Fixed-income investing in a ‘no-textbook’ market

Three operating principles when the old rules don’t apply

As we wade further into 2023, we find ourselves in a curious environment. Speaking at the recent Norges Bank conference, storied hedge fund manager Stanley Druckenmiller gave a rather succinct accounting of this year’s investing crosscurrents:

“[At] the top of my mind is just how uncertain for me trying to analyze the environment is going forward. I’ve been doing this for 45 years. I’ve studied a lot of economic history, but I’ve never had a situation where you had free money for 11 years, a very broad asset bubble, followed by jacking up rates 500 basis points in 12 months.”

Druckenmiller’s uncertainty resonates with us. There is no “textbook” for this cycle, because this cycle has few historic benchmarks. Some elements of the existing environment look like the 1970s, others like the 1930s, and some like the early 2000s. But none of those environments had central banks that were in the practice of “fire-hosing” financial crises with massive quantities of freshly created cash.

We understand the playbook for preparing for inflation, and we understand the playbook for preparing for a recession. But what of the playbook for doing both? And, to throw out a devilish idea, what if the hedging that others have done in preparing for difficult times has already created the prices necessary for us to just proceed as if the worrisome events have already taken place?

Operating principles

Given the uncertainty, we are drawn to a few operating principles for fixed-income investing that seem to fit the occasion.

1. Stay liquid

The first is the imperative to stay liquid. Keeping an ample supply of short-term, high-quality securities is not so much a get-rich scheme. It is rather an acknowledgement of our limited ability to forecast the future. Ideally, such abundant liquidity will help us capitalize on opportunities should they become clearer in the coming months. The liquidity also provides us with a strong ability to manage redemptions in the event that our path forward is bumpier than some of our partners can tolerate.

2. Look for capital-deprived situations

The second imperative is to seek out those market situations where capital is scarce. We believe we are far likelier to earn outsized returns on our credit investments when we are entering situations as one of a small number of investors prepared to underwrite a deeply discounted risk in the secondary market, as opposed to lining up 10 rows deep to subscribe for popular new issues. Investing in these situations does expose us to volatility, and we do not succeed in 100% of such cases. But over the passage of time, it is a practice that has borne fruit for us.

3. Stay active

The final imperative in this market is to remain active. In particular, our activity is oriented around the regular assessment and re-assessment of risk versus reward of credit securities. Is the debt from an issuer protected by the fact that the issuing company, in liquidation, would be worth far more than its financial liabilities? Does the yield of a given bond provide a relatively attractive return given the issuer’s probability of default? These are the simple questions we are asking ourselves every day, and answering these questions drives our activity.

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income Manager’s Commentary, April 2023. Used with permission.

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