unique to each instrument. Three of the most common characteristics are:

• A fixed amount of income is paid only until the first call date. After this date, income payments become variable with the rate typically referenced to the swap market.
• Hybrid issuers can have the right to defer interest payments.
• In the event of a company’s insolvency, hybrid debt ranks below that of other unsecured bonds, but before equity.

As figure 1 shows, the additional risks mean that a hybrid security has a higher beta, but it will also typically offer a higher level of income than a company’s senior debt to compensate. Careful analysis of these risks has enabled us to add attractive levels of income to our strategies through what are often high quality, highly cash generative, investment grade issuers, such as EDF, Vodafone and Volkswagen. 

Peripheral Eurozone debt

The widening of peripheral Eurozone sovereign spreads in 2011/12 presented a compelling investment opportunity. The market, at this time, was starting to price in the domino effect of multiple sovereign defaults and, at the extreme, the break-up of the Eurozone. These concerns had a knock-on impact on credit spreads across the region.

We believed that this was an overreaction, which misunderstood the political significance of the European project. We used the market weakness to build exposure across our strategies in both sovereigns, which had come under pressure, and corporates, which had suffered as a result of the underlying sovereign.

The commitment of politicians and officials to the European project was subsequently underlined by ECB governor Mario Draghi’s ‘whatever it takes’ speech in summer 2012. Since then, with huge support from European authorities and a gradual improvement in macroeconomic conditions, the bonds recovered strongly.

Political uncertainty, particularly in Italy and Greece, has continued to present opportunities since 2012 and we have sought to exploit these across our portfolios.

Liquidity

Our philosophy that we will only invest if we believe that we are being appropriately rewarded for doing so, also means that if we do not think there is adequate compensation, we will not invest. During such periods, we typically look to take ’off-index’ exposure by increasing our strategies’ exposure to cash, government bonds and very short dated bonds.

Where appropriate, derivative instruments may also be used to hedge out the underlying interest rate risk. This means we are left with high quality liquidity rather than high levels of interest rate risk. This helps to mitigate the impact of market volatility but also means we are well placed to exploit any opportunities that may arise.

A world of opportunities

Countries are frequently at different stages in their economic cycle and this means that their underlying interest rates may differ. Looking beyond the restrictions of a benchmark’s geography means we can often add higher yielding bonds to a portfolio without taking on additional credit risk. In other words, we can achieve a better balance of risk and return.

In recent years, the US market has provided such an opportunity. Prior to the pandemic, the US was further along in its interest rate cycle than its European counterparts. As a result, US bond yields were materially higher. Although some of this yield was given up when hedging the currency exposure, the depth and breadth of the US market meant that we were able to source many attractive bonds and add yield to our strategies. 

Conclusion

Extending our investment universe means we need only allocate to those parts of the market that offer appropriate compensation for the risk of doing so. At times, we have been able to reduce market volatility while at others, we have used volatility to maximise opportunities of capturing periods of market strength. This has proved to be a successful strategy for us and we believe this will continue in the years ahead.