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Downside defence: yesterday’s strategy won’t work tomorrow

Hermes Credit

Home / Perspectives / Downside defence: yesterday’s strategy won’t work tomorrow

Fraser Lundie, CFA, Co-Head of Credit and Senior Credit Portfolio Manager
29 November 2016
Credit

Lower-for-longer interest rates, stagnant inflation and muted growth have prompted yield-seeking credit investors to buy longer durations and rely on diversification for protection. With the evidence supporting this defensive strategy diminishing, an alternative approach is needed.

Years of record-low interest rates and stunted inflation have caused dangerous trends to develop in the credit markets. Rising correlations across asset classes have numbed the protective power of diversification, while the hunt for yield has driven credit investors towards longer, riskier durations. We believe that a failure to mitigate these risks amounts to a threat to capital.

The widespread bond sell-off in the days following the election of Donald Trump further emphasised the precariousness of global fixed-income markets. With US interest rates now expected to rise further and inflation to pick up, the assumptions that have long governed credit investing are weakening. We see a pressing need to employ an alternative defence.

The importance of dynamic duration management
With interest rates at record lows and asset prices at historical highs in the last few years, yield has been scarce. This has resulted in investors accepting much longer durations in exchange for yield, exposing them to more risk when rates rise – as they are expected to do in the US and UK.

However, yields from longer duration credit instruments are now so low relative to history that there is no guarantee that they will preserve capital as they have in past bear markets (see figure 1). Conversely, focusing on shorter duration has led some investors to forfeit a significant degree of convexity. Given these circumstances, we believe that actively managing duration is essential.

Figure 1. Declining yields have set long-duration investors up for a mauling

Date US 10-year Treasury bond yield Cumulative total return during bear market
September 2000 6% 27%
2007 4.5% 20.8%
September 2016 2.2% ?

Source: Hermes, Bloomberg as at 17 November 2016.

Low yields have also pushed investors further down the credit-quality spectrum. However, while fundamentals such as balance-sheet health and earnings momentum among investment-grade and stronger high-yield companies are relatively healthy, weaker high-yield issuers are more vulnerable. This has forced investors to gamble on growth, the trajectory of interest rates and the path of the commodity cycle – to which the fortunes of these companies are increasingly tied.

Don’t depend on diversification
A further risk to credit investors is the general rise in correlations, which limit the ability of fixed-income instruments to preserve capital amid volatility. Correlations have risen not only between equities and bonds but also between different credit markets (see figure 2).

In past crises, investors have relied on diversification to provide a buffer against market turbulence because correlations were consistently low. Instead, during the 2013 ‘taper tantrum’, risk assets and bonds declined together, reflecting a higher correlation that has not reverted since. This new reality means that the traditional defensive ‘barbell’ strategy of combining higher and lower risk assets is no longer proving effective.

Figure 2. Correlations among fixed-income markets (36-month rolling v US Treasury bonds)

fixed-income-correlation-chart

Source: Bloomberg as at 30 September 2016.

Dynamic defence, assertive offence
The 30-year government bond bull market can’t last forever and neither can the cushioning effect of rates. However, the traditional defence of yield and diversification is unlikely to offer the protection investors will need in the event of a shock. In the Hermes Multi Strategy Credit Fund, we dedicate a portion of our portfolio to defensive credit trades as an alternative to holding government debt and long-duration instruments.

This defensive bucket is a permanent feature of the Fund. It holds trades that are designed to preserve capital and limit the volatility of the Fund’s returns. By not relying on the correlation between government debt and risk assets, it should lower the overall portfolio’s exposure to the risk of rising correlations.

The trades executed in this defensive bucket are varied. Examples include:

  • Using curve trades on instruments with higher levels of liquidity but weaker long-term fundamentals. This allows us to exploit the differences in relative value at various points on the credit curve. One example is ArcelorMittal, which has low short-term financial risk but faces significant long-term challenges
  • Shorting companies with poor fundamentals, such as Macy’s. We believe that the US department store is less likely to fulfil its credit obligations in the long term
  • Using government-bond futures alongside credit derivatives and loans to reduce the threat of rising interest rates, thereby neutralising our duration exposure

Such trades enable our defensive bucket to mitigate risk more effectively than traditional approaches. This allows us to commit the majority of the Fund’s portfolio to long-only, high-conviction trades. For this best-selection bucket, we look beyond upcoming maturities to capture a better level of convexity compared to what short-duration instruments can provide. This combination of return-seeking and defensive trades has resulted in favourable risk-adjusted returns compared to the high-yield and senior loan markets (see figure 3).

Figure 3. Hermes Multi Strategy Credit Fund: risk-adjusted returns

duration-bar-chart-2

Source: Hermes and Bloomberg

Rethink your defence
The evidence supporting traditional fixed-income defences is weakening. With interest rates likely to increase, duration risk becoming more potent and correlations rising across markets, credit investors can no longer afford to rely on government bonds and diversification for protection. We believe that the defensive trades exercised through the Hermes Multi Strategy Credit Fund provide a robust alternative: not only by reducing downside risk, but by enabling us to devote the majority of our portfolio to seeking upside.

Since the Strategy’s inception in June 2013, it has returned 6.06% on a gross annualised basis in US dollars, and over one year to 31 October 2016 it has returned 8.04%.1

  1. 1 Performance shown is the gross composite performance in USD as at 31 October 2016. A full GIPS disclosure is available on from our factsheet.
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Fraser Lundie CFA, Co-Head of Credit and Senior Credit Portfolio Manager Fraser joined Hermes in February 2010 and is lead manager on the Hermes range of Credit strategies and co-head of credit. Prior to this he was at Fortis Investments, where he responsible for Euro High Yield.  Fraser graduated from the University of Aberdeen with an MA (Hons) in Economics and earned an MSc in Investment Analysis from the University of Stirling. He is a CFA® charterholder and member of the Association for Investment Management and Research (AIMR), having gained the UKSIP Level 3 Certificate in Investment Management (IMC). In 2013, Fraser featured  in Financial News’s ‘40 Under 40 Rising Stars of Asset Management’, an editorial selection pick of the brightest up-and-coming men and women in the industry, and in January 2015, Fraser was named as one of the top 10 star fund managers of tomorrow by The Daily Telegraph. CFA® is a trademark owned by the CFA Institute.
Read all articles by Fraser Lundie