The current environment of rising correlations and falling yields means that the ‘barbell’ strategy of combining lower and higher risk assets has lost its ability to preserve capital in times of stress. Investors therefore need to challenge traditional assumptions about risk and where to find protection
No silver bullet: The weakening ability of fixed income to preserve capital needs to be recognised by investors. We have already seen this in effect during the 2013 taper tantrum, when risk assets and bonds declined together. This was an important event which investors should draw lessons from.
The yield cushion is also becoming less comfortable. 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% return in the period leading up 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 today’s historically low starting point of 1.5%.
A global problem: This challenge is evident in the European market as well. The current yield to maturity of German 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 rise from the extremely low levels set during the financial crisis. Such low prospective returns undermine the ability of long-duration instruments to provide returns during future market shocks.
Reconstructing protection: To defend against down markets and opimise risk-adjusted returns, we believe that investors need to deconstruct traditional fixed-income diversification frameworks. For example, given the broader market dynamics, we no longer consider a long-duration credit exposure to be a source of adequate downside protection – the correlation to government bonds is almost one and so poor yields cannot be avoided through fixed-income diversification alone. Rather, it is a threat to capital in a rising-rate environment. Instead, we replace government and long-duration bonds with defensive credit trades, removing any reliance on the relationship between interest rates and risk assets to provide down-market protection. We prefer to replace duration with a portion dedicated to bearish credit strategies. In effect, we combine defensive credit trades to create a bucket which should behave as a government bond would inperiods of market stress.
Working with the curve: One of the credit strategies we use is curve trading, where we take a view on the relative value offered at different points on an issuer’s credit-default swap (CDS) curve. This defensive trade works well when 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, such as asset sales or equity sales – available to the company.
One example of this is ArcelorMittal. While the multinational steel producer faces significant challenges, including the supply of cheap steel from China, higher fixed costs than emerging-market competitors, dependence on global growth prospects and significant pension liabilities, its short-term financial risk is relatively low. It has a favourable maturity profile and strong liquidity – including €3bn in cash and €6bn in credit facilities, more than double the €4bn of debt maturing over the next two years plus the ability to access bond markets for refinancing.
Finding protection: A strong defensive curve trade could include a long position at the two-year point on ArcelorMittal’s curve, established by selling CDS, and a short at the five-year point, implemented by buying CDS. The two-year long position helps support the carry that finances the short. We also expect the two-year CDS to mature without being triggered, given our short-term liquidity outlook. In a sell-off, the five-year point will underperform the two-year because the price of the latter is driven by short-term liquidity while the five-year CDS is driven by longer-term credit prospects.
A new world: Finding alternative sources of downside protection 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 about diversification. Credit portfolios need exposure to different risk models and approaches that have evolved to suit the environment we face.
Fraser Lundie is co-head of Hermes Credit; Andrey Kuznetsov is senior credit analyst
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