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Unconstrained Opportunities And Cheap Parachutes

GAM’s Tim Haywood believes an absolute return approach to fixed income could prove ideal against a backdrop of rising interest rates and a reversal of QE.

Friday, December 01, 2017

Bond markets are diverse, including such assets as rates, foreign exchange (FX), convertible bonds, investment grade credit and high yield credit. Opportunities from each of these change over time, as the chart below illustrates.

Unconstrained Bond Chart
Source: BofA Merrill Lynch and JP Morgan Indices via Bloomberg. All indices are based on total returns and are displayed in local currency terms, except EM Local. EM Local = JP Morgan GBI-EM Global Diversified Composite, Unhedged in USD. YTD represents performance to 30 Sep 2017

There are currently a number of reasons to be pessimistic in today's bond markets, including a sense that inflation is creeping up. This, combined with very low absolute yields and little volatility, suggests that equities might perform better than their bond equivalents.

Against a backdrop of interest rates starting to rise, fairly flat yield curves and quantitative easing (QE) either stopping, slowing or being reversed, an absolute return approach in the fixed income space is a potential solution.

A near 40-year bull market

The absolute return fund label includes a broad spectrum of strategies, with some almost indistinguishable from traditional long-only products. Whether this is a short-term tactical stance or a hard-wired bias can be difficult to discern, as the bull market in bonds is older than most funds in this peer group.

After the near 40-year bull market in government bonds, the risk / reward profile is negatively asymmetric. For instance, a stress-testing exercise shows that if 10-year UK Gilts reverted to their historical average yield of 5.2%, investors would see mark-to-market losses of around 30%. Even if UK yields merely converge with US yields, investors could see a hit of 7% or so. Assuming the Fed does hike its short-term interest rate in December, this is likely to be followed by two or three 25 bps moves in 2018. There are a number of ways to position for such an environment, including relative value trades, yield curve steepeners and outright shorts.

There are still moves that can be made in the face of unwinding QE – what is important is to be open minded and to look at different ways of doing things. For example, not only can investors buy credit protection, but also ‘insurance on insurance’ by buying receivers, which can protect against credit getting even tighter for very little cost. That is potentially appealing as the absolute entry level of buying credit protection is so low — if something shocking were to happen, the combination effectively constitutes a cheap parachute.

If you believe equities might further outpace fixed income, convertible bonds are another option. Although the corporate bond component no longer has much value, given that interest rates are low and credit spreads are tight, the equity warrant might significantly appreciate in value in strongly rising markets.

Challenges and opportunities for fixed income

The positive news is that divergent economic growth stories and central bank policies are likely to create opportunities across global fixed income markets. This is a good environment for absolute return investors – tight spreads mean you can get more bang for your buck. Low volatility also makes it cheap to insure portfolios against volatility spikes.

Investors have, nevertheless, faced a number of challenges during the last few months, with heightened political tensions supporting a move into defensive assets, while the potential for rising interest rates suggested such a transition could prove costly. While it is certainly true that an environment of policy normalisation could prove tricky for many traditional fixed income investors, the negative outlook that has been so prevalent in the financial press seems overly pessimistic. In fact, the divergence we are beginning to see between central banks in both the developed and the emerging world creates a plethora of opportunities for unconstrained fixed income strategies.

Flexibility of an absolute return approach

An absolute return approach provides active, dynamic exposure to global fixed income markets via a diverse set of assets. To deliver absolute returns a fund’s approach needs to be flexible and adaptable, drawing on the experience of the manager and team. Absolute return fixed income funds aim to preserve capital and consistently deliver positive returns regardless of market conditions. The ability to allocate to different sectors on both a long and short basis at different times provides the broadest spectrum of opportunities accessing multiple sources of return. This flexibility is essential in terms of protecting client capital.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.