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Trends – Institutional Monthly
Fixed income strategies to strengthen your portfolio

06.03.2017 Fixed income strategies to strengthen your portfolio

There is palpable sense among investors that old paradigms are shifting, and that this could cause volatility in economic indicators, interest rates and markets. At the same time, many signals coming from the global economy and financial markets have been encouraging. Yields have eased away from their lowest levels, and should remain stable, and we believe solid growth momentum in the major advanced economies is likely to continue at a pace that does not put severe upward pressure on prices.

The fixed income environment

Global growth should improve somewhat in 2017 but remain well below pre-crisis levels with pronounced differences between regions and countries. Commodity price stabilization in 2016 suggests that inflation should edge higher, most significantly in the USA, which may lead the Federal Reserve to cautiously raise rates further. Other central banks should remain more accommodative. The biggest challenge investors face in 2017 is to find yield at a reasonable risk.

Traditional fixed income approaches have lost much of their attractiveness as investors are pushed into longer-dated and lower-rated bonds in their quest for returns. This is associated with additional risk, which is then even further exacerbated by lower liquidity and increased correlations within the fixed income universe, as well as with other asset classes. However, fixed income has had to adapt to a changing environment, and innovation has broadened the spectrum of possible solutions. A number of interesting approaches are now available to investors that can meet expected challenges, such as absolute return elements to counter high correlations or a systematic focus on short duration to lower interest-rate sensitivity.

Short duration to counter volatile rates

Duration measures a bond’s sensitivity to interest rates – the higher the duration, the more sensitive the bond is to changes in interest rates. With bond prices inversely related to interest rates, and with the latter set to rise, short-duration corporate bonds (typically with maturities of one to three years) could be an attractive investment solution.

There is still much debate about the exact pace of monetary policy normalization. Regardless of how quickly or slowly interest rates rise, short-duration bonds could suit many investors. If interest rates remain low for an extended period, short-duration bonds may be an appropriate investment for those who have excess cash reserves. If interest rates begin to rise, short-duration bonds may be a good choice for investors who have the majority of their fixed income allocation in longer-term bonds.

In the past, bonds offered coupons that were often high enough to offset price changes during periods of rising interest rates. However, current coupons do not offer decent levels of income or protection anymore. Short-duration bonds offer price stability and low volatility by their lower sensitivity to interest rate moves – an attribute that may be at a premium in the coming months.

As carry fails, follow the trend

In an environment where investors are crowded in carry-maximizing strategies with a structural long duration or credit risk exposure, uncorrelated fixed income strategies are needed.

Trend-following strategies are based on the assumption that assets that have performed in the past will also perform in the future, and those that underperformed will continue to do so. A trend-following strategy therefore aims to replicate a pay-out profile similar to a long straddle option strategy (long call and long put option), taking advantage of the mechanics of the long and short positions, which benefit from up-and-down-trending markets but have a stop-loss policy in place to limit losses in adverse or sideways-moving markets.

Studies have convincingly demonstrated the ability of trend-following strategies to generate attractive returns in bonds and equity markets with large drawdowns. This is due to the gradual nature of many market corrections, rather than an abrupt correction over a very short time period.

In other words, trend-following strategies seem to be positively correlated to increasing volatility, which is what we expect over the coming months, and is the exact opposite for carry-based strategies. A trend-following strategy performs best in a trending price environment, independent of a down or uptrend. This advantage, relative to a long-only strategy comes with the price tag of an underperformance in sideways moving markets, where option premiums have to be paid and the stop loss policy is costly. However, as today investors already have plenty of exposure to carry strategies that perform strongly in sideways moving markets, adding trend following strategies enhances portfolio efficiency by offsetting portfolio losses while not reducing the ability to generate returns.

The long and the short of it...

Alternative fixed income funds that can access all areas of the fixed income space, including derivatives, are able to profit from low and even negative rates, and to benefit from diverging valuations between different markets. In addition, with market volatility likely to persist or perhaps even rise, funds that have the flexibility to go both long and short can generate sustainable positive returns in all market situations.

Long/short strategies allow funds to generate returns by combining fixed income instruments without being obliged to take on directional market risks. The ability to implement covered short positions via short sales of securities, as opposed to solely via derivatives, offers investors access to risk premiums that may remain hidden otherwise.

In the Swiss market in particular, this also generates convergence opportunities, which refer to the diverging relative pricing of closely-related fixed income instruments. Examples of this are the combination of a cash bond with a credit default swap, or a long and a short position in two bonds of the same issuer. Funds that have access to all areas of the fixed income market can exploit these opportunities.

Meet high correlations and low yields head-on

The difficult environment for fixed income has forced investors to remain flexible, and the solution-providers to seek new ways of generating returns. Alongside the approaches mentioned above, which primarily seek opportunity via methodological solutions, the market can also be segmented geographically, by rating or by type. By concentrating on emerging markets or on certain regions such as Asia, specific sources of return can be tapped. Convertible bonds can benefit from moves in equity markets although high-yield bonds have lost some of their luster recently due to spread-tightening.

We see the biggest risk of today’s fixed income environment in the reliance on investment strategies that are entirely biased toward carry-related investments with low liquidity and high potential correlation in times of market stress. The approaches listed above offer opportunities to diversify a fixed income portfolio and to access new sources of return. As ever in uncertain times, diversification remains the cornerstone of a rational and prudent investment strategy.

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