Under the bonnet: Key trades within Neuberger Berman’s unconstrained fixed income strategy

The synchronised global expansion and buoyant markets have been able to withstand a number of crucial questions.

How will extreme levels of monetary policy accommodation eventually be unwound? Are the reflationary, pro-growth elements of President Trump’s agenda alive or dead? When will a long forecasted increase in government bond yields materialise? What is the impact of a wildcard such as North Korea?

As unsettling as it may be, we do not expect complete clarity on these questions in the near term, and we do think there may be some unexpected answers – including that the global economic cycle may nevertheless continue to power through.

In respect to central bank action, we do believe reducing balance sheet holdings – quantitative tightening – should add to volatility in fixed income markets, just as adding to central bank balance sheets – quantitative easing – had previously reduced volatility. In this environment, we are reducing corporate credit risk in our portfolio as we don’t see reasons for further spread tightening. At the same time we have increased risk in currency and rates markets as we see significant dislocations and attractive investment opportunities.

Here are four key trades within our unconstrained fixed income strategy:

European Credit

The European high yield sector continues to benefit from strong recovery in Europe and lesser sensitivity to changes in US monetary policy, while at the same time being technically well supported by the European Central Bank’s investment grade corporate bond purchases – depressing yields and spreads beyond the target universe. Projected default rates remain subdued, which in relation to improving fundamentals maintains the attractiveness of the risk premium offered by European high yield credit spreads.

That said, we currently partially hedge our 28% exposure to European credit through credit default swaps, reducing the effective credit sector exposure as valuations are at recent tights and volatility may emerge from the monetary policy surprises and political risk on the horizon.

30-Year Government Bond Spread – US vs Germany

We continue to hold a position representing 1 year of duration contribution in a 30-year government bond spread trade between the US and Germany. The 30 year spread, having averaged 190bps over Q1 tightened over the course of Q2 to 160 bps, as economic dynamics, and to an extent inflation dynamics, between US and Europe began to look more alike. We continue to assess these levels as substantially fundamentally dislocated as the growth rate differential between the two economies implied by this spread cannot be sustained in the long run, especially with still substantially diverging monetary policies of the respective central banks. Until the spread converges further, this position should continue to provide for attractive carry uplift to the portfolio.

Short Duration

The portfolio continues to have negative headline duration of -2 years as we continue to see more opportunities in reflationary stories across developed markets. Historically-low sovereign bond yields faced by investors today cannot be sustained indefinitely amidst the improved economic outlook, rising inflation and continuously improving labour market situation. There is no doubt that central bankers will try and move cautiously on the path of rate normalization. But there should also be little doubt that the realization of sustained above-trend global growth and a modest rise in core inflation will likely produce a substantial and broad-based shift in monetary policy stances.

We believe this extremely gradual pace for hikes priced by markets is a low bar to exceed, even if the path of hikes is slow as we expect.

Inflation-Linked Bonds

We also continue to hold a 15% position in US TIPS, as we believe the US economy will reflate beyond recent trend growth but fall short of pre-crisis levels. Inflation expectations have further to recover should fiscal agendas be followed through and US yield curve continues to reflect milder pace of hiking cycle than indicated by US Federal Reserve. Inflation will likely move toward the Fed’s 2% target rate and maybe even run a little bit hotter than this. We believe the bias for higher real rates remains over the coming 12 months due to three factors: higher economic growth expectations, higher inflation expectations and an increase in risk premia.

Currency

We hold core underweights in the Australian dollar and Swiss franc. Our analysis suggests that both currencies are significantly overvalued, and we believe the current market environment is conducive to a continued depreciation towards fair value.

We opportunistically bought the Norwegian krone. Whilst cognisant of the clouded economic outlook in Norway, our analysis suggests that the currency has depreciated too far and is now fundamentally undervalued relative to the economic environment and outlook.

Moreover, the rally in energy prices supports Norway’s terms of trade but has not yet been reflected in the krone. We continue to construct a relative value portfolio and monitor the data and risk events closely.