Fixed Income. Bond Management in a Volatile Interest Rate Environment January 2014

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1 Bond Management in a Volatile Interest Rate Environment As central bankers ponder fine-tuning monetary policy, yield volatility promises to rise over the coming months. This will reinforce the importance of strategy and manager selections, as bond portfolio returns are more likely to be driven by the skill of the manager rather than market beta, says Roubesh Adaya, director at

2 2 In an increasingly volatile market, consider an expanded toolkit Table of contents 03 A New Paradigm for Bond Markets 04 A Need for Income Protection 05 Preservation Strategy 06 Active Unconstrained Portfolios 07 Call for Active Bond Management is an independent, privately owned, financial services firm that provides advice and solutions to companies and institutional investors around the globe. We combine specialist expertise with a global perspective to help our clients develop, implement and manage best-in-class investment programmes. Our in-house capabilities span all traditional and alternative asset classes. We deliver high-quality, customised services. Our teams have earned a reputation for innovative research, reporting and fund selection. Increasingly, as our clients needs evolve, we also act as a specialist advisor. is headquartered in London, with offices in Paris, Amsterdam, Munich, Dubai, New York and Montreal. The firm has advised over 300 of the world s most sophisticated institutional investors across over 25 countries and with total assets in excess of $1 trillion To receive future publications in electronic form about this topic or others, please visit our Web site at

3 3 A New Paradigm for Bond Markets The unprecedented decline in interest rates observed over the last 30 years, which benefited the majority of fixed income asset classes, especially the riskier paper, should now give way to a period of normalisation. US Federal Reserve chairman Ben Bernanke s comments before Congress on May 22 about the possibility of a slowdown of the quantitative easing (QE) programme in the following months propelled the vast majority of active bond managers into a new paradigm, characterised by more volatile and rising interest rates. This means that increasing spread risk and relying on directional duration trades (in a tactical move to make money from central banks asset purchase programmes) are no longer valid strategies to achieve consistent outperformance. Right after Ben Bernanke s comments, investor sentiment that the party is over resulted in a spectacular rise in 10-year US Treasury yields by over 100bps. These first signs of tightening were replicated across bond markets globally in a relatively short period of time. Along with rising interest rates and term premiums, increased volatility may also render the future value of portfolios less predictable. With the upcoming appointment of Janet Yellen as the new Federal Reserve Chairman, and on the back of the United States federal government shut down, Government bonds have rallied back to lower levels. Sophisticated investors though, have already started to position themselves to counter the impact of more volatile interest rates. Massive asset purchases have dampened volatility across fixed income markets over the last years, whereas the removal, or reduction, of quantitative easing programmes may result in heightened volatility. Renewed Interest Rate Volatility since May ,9 0,8 2-year US Treasury Yield (%) LHS 30-day Annualised Volatility (%) RHS 4,00% 3,50% 0,7 0,6 0,5 0,4 0,3 0,2 3,00% 2,50% 2,00% 1,50% 1,00% 0,1 0,50% 0 0,00%

4 4 A need for Income Protection While the fragile economic recovery suggests a slow rise in interest rates (especially as inflation pressures are mild), forward guidance, as well as the introduction of soft unemployment and inflation targets into central bank monetary policies, create significant need for active duration management. As a reminder, duration represents the sensitivity of a fixed income instrument to movements in prevailing interest rates. Portfolios with elevated duration tend to perform better than those with lower duration when yields are falling. Conversely, they underperform when yields rise. Several interest rate management strategies have been put forward over the last few years by asset managers to control the sensitivity of fixed income portfolios. Among them, shorter duration products across the fixed income spectrum have attracted wide interest from institutional investors, as evidenced by the numerous manager selection searches conducted by for this strategy since Investors also expressed a willingness to sacrifice liquidity to protect their portfolio against rising yields, with senior loans having been in high demand. Investment flows into this asset class have driven much of the returns over the last two years. Importantly though, fixed income managers have started to require more leeway when managing against benchmarks, or through duration-neutral portfolios. With returns likely to be driven by alpha over beta, the more active managers have developed an array of tools to deliver absolute return. Several interest rate management strategies have been put forward over the last few years by asset managers to control the sensitivity of fixed income portfolios.

5 5 Preservation strategy To protect against rising yields, duration management has become a critical part of any interest rate desk and the use of interest rate futures has become more acceptable to clients. Hedging out duration to zero may be useful to eliminate interest rate risk, but it also means that should yields fall, the portfolio would not benefit from this positive effect. While allowing wider duration guidelines to an external fund manager may involve better protection if yields are rising, the strategy remains heavily reliant on the manager s view of where interest rates will be heading. Based on an annualised volatility target of 1% for efficient comparison of excess returns, the track record of interest rate overlay strategies, obtained from investment managers, shows substantial dispersion across the universe. On the plus side, a few managers substantially outperform on a risk-adjusted basis over LIBOR. Among the 12 overlay strategies analysed, the style of interest rate management varies, with some managers opting for pure quantitative approaches, while the majority of investment houses opt for a blend of quantitative and judgmental analysis. Ultimately though, the median return of interest rate overlay strategies is low, at 0.08%, illustrating the managers difficulty in using interest rates as a significant source of alpha on a stand-alone basis. To a large extent, this is the main problem of active strategies based on duration only. While managers using duration as a pure hedge against rising interest rates seem to be successful in protecting assets, they struggle to deliver excess returns in environments where yields rally. Minimising duration may be key to deterring negative performance in times of rising yields, which is not a certainty given the reactive nature of Central Banks at the moment and an increased emphasis on data. On a stand-alone basis, interest rate overlay may not prove sufficient for managers to deliver positive returns consistently. An increase in the term premium for Sovereign bonds may ultimately lead to more opportunities for alpha generation within Government securities, but over the last year, returns have been subdued at best, with few managers able to fully utilise their risk budget in that space. One year Performance of Interest Rate Overlay - %

6 6 Active unconstrained portfolios Unconstrained portfolios, especially those with zero duration and using multiple alpha sources, have been a noticeable offering across investment houses. The systematic use of multiple alpha strategies, especially if they are uncorrelated, can ensure that the manager is able to use his risk-budget in ways that are more optimal over time. Some market environments are more conducive to certain types of strategy than others and managers may not always be able to fully utilise the risk budget allocated to interest rates in particular market configurations. In those cases, it is essential to provide sufficient resources in other areas where the manager is able to implement trades. The contrasting styles and best timing for the use of different alpha strategies has led certain institutional investors to study unconstrained portfolios, where managers are left to freely implement their views through the use of multiple sectors, geographies and instruments. Asset managers offering absolute return strategies purely focused on fixed income seem to deliver better performance than managers following a single-strategy portfolio focused on duration management. Using an annualised volatility target of 1% as above, the 18 track records analysed illustrate a higher median return over the last year, at 1.66% for multi-strategies versus 0.08% for strategies focused on duration management. Diversification also seemed to be at play, with managers able to use other sources of alpha to allocate their risk budgets when interest rate strategies were not performing. In comparison to managers concentrating on duration management, multi-alpha portfolios have been able to deliver positive absolute returns more consistently. The lowest return for Interest Rate Overlay strategies was -2.42%, in contrast to multi-alpha strategies, where the lowest return was -0.71%. Asset managers offering absolute return strategies purely focused on fixed income seem to deliver better performance than managers following a single-strategy portfolio focused on duration management One year Performance of Absolute Return Strategies - %

7 7 Call for active bond management The importance of interest rate management has increased over the last few months, but it may not consistently offer the best alpha opportunities over time. While central bankers consider fine-tuning monetary policy, active management will become more important, as the market becomes more volatile. Investors should however be careful about the underlying strategies in which those funds invest. While current market dynamics present opportunities for the long-horizon investor to lock in high margins, strategies relying on this type of asset class as their primary source of added value may not fare so well should there be a dry-up in liquidity as a result of a sudden risk-off event. However, with significant diversification re-allocate risk budgets, the opportunity for increased returns may outweigh the increased risk-taking. The choice of manager will be critical, as a bigger proportion of returns are now likely to be driven by manager skill, rather than market beta. Finding the right manager, who is able to benefit from interest rate management will be vital, but investors should also be on the lookout for sources of alpha, where the return per unit of risk may be a more pertinent approach.

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