In the last two bear markets, duration has provided a valuable source of downside protection. Now, falling yields and the rising correlation between equities and bonds should compel investors to seek alternative defences, says Fraser Lundie, Co-Head of Credit and Senior Portfolio Manager.
Bond prospects: low US bond yields and fears of a market bubble have called into question the role, if any, that a long-duration credit exposure should play in investors’ portfolios in the coming years. This concern is justified: the best indicator of future bond returns, their current yield to maturity, implies returns of 2.15% in the next decade – a period in which interest rates in developed markets will increase from the extremely low levels set during the financial crisis. Such low prospective returns undermine the ability of long-duration instruments to withstand future market shocks.
Limited yield cushion: in September 2000, high-quality, long-duration bonds yielded just over 7%, contributing to their cumulative 22.8% return in the ensuing bear market. In 2007, they yielded 5.3% and provided a cumulative 7.6% return from the outbreak of the financial crisis through to the equity market nadir in March 2009. Such gains provided valuable downside protection, but current yields are unlikely to provide a similarly robust defence in the next bear market.
Rising correlation: negative correlations with equities also drove the strong performance of credit in the last two bear markets. This relationship, however, fluctuates over time and has largely been driven by the relatively disinflationary environment of the last 25 years. The correlation between bonds and equities is now approaching zero, further weakening the ability of credit to preserve capital in episodes such as the taper tantrum, when the two asset classes declined together.
Figure 1. US bond and equity correlation (36m rolling v S&P 500 Index)
Source: Bloomberg as at 30 June
Finding protection: given these dynamics, we no longer consider a long-duration credit exposure to be a source of adequate downside protection. Rather, it is a threat to capital in a rising-rate environment. As a consequence, starting early this year we have reduced duration in the Hermes Multi Strategy Credit Fund.
Dell deal: our recent investments in two instruments issued by Dell, the world’s third-largest PC manufacturer, illustrate this approach. The company’s credit profile benefits from its scale, strong free cash flow, low leverage and commitment to pay down debt, but its sales and earnings are declining amid the growth of mobile devices. In mid-June, we saw good value in Dell’s term loan, which traded about 100bps wider than other investment-grade competitors facing similar challenges. At the time, the five-year credit default swap on Dell was trading about 30bps tighter than its secured loan. Given Dell’s challenges, we invested long in the secured loan, and short through the CDS in a capital-structure arbitrage trade, aiming to benefit from expected decompression in the relationship.
Figure 2. Dell 2020 senior secured bond v five-year CDS
Source: Barclays live as at July 2015
No more Goldilocks: this trade should benefit from broader market stress as the CDS underperforms on concerns of Dell’s creditworthiness. Finding such alternative sources of downside protection to long-duration credit is imperative now that the goldilocks conditions of the past – strong long-term bond yields and negatives correlations – no longer exist.
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