Defensive stance helped weather the crisis

We are pleased to say that the Jupiter Flexible Bond strategy entered this exceptional crisis in a defensively stance. Even before the crisis, we were concerned about high valuations in corporate credit given how late we were in the economic cycle and the weakness of global economic activity. Our view was that this left markets and the global economy extremely vulnerable to an exogenous shock.

That’s why we entered 2020 with around 40% of the strategy in some of the higher yielding AAA rated sovereign bonds, such as US Treasuries which have rallied sharply year-to-date. While the US economy was faring somewhat better than others last year, we classified it as the ‘least dirty shirt’ in the basket. Large positions in Australian government bonds and smaller allocations to New Zealand government bonds also performed well, but US Treasuries have been the star performers.

Unwinding credit hedges and capturing upside

Before the crisis hit, we also held 10% in shorts on US and European high yield indices expressed through credit derivative swaps. This turned out to be a very successful trade for the strategy this year – we unwound the CDS hedges in March when credit spreads ballooned, just before governments worldwide announced they’d do ‘whatever it takes’ to stabile the economy. Despite deteriorating fundamentals in credit markets, our view was that upcoming fiscal and monetary stimulus would be very supportive, making it a fool’s errand to be short from already stressed valuations. Exiting the CDS positions effectively unhedged our high yield allocation which has proven timely as markets have rebounded sharply in response to the aggressive policy response seen on a global basis.

Beer and burgers: focused on ‘through-the-cycle’ credit

We have focused on opportunistically buying high-quality debt in the investment-grade space at attractive spreads of between 250 and 350 basis points. We like defensive, ‘though-thecycle’ businesses – those backed by tangible assets, with robust top and bottom lines to help service their debts.

This has included bonds in the alcohol and fast food sectors – ‘beer and burgers’ – such as Anheuser-Busch InBev, Pernod Ricard, Keurig Dr Pepper, and McDonald’s. Other additions included semiconductor company Broadcom, UK packing business Mondi, Vodafone, and hospital operator HCA, as well as tech names like Oracle. We also added BB-rated high-yield bonds, such as Virgin Media, Netflix and Pinewood Studios, which have since performed very well.

Why are we still relatively defensive in credit despite the fiscal and monetary bazooka?

While the massive fiscal and monetary response has stabilised financial markets, it is hard for these measures to have much impact while the global economy is in lockdown.

We saw the liquidation phase in March, when investors rushed to unload even their most liquid assets in a ‘dash for cash’. We believe it is wise to expect an insolvency phase later in the year. This is where highly indebted companies, and sovereigns in certain emerging markets, simply cannot cope with a lower level of economic growth. To facilitate high levels of debt, you need growth and cashflow – both of these will likely be in short supply for the foreseeable future. Thorough credit analysis is vital in this sort of environment.

The tug-of-war between aggressive stimulus and deteriorating fundamentals is likely to continue for some time. This will be a credit pickers market, with significant opportunities to add alpha by avoiding downgrades and defaults while capturing upside in the corporates wellpositioned to navigate the economic turbulence. We envisage using risk-off phases to add to quality names at stressed valuations.

Japanification: still bullish on US Treasuries

We continue to run a barbell strategy, with around 40% of the strategy invested in US Treasuries and Australian government bonds, with a long-dated bias. With the global economy on life support and potential more fiscal support to come, there is the potential for yields in these markets to converge with lower yielding sovereign debt markets like Japan or Europe. In fact, despite yields already being at historic lows, we would not be surprised to see the 10- year US Treasury yield fall to zero, with real rates moving sharply higher on the back of much lower inflation.

This is because we think recessionary conditions are only just beginning and central banks are fast running out of bullets. Spiking unemployment (in the US, all the jobs created since the 2008 financial crisis have sadly been lost in the space of just one month), severely negative GDP readings, and the risk of further waves of infection will all combine to place further pressure on central banks to ease policy further as the year progresses.

When volatility returns, we could see the Fed step in to purchase equities, as the Bank of Japan has been doing for some time. We have long held the view that developed markets will eventually follow Japan’s economic path. With a V-shaped rebound growth unlikely, and with conventional policy at its limits, we could see measures like yield curve control adopted on a broader basis or greater consideration being given to controversial policies like Modern Monetary Theory or helicopter money.

The US dollar is set to reign

The strength of the US dollar over the past year has been incredible when you consider that US interest rates have been slashed to zero and the Fed has promised unlimited QE. There is clearly a shortage of US dollars greasing the wheels of the global economy. This is hurting emerging markets which have around $13trn of debt that becomes difficult to service when the US dollar strengthens. That’s one reason why we have reduced our exposure to emerging markets, although we retain a position in Russia, as well as short-dated paper in Ukraine as we are optimistic that they will get an IMF deal.

A currency position in the strategy worth highlighting is the short on the Omani rial. The collapse in oil prices is crushing the Omani economy as they need oil prices of around $90 a barrel to balance the budget. The Omani rial is pegged to the US dollar, but we think that peg is under immense pressure with a risk of a substantial downward adjustment. Elsewhere, we are short the Chinese renminbi as we think China’s growth will remain under pressure – with the US and Europe in lockdown, China’s export markets are severely curtailed – and this leads us to short the Hong Kong dollar too, where we have additional concerns about leverage in their banking system.

Beware of the bear

Bear markets have precedent for luring investors back in too early. We expect the current phase of market volatility to continue, creating an abundance of mispriced credit opportunities for active managers to generate alpha. We will continue to be disciplined, adding primarily to high quality debt where default risk is low and spreads are attractive, while remaining focused on liquidity and mitigating downside risk.