Kames Capital’s Lynch: Two eye-catching alpha trades in fixed income markets

James Lynch, co-manager of the Kames Absolute Return Bond Constrained Fund, says two alpha trades have caught the investment team’s attention in recent weeks.
Lynch, who co-manages the constrained fund alongside Euan McNeil, says that with inflation having the potential to climb in the US, an opportunity has emerged to focus on inflation-linked treasuries. Meanwhile in Europe, there is the potential for fixed income investors to exploit the differing outlooks for France and Italy.
Below, Lynch explains in detail why these two trades in particular are standing out right now.
Short Italy v Long France
“We think Italy is facing both short term and long term difficulties, and indeed, in the near term Italian fundamentals appear to be deteriorating. The recent referendum was rejected, making it harder to carry out the economic reforms the country needs, in turn meaning investors who are going to lend to the Italian government will need a higher rate of return, hurting Italian debt.
“The region is also more likely they get a ratings downgrade by the agencies, and this means that when Italian bonds are used in the financial system as collateral, the person receiving the Italian bonds will then have to apply a higher haircut.
“Contrast this with France. The political problems there will either be extremely profound or non-existent depending on who is elected president. A Macron or Fillon victory will, from an overseas perspective, be seen as a continuation of the status quo, while the possibility of some reforms would be positive for French debt, at least against other European debt markets.
“On the other hand a Le Pen victory is a big risk to the status quo on almost every policy, immigration & defence to foreign policy and economics. Markets though are more focused on her willingness to pull France out of the Euro.
“If this scenario emerged it would dwarf the recent turmoil caused by Brexit, and could lead to investors fearing the total breakdown of the EU.
“Ultimately, when the market has to price an increase in such an outcome it should be much worse for Italy than France because of its current weakness. Italy’s debt dynamics are in a worse state by far than France’s, and in the event of an EU breakdown the market would seek out the weakest links in the system (the periphery and Italy) and focus their attentions on them.
“As such, we think regardless of which scenario does emerge, it is more likely France can outperform Italy, and our focus is on the 10-year segment of the market.”
Long US Treasury Inflation Protected Securities (TIPS) on breakeven expectations
“TIPS are directly linked to how much inflation rises or falls in the US, and thus the more inflation rises, the more these TIPS become valuable assets. In comparison, with nominal treasuries you are locked into the return which can be eroded by inflation.
“The problem for nominal treasuries is inflation and growth. We expect the current inflation rate in the US to move higher over the next few months in the US, and although we don’t know by exactly how much, a rate of inflation of 2.5% looks reasonable.
“We therefore recently bought a 5-year TIP against 5y US Treasuries with a breakeven of 1.98%. If inflation comes in exactly at 1.98% for 5y we breakeven, but if the market at some point were to price in higher inflation expectations we can make money on that spread.
“Even if you take away the most volatile components out of inflation and just focus on core numbers, we see an inflation rate of 2.2% coming through, so even this is above the current 5-year breakeven.
“Of course, Trump’s policies could also prove to be more inflationary, with more spending on infrastructure, or the introduction of tariffs on imports. The market is yet to price such risks in, so inflation expectations could climb even further if these policies are introduced.”