Trends – Institutional Monthly
Generating returns through alternative sources of fixed income
In the current climate, investors need to look beyond traditional fixed income offerings to fulfill their yield and return requirements. Absolute return long/short strategies are one such option.
Risk/return relationship is out of balance for Swiss franc bond investors
Although we have started a new year, for fixed income investors very little has changed, with little return to be had in developed world government paper or investment grade corporate bonds. In Switzerland, the Swiss franc fixed income market has experienced a near 25-year rally with government bond yields decreasing from over six percent in 1992 to negative territory today. At the same time, credit spreads have reverted to their historical averages. This means that credit risk premia has only limited potential to mitigate the effects of low yields.
In the face of falling interest rates, many debt issuers have been refinancing at longer maturities, leading to longer durations in Swiss fixed income benchmarks and, accordingly, higher portfolio exposures to interest rates and credit spreads. These historically high benchmark risks contrast with yields that are close to zero or negative, leading to a risk/return relationship that is completely out of balance.
Common strategies to address the issue of low interest rates are longer portfolio duration or an increase in the exposure to lower quality credit. Both strategies lead to heightened portfolio risks, with elevated credit exposures potentially increasing the correlation of the fixed income portfolio to equities.
Higher market volatility is expected due to decreasing market liquidity
In the aftermath of the financial crisis, stricter regulation has led to significantly shrinking dealer inventories. This has been combined with an increase in outstanding debt instruments and only a small number of market makers acting in Swiss franc fixed income investments. Accordingly, in periods of stress in financial markets, faster and wider price movements in Swiss franc bonds are to be expected due to the lack of intermediaries that absorb investor flows.
Furthermore, in periods of market or idiosyncratic stress, market depth tends to evaporate and bid/offer spreads widen significantly. This pattern is expected to be more pronounced in the future due to the decreasing risk capacity of dealers. This will offer attractive opportunities to monetize increasing liquidity premia in moments of stress by providing liquidity.
Negative expected returns and higher market volatility are the major challenges for Swiss franc bond investors. Investors will therefore need to look beyond traditional fixed income investments to fulfil their yield and return requirements. This is particularly true for Swiss pension funds’ assets, with more than a third affected by low or negative interest rates. One such option would be Swiss franc bond funds that can invest beyond the traditional universe and thereby provide access to alternative sources of fixed income returns.
Access to alternative fixed income returns
Alternative fixed income funds that can access all areas of the Swiss franc fixed income space, including derivatives and the repo market, are able to profit from negative rates and to benefit from diverging valuations between the Swiss and international markets. In addition, with investment conditions expected to remain difficult and market volatility likely to persist, 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 and not only via derivatives, offers investors access to risk premia that historically in the Swiss fixed income market only investment banks have been able to internalize.