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Flexible credit: the upside of downside protection

Flexibility always has a place, but its capacity to provide downside protection makes it particularly important given the advanced age of the credit cycle. In the fourth instalment of a five-part series, we explain why credit investors cannot afford to just rely on rates and diversification for protection. We also consider the robust suite of tools needed to preserve capital during market sell-offs and help protect our ability to take risk when opportunities are greatest.

Safety first

In 2019, much of the news flow was dominated by the stock markets’ longest – and best ever – bull market in history. But arguably, bonds have been on a general upward trend for much longer (the global bond bull market began in 19851). Despite a few significant setbacks, bond prices have risen, and yields have declined for the best part of four decades.

During this time, low interest rates (major central banks reversed course last year and are once again in easing mode), subdued inflation and muted global growth have prompted investors, searching for ways to generate income in the low-yield environment, to buy longer, riskier durations and rely on diversification for protection. And although this backdrop is unlikely to change just yet, vigilance is necessary. That’s because if the market enters periods of tumult in the future multiple lines of defence – not just rates and duration – will be needed to navigate it successfully.

Positively negative

Over the past century, there have been many stock-bond correlation regimes: the rolling three-year correlation was positive from the mid-1960s to 1998, but it has been almost entirely negative since the late 1990s (see figure 1a).

This regime change has been driven by a subdued inflation environment over the past 25 years. Indeed, this can be demonstrated by comparing the correlation of bonds and equities and inflation-linked bonds (real rates) and equities (see Figure 1b). Owing to an environment of low interest rates and disinflation, investors wishing to hedge their credit exposure have used rates, accepting much longer, riskier durations in exchange for yield.

Even though longstanding predictions of the end of the bull market (which started after former Federal Reserve Chair Paul Volcker quashed inflation in the 1980s) have not materialised, it can’t last forever. As such, actively managing duration is therefore important, but investors should not rely on the relationship between interest rates and risk assets to provide protection. This would be a threat to capital in a rising-rating environment.

Figure 1: The yin and yang of financial markets

Source: Bloomberg as at 31 July 2019.

From defence to offence: building a multi-faceted strategy

Diversification: still on the menu?

Harry Markowitz, the Nobel Prize winning economist and godfather of modern portfolio theory, famously remarked that diversification is “the only free lunch in investing” – and although multi-asset credit benefits from decorrelation across sub-asset classes, the rise in correlations2 have eroded the impact of diversification in recent years (see figure 2). For example, during the 2013 taper tantrum, risk assets and bonds declined together, reflecting a higher correlation (we will return to the impact of the taper tantrum later in the piece).

Figure 2. Don’t depend on diversification  

Fixed income asset class correlation (36m rolling v US government bond)

Source: Federated Hermes, Bloomberg and Bank of America Merrill Lynch as at 31 July 2019. Note: the R coefficient is a numerical output used as a correlation measure tool between two variables.

Of course, there is value in adding diversifying sources of return by investing across different sub-asset classes but, given rising correlations, diversification alone should not be considered an adequate source of downside protection.

Dynamism is vital

The defence approach of rates and duration alone is unlikely to offer investors the protection they will need in the event of a market shock. To successfully manage downside risk, we believe dynamism is vital. We understand that a long-only exposure to bonds cannot continue to deliver the strong returns of recent years. Dynamic and flexible allocation allows us to respond to market changes with greater flexibility and security – that is, adjusting our portfolios to seek optimal sources of value throughout the cycle (see figure 3).

Figure 3. Dynamic and flexible allocation through the cycle

For illustrative purposes only. To be measured over the market cycle.

Another way in which we aim to preserve capital is through our ability to access a broad spectrum of liquid credit. This allows us to leverage our credit view across all debt instruments, gives us the ability to diversify our sources of alpha generation, and respond to changes in the market. We exploit relative value through high-conviction name- and security-selection.  We also believe in active management predicated upon bottom-up, fundamental stock picking within a top-down framework. The discipline of assessing and pricing credit, ESG and liquidity risks is deeply ingrained in our investment process. ESG integration is a valuable tool for both downside protection and alpha generation through engagement on key issues that can impact the enterprise value and cash flows.

For example, one of our flexible strategies, Multi-Strategy Credit, aims to deliver positive performance based on superior security selection, sector and geographical allocation (see Figure 4), and by searching for the most attractive deb