Lead Story: BlackRock anticipates volatility, holds cash

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SIX years ago, widespread propagation of collateralised debt obligations on subprime mortgage loans in the US precipitated the global financial crisis. The nerve-racking meltdown on the financial markets is still fresh in memory.

Yet, in an environment of rising interest rates and slow economic growth, such securitised debts are coming back in favour with fund managers.
“With low global interest rates and a large amount of central bank involvement in the market, it requires a flexible and nimble approach to find the outcome you are looking for,” says Tony Marek, director and portfolio strategist for BlackRock, which directly manages some US$4.5 trillion around the world and advises on trillions more.

In fact, US-based Marek tells The Edge that investors should take a global view and consider asset classes and strategies that they may not be familiar with. After all, he is a member of the BlackRock Multi-Asset Portfolio team that develops and markets such innovative products.

“I am talking about broadening your horizons — investing in these types of asset classes like people’s home loans, pools of car loans and pools of credit cards. And things like mortgages on commercial properties — commercial-backed mortgage securities,” he explains.

While the subprime mortgage crisis of 2008 has left a bad taste in investors’ mouths, Marek points out that with a solid research team, these securities look attractive, especially compared with global high yield assets.

“All assets have risks. Nothing that is low risk is cheap. We have to think about the relative attractiveness. With the improving economic landscape in the US, the credit conditions of these assets stand to improve. This should offset any negative impact of rising interest rates,” says Marek, pointing out that many of these asset classes have much shorter lives than bonds.

After all, improving economic conditions enhance people’s ability to service their borrowings. It is worth noting that the unemployment rate in the US fell to 5.9% in September, the lowest since the financial crisis began six years ago.

Marek concedes that investors may feel uncomfortable investing in non-conventional assets but stresses the importance of being flexible at this juncture.

Ironically, the same assets that investors have flocked to in the past few years — global high yield assets — look relatively risky going forward.

“Many investors have made the same trade over the course of the past several years,  buying large amounts of global high yield assets. When people want to get their money out at the same time, those asset classes don’t behave as well as other asset classes. It isn’t as liquid and as easy to sell,” explains Marek.

Considering that we have had 95 weeks of positive inflow into the US high yield market, global investors have utilised high yield and complacency over low default rates as a solution for all their problems, he says.

“When everyone owns the trade, you have to worry about risk first. What happens when you want to sell [and] there are no buyers?” asks Marek.
Low volatility and low corporate default rates over the past few years have led investors to be complacent, unaware that volatility put an end to it quite dramatically. The volatility in this case is expected to come from a rising interest rate regime in the US that is likely to begin sometime next year, says Marek.

“Rising rates doesn’t mean that they rise quickly. You just face headwinds as an income investor in a rising rate environment,” he explains.
Rates could stay low, and Marek’s view is that it will stay low and climb over time. Nonetheless, it is a difficult paradigm for investors to cope with and will be one of the biggest global issues going forward for investors, he says.

With this in mind, he says his portfolios are holding more cash than it typically does, roughly 10% at the moment.

“We refer to this as dry powder, keeping some [gun]powder dry to invest if the opportunity arises. Currently, we are at 10% cash. Normally, we would hold well under 5% in cash,” he explains.

He says he does not want readers to think that doom is imminent. Holding cash is not a decision to not invest. It is a decision to invest in safety and liquidity and a proxy to fixed income.

“If you look at where your rates are at and where yields are headed, cash becomes a good investment to manage the risk. When the US Federal Reserve begins to move rates, it could create some attractive opportunities to buy assets,” he says.

Liquid markets like the US and Europe will be the key focus, he adds. “We feel that these markets give us the best opportunity to invest in the event of a sell-off.”

Another reason for holding more cash is the fact that the fund is also holding more equities on its portfolio than it normally does. This is because the fund has become quite cautious on global high yield assets that are typically held to generate income for the portfolio. However, as mentioned, a lot of money has been chasing these assets, driving down yields and making it relatively expensive. Thus, to ensure sufficient income is generated and to optimise the fund’s risk profile, BlackRock has been issuing calls on its securities.

“To generate income, we are looking at a unique covered call strategy. This basically allows an investor to benefit from the price movement while enjoying a price coupon,” says Marek.

To create a covered call, a security is bought and a call option is sold on it — the right to buy the security at a specified price.
“For example, we can generate a 12% yield on the equity exposure while giving the client the opportunity to enjoy 5% to 8% upside as well on household names that they would be familiar with,” he says.

Such hybrid assets are ideal in an environment when valuations and credit look expensive and, at the same time, growth is expected to improve. It is an effective way to keep income high while allowing the client to enjoy some price appreciation. Furthermore, the coupon received upfront helps offset the downside the security might have, explains Marek.

Unfortunately, for most retail investors, such strategies require a huge scale to accomplish and would have to rely on large funds like BlackRock.

Alternatively, investors can invest in preference shares. Since they are more senior to common equity (in terms of claim of the companies’ assets and dividend payment) but less senior than bonds, such stocks have characteristics of both equities and bonds. Such stocks may have coupons above 5% and have the ability to appreciate, says Marek.

It is interesting to note that these strategies assume a strengthening global economy, something that has been taking longer than expected compared with the cases in the past. Marek concedes that this is something investors will have to get used to going forward.

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Take a flexible approach .... Investors should take a global view and consider asset classes and strategies that they may not be familiar with, says Marek. - Photo by Reuters

This article first appeared in The Edge Malaysia Weekly, on October 27 - November 2, 2014.