Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Fraser Lundie, co-head of Credit at Hermes Investment Management and Andrey Kuznetsov, Senior Credit Analyst discuss deconstructing fixed income: how to find protection in the new bond world.
The current environment of rising correlations and falling yields means investors are compelled to seek alternative defences, as the traditional diversification ballast of a mix of lower and higher risk assets is no longer effective. This means challenging and rethinking widely held approaches to portfolio management. Within the fixed income arena, current market conditions mean the ‘barbell’ strategy has lost its ability to preserve capital in times of stress and investors need to challenge traditional assumptions around risk and where to find protection.
Ability to Preserve Capital is Diminishing
The reality is that investors need to recognise the decreasing ability of fixed income to preserve capital. We have already seen this in effect during 2013’s taper tantrum, where both risk assets and bonds declined together. This was an important portfolio stress test which investors should heed and draw lessons from.
The yield cushion is also becoming less comforting. In September 2000, US 10 year government bonds yielded 6%, contributing to their cumulative 27% total return in the ensuing bear market. In 2007, they yielded 4.5% and provided a cumulative 20.8% total return from the outbreak of the financial crisis through to the equity market trough 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, given the historically low starting point of just 1.5% today
Risk on Both Sides of the Atlantic
This reason for concern is present in the European market as well. The current yield to maturity of Germany 10 year bunds implies a return of just -0.07% in the next decade – a period in which interest rates in developed markets are likely to increase from the extremely low levels set during the financial crisis. Such low prospective returns undermine the ability of long-duration instruments to provide returns through future market shocks.
Where Can Investors Find Protection?
So, the question for investors is where to find protection. To achieve this, we believe we need to deconstruct traditional fixed income diversification frameworks to optimise risk adjusted-return allocations.
For example, given the broader market dynamics, we no longer consider a long-duration credit exposure to be a source of adequate downside protection – its correlation to Government Bonds is almost one and so the above obstacles are not eradicated by simply diversifying one’s fixed income allocation. Rather, it is a threat to capital in a rising-rate environment to do so.
Thus, we believe the key is replacing the necessity to hold government and long-duration credit with defensive credit trades, thereby taking away the reliance on the relationship between interest rates and risk assets. As the below diagram shows, we replace duration’s traditional role as capital protector with a portion of the portfolio dedicated to bearish orientated credit strategies. In effect we are looking for this bucket to behave like a government bond would in times of market stress.
Curve Trades to Provide Downside Protection
One of the credit strategies we use within the defensive bucket is curve trading, meaning we take a view on the relative value of different points on a name’s CDS curve. This defensive trade works well on names where we are cautious on the longer term fundamentals of the business but have a favourable view of its liquidity profile, taking into account all sources including cash, committed credit facilities and levers available to the company such as assets sales or equity sale.
An example of this approach is shown in our holdings in ArcelorMittal. This is an integrated steel company exposed to cyclical industries, challenged by the supply of cheap steel from China while having higher fixed cost challenges than its emerging market peers, who have the benefit of weakening local currency.
It also has less flexible production techniques and significant pension liabilities. Even with improving steel prices, the free cash flow generation is weak post pension payments. The company is heavily exposed to global growth prospects, especially in China. However, its short-term financial risk is low.
Our view on its financial risk is supported by its favourable maturity profile, strong liquidity and ability to access bond markets for refinancing. Following its recent liability management, there is less than €4 billion of debt maturing over the next two years. Its current liquidity stands at €9 billion and consists of €3 billion in cash and €6 billion credit facilities, more than double the maturities in the next two years.
With bonds around the five year point trading not far away from par, we think that ArcelorMittal will be able to opportunistically access the bond market to cover its short-term maturities. This is supported by recent issues by North American steel producers like AK Steel and US Steel, and European producers such as Outokumpu and ThyssenKrupp.
As a result, a defensive curve trade in the name could be to take a long position at the two year point on the curve by selling CDS, and combine it with a short at the five year point by buying CDS. First of all, the two year long helps support the carry to finance the short. Secondly, we expect the two year CDS to mature without triggering given our outlook on two year liquidity. Thirdly, in a sell-off environment the five year point will underperform two year as a result of the fact that the two year CDS price is driven more by short-term liquidity while the five year CDS is driven by a longer-term credit view on the name.
The New Bond World
We believe that 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 negative correlations – no longer exist. Event risk, such as the taper tantrum, has already challenged traditional assumptions around diversification. Portfolios need access to different risk models and approaches that have evolved to suit the environment we face.
If investors want to thrive in this new bond world, it’s time to think differently.
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