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The fundamental approach to fixed income

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Earlier this year saw the launch of a joint venture between Lombard Odier Investment Managers and ETF Securities, which brought Lombard Odier’s fundamental fixed income approach to the ETF world.

Kevin Corrigan, head of fundamental fixed income at Lombard Odier, explains that his fundamental formulation of fixed income indices started in 2008, post the global financial crisis. He was at the time at Goldman Sachs and realised that all his clients had the same problem.  While he had done a good job of being underweight banks, the bond portfolio was still down because the market cap benchmark indices had an outsize allocation to the banking industry, and this was principally because the banking sector had issued masses of bonds.
 
“After the global financial crisis, we realised that the approach of traditional market cap bond indices by which we judge ourselves is deeply flawed and illogical.  If you behaved like this as a bank manager, lending more to customers because they had already borrowed the most,  you would be fired,” Corrigan says. “Traditional fixed income investing is one dimensional and has given us big problems in the past, so our approach tries to address a lot of that.”
 
The joint venture with ETF Securities is a new iteration of his business. “We were looking for someone to partner with in an area of expertise we didn’t have,” he says. “The ETF range gives a wider range of investors a chance to access this strategy and for institutions ETFs gives them speed, liquidity and transparency.”
 
The range of Lombard Odier’s fundamentally weighted bond products covers global government, global corporate, European corporate and emerging market debt.  So far USD100 million under management has been raised since launch in May.
 
“We are out there talking about this approach and educating. It’s not just another strategy linked to a familiar asset class, these are  unique weightings based on fundamental financial strength criteria.”
 
Corrigan explains that size is a factor since big and wealthy countries and companies are more capable of raising and paying their debt.  But this is not enough to capture all aspects of creditworthiness. Indebtedness comes next.  Investors need to invest in healthier issuers so the ability to service its debt is considered; and whether financial strength is improving or deteriorating. 
 
For countries, social imbalances can impact a government’s ability to repay debt. History is littered with social misery that has led to debt defaults such as the Russian repudiation of 1917 or the 2002 default of Argentina. On top of those risks, old-age dependency can lead to a surge in public debt, as countries with ageing populations find dependency costs becoming government’s responsibility.
 
A differentiation in fundamentals between a company and a country is that you need to consider not just the specific company but also its industry, which may be overborrowed, explains Corrigan, as financials were in 2007 and telecoms was in 2000.
 
With sovereigns, he considers what the government debt looks like compared with GDP which skews the portfolio and allows a country such as Korea to have a higher weighting in the fundamentally weighted portfolio than Japan. This is because while Japan has  a large GDP, third in the world after China and the US, its borrowings are relatively high compared to GDP.
 
“In a traditional benchmark approach a lot of money would be in Japanese government bonds because there are a plenty of them out there, often held by domestic investors,” Corrigan says. “But what we are saying is that you have to fundamentally ask ‘can this borrower pay me back my money?’”
 
He continues: “We are not anti-debt but we want an approach that reflects not just how much debt there is available to buy but are you buying debt from those who can pay you back?”
 
His emerging market index performance has outperformed the traditional benchmark with annualised returns of 7.36 per cent and a maximum drawdown of 18.7 per cent, from December 2003 to December 2014, (the benchmark returned 7.95 per cent annualised with a maximum drawdown of 27.1 per cent over the same period).
 
“It’s been a tough time but what’s clear is that you have to be careful how you allocate your money” Corrigan says. Going forward he doesn’t believe there will be a one stop moment when the world is back on an even economic keel. “There won’t be a cyclical realignment of rates” he says. “There are different speeds and policies with the US about to tighten its economy while China is slowing down and the ECB maybe bringing in more QE – we need to watch the speed at which the rates rise and what’s causing it.”
 
 

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