generally rewards investors for investing in longer term instruments. In a normal rate environment, the longer the term to maturity, the higher the yield. Yield can be further broken down into four
1. The real yield, which is based on the term structure of interest
2. The inflation expectations as yields incorporate both real return
3. Credit risk as investors demand greater yield in return for a
reduced certainty of repayment
4. The liquidity premium as investors demand a greater yield in
return for giving up liquidity
There are generally three ways to seek increased returns from fixed
1. Increase term to maturity – This is called duration risk. If rates
rise the price of bonds will fall. This is the trade off – to the
longer the bond the larger price moves in response to changing
yields, increasing volatility.
2. Increase credit exposure – The lower the credit quality, the
higher the coupon. Investors can increase the return by having
more exposure to “credit”. These higher returns come at the
cost of increased risk – both of default and of portfolio volatility. The addition of credit risk comes with another hidden
cost as it reduces the diversification benefits of bonds. During
the 2008 credit crisis, corporate bond spreads increased dramatically and corporate bond portfolios fell in value alongside
equities. An investor holding corporate and high yield bonds
did not see their fixed income holdings appreciate, reducing
the diversification benefits of their portfolio. The lower the
credit quality, the higher the correlation with equities.
3. Give up liquidity – The inability to sell usually commands a
yield premium over comparable issues of similar credit and
term. This liquidity premium can enhance returns, but comes
at the cost of reduced diversification as these securities do not
increase in value in a falling rate environment (they are, in
theory still more valuable though, but that value can’t be realized). The lack of liquidity also prevents your ability to sell and
rebalance or to mitigate losses in the case of a negative credit
event (like a default).
There are a couple of other ways of attempting to enhance the
returns from fixed income holdings. Look abroad to foreign
markets where yields may be higher, though this brings volatility
in the form of currency exposure. Investors can also get more tactical, trading term and credit premiums.
Given these strategies to increase returns in fixed income, we would
remind you – and this is one of the primary purposes of this
study - it is not just about maximizing returns. The diversification
benefits of traditional fixed income and capital preservation it
provides are important considerations. Portfolio theory aims to
increase return AND lower volatility. Taking on any of the above
risks in order to enhance return always comes at the cost of these
two other pillars.
Now that we have a better understanding of fixed income returns
and the costs and tradeoffs that come with them, let’s examine some
alternative fixed income securities, highlighting our three risks:
duration, credit and liquidity:
Credit and Bond Hedge Funds
• Long/Short credit managers have the tools to hedge out certain
risks (like rising rates) and have become popular.
• Both spaces can be attractive, but the mainstream narrative for
choosing these strategies can be flawed. Picking the right
managers is paramount.
2016 saw record fund flows into the High Yield bond market as
investors sought higher returns from fixed income. At the same
time, many have sought refuge with Long/Short (L/S) credit managers because “rates are going higher”, or in the Private Debt space
where there is “no volatility”.
Hedge Funds: L/S credit managers have sought greater returns
while also protecting investors from rate sensitivity, volatility, and
drawdowns. In theory, the ability to go long and short while applying leverage allows them to achieve those results.
We’ve seen this trend with a growing number of Canadian investors
allocating to L/S Credit managers, capital structure arbitrage funds
and duration managed products, in attempts to increase returns
while minimizing various forms of known and manageable risk.
While all these alternative strategies have provided substantially
higher yields versus the fixed income indexes, it is very important
to keep in mind that the risks being taken and some key metrics to
monitor before allocating to these strategies.
When examining duration, it’s worthwhile to find out how a credit
manager is investing your money. Questions you should ask
• What is the average duration of the portfolio?
• How is the manager taking out rate sensitivity through the L/S
• How does the manager track rate sensitivity?
• What is the manager’s track record when it comes to execution?
Removing duration has been a very popular strategy as the narrative
of ultra-low risk-free rates being anything but risk-free persists.
While this narrative came far too early (we have seen many attempts
at marketing this since 2009), it looks to be finally working.