BlackRock managing director Brian Weinstein, a New York-based fixed-income specialist in institutional multi-sector strategies, says his portfolios for pension funds and other long-term investors are shifting out of investment-grade securities.
“We’ve cut our allocation because spreads have become tight and liquidity is not as good as before,” Weinstein says. “We are beginning the shift out of investment grade, even though the sector remains strong.”
His marginal allocations are being made to high-yield bonds and to mortgage-backed securities (MBS), a sector that remains maligned by most investors.
Weinstein argues that agency MBS (issued by Fannie Mae and Freddie Mac) offer value. Extended homeowners and rising interest rates have led investors to fear rising MBS durations, pushing MBS prices down. But now these prices are low enough that new buyers can pick these up at wide spreads relative to US Treasuries, and still enjoy government bond-like behaviour.
Weinstein says the biggest concern among investors is a bubble in bonds, although after a run in the market in December, yields on 10-year Treasuries rose from 2.5% by nearly 100 basis points (just recently, the 10-year yielded 3.47%).
Nonetheless, these relatively low yields continue to force investors to seek better-yielding instruments. High yield has become a more popular destination, particularly among those issuers with relatively strong balance sheets. Weinstein also favours instruments on the short end of the bond yield curve, which includes asset-backed securities.
“If there is economic growth this year, then equities will look cheaper relative to bonds,” Weinstein says. “My fear for 2011 is that fixed income won’t be in vogue. So bond managers need equity-like parts of fixed income.”
But he also expects more volatility. In fact, volatility has been a fact of life since 2008, but markets have tended to rise and fall in tandem. Problems in the eurozone suggest to Weinstein that this year will see volatility increase among market segments. If US growth doesn’t pan out as the market now expects, the repercussions in all asset classes will be powerful.
“The pre-crisis years were misleading because they were so non-volatile,” Weinstein says. “Back then, leverage investing became the most popular way to generate returns. Even long-term investors thought very short term. If you have 20- or 30-year liabilities, you really need to think longer term.”
Weinstein reckons there are three potential outcomes that could emerge over the course of the summer.
Most likely is that the Federal Reserve’s easy money does the trick and the economy returns to trend growth, in which case investors will want exposure to financials and credit below investment grade.
A second, less likely, possibility is that the economy falters, in which case credit is dangerous, given that it is currently pricing in a stronger outcome.
We may also get a slightly stronger growth trajectory than expected, allowing the Fed to modestly hike interest rates, in which case it’s time to exit from carry-priced securities.
Weinstein says he is closely watching the development of US employment figures, and expects to see 3.5-4% GDP growth in the first half of the year. He believes that increased volatility will provide better opportunities to add risk in fixed income, as the market debates which of these outcomes is the most likely.