Using Derivatives in the Fixed Income Markets A White Paper by Manning & Napier www.manning-napier.com Unless otherwise noted, all figures are based in USD. 1
Introduction While derivatives may have a negative connotation to some investors, it is common for fi xed income managers to simply utilize them as risk management tools to adjust exposure to interest rate, credit, and currency risk rather than a means to take on excessive risk/leverage. As such, when discussing fixed income derivatives, we believe it helps to classify them based on the specifi c risk they can be used to help manage. The bullet points below will highlight certain types of derivatives associated with interest rate risk, credit risk, and currency risk, respectively. Likewise, we will also highlight how similar types of risk exposure can be achieved in the cash bond markets (i.e., by purchasing individual bonds). Interest Rate Risk The risk of adverse interest rate movements. Increase (decrease) exposure by purchasing longer (shorter) maturity bonds Interest Rate/Treasury Futures» Contract to buy/sell U.S. Treasury bonds at a certain date and at a predetermined price» Long futures position = Buying Treasury Bonds = Increase interest rate risk exposure» Short futures position = Selling Treasury Bonds = Decrease interest rate risk exposure» Treasury futures were fi rst introduced on the Chicago Board of Trade in 1977» Highly liquid market with 2.96 million of daily contract volume during 2013 (contract size is either $100,000 or $200,000)» Highly regulated and traded through a central clearing exchange operated by the CME Group Credit Risk The risk of default and/or widening credit spreads. Increase (decrease) exposure by allocating more (less) assets to spread sectors (e.g., corporate bonds) Credit Default Swaps (CDS)» Sellers of CDS receive periodic payments from the buyer and agree to compensate buyer in the case of a credit event (e.g., default)» CDS can be issued on individual corporate issuers or corporate bond credit indices» Buying CDS = Decreasing spread sector allocation = Decrease credit risk exposure» Selling CDS = Increasing spread sector allocation = Increase credit risk exposure» The value of CDS generally changes as the perceived default probability of the company/index on which the CDS is written increases/decreases» CDS were fi rst created in the 1990s. As of December 2014, credit default swaps were used to insure bonds with a market value in excess of $16 trillion Total Return Swaps» Used by investors to exchange return streams» An investor could agree to pay LIBOR (London Inter-Bank Rate) and receive the returns of a given fi xed income index (e.g., investment grade credit or high yield credit index)» Entering into an agreement to pay LIBOR and receive the returns of an investment grade credit index would provide similar portfolio exposure to selling CDS or buying investment grade corporate bonds 2
Currency Risk The risk of adverse currency movements (usually relative to the U.S. dollar). Increase (decrease) exposure by allocating more (less) to bonds denominated in foreign currency (or actual foreign currency) Currency Forwards» Agreement to buy/sell currency at a certain date and at a predetermined exchange rate» Long position = Buy foreign currency (sell U.S. dollars) = Increase Currency Risk exposure» Short position = Sell foreign currency (buy U.S. dollars) = Decrease Currency Risk exposure» Currency forwards are among the most common means of gaining currency exposure» Developed in the 1970s. As of December 2014, there was approximately $76 trillion of notional market value outstanding related to foreign currency derivatives contracts Derivatives Use in Manning & Napier Fixed Income Portfolios The current fixed income market environment presents several challenges for fi xed income investors. While investors may have benefi ted from a sustained period of declining interest rates since the 1980s, similar tailwinds to future fixed income returns appear less likely with interest rates remaining near historical lows. Specifi cally, the current level of interest rates has two important implications for fi xed income investors: The possibility of interest rates increasing from current levels may raise the likelihood of negative fi xed income returns going forward, given the inverse relationship between interest rate movement and bond prices The current yields (and futures return potential) of many fi xed income securities may not be suffi cient to meet investors long-term objectives Broadly speaking, we believe that the compensation for taking interest rate risk in the current environment is unattractive. Therefore, given current yield levels, the fl exibility to use a greater variety of tools to in an effort to generate absolute returns may help investors achieve their long-term goals. We believe that fi xed income derivatives are tools that can be effectively utilized to help meet the challenges facing fi xed income investors. As such, Manning & Napier is incorporating derivative use into our most fl exible fi xed income portfolio. While derivatives can be used to introduce excessive risk or leverage into a fi xed income portfolio, Manning & Napier will use derivatives primarily for risk management purposes and to execute desired portfolio positioning. To help illustrate how derivatives could potentially be utilized within our fixed income portfolios, highlighted below are specific examples of how various derivatives may be used to adjust exposure to interest rate risk, credit risk, and currency risk. Interest Rate Risk During environments in which interest rate risk exposure is deemed unattractive, the investment manager of a typical aggregate bond product would generally position the portfolio to have a lower duration. This can normally be executed by selling longer maturity bonds to purchase shorter maturity bonds. Should interest rates increase, the portfolio may produce returns that exceed the benchmark on a relative basis. However, given the current low interest rate environment, there is an increased probability of negative returns. As such, Manning & Napier could use derivatives to hedge those risks that we do not believe our clients are being compensated for and target those exposures that we view as being attractive. As mentioned previously, interest rate futures can be an effective tool for adjusting a portfolio s exposure to interest rate risk. For example, if we wanted to decrease portfolio duration from fi ve years to three years, we could sell longer maturity bonds to purchase shorter maturity bonds, or we could sell interest rate futures. However, the use of interest rate futures may actually allow us to specifi cally hedge a bond s interest rate risk while maintaining exposure to its other risks. For instance, if the credit spread on a 10-year corporate bond is deemed attractive given the issuer s fundamentals, but the compensation for the bond s interest rate risk is unattractive, we would be less likely to own the security in a traditional aggregate fi xed income product. However, in our most fl exible portfolio, we could purchase the bond and use futures to hedge its interest rate risk exposure (i.e., sell futures), leaving exposure only to the bond s credit spread, which is viewed as attractive. 3
Credit Risk The use of derivatives that manage exposure to credit risk is best explained in the context of the likely adjustments to the credit exposure of our fi xed income portfolio throughout a full credit cycle. In general, a full credit cycle would begin with an environment of relatively wide credit spreads (i.e., increased perception of credit risk) with spreads generally tightening as the cycle progresses. From a valuation perspective, we anticipate that our credit exposure would generally be higher at the beginning of a credit cycle, and decline as the cycle comes to a close. While credit exposure is generally expected to be higher at the beginning stages of a credit cycle, there may be instances where the markets become overheated on a shorter-term basis. In these instances, we may not wish to sell individual bonds as re-obtaining exposure could be difficult, but still target a lower level of credit risk in the portfolio. To accomplish this type of positioning, credit default swaps (CDS) could be purchased on individual bonds or various credit indices to reduce exposure to credit risk without selling individual bond positions. Likewise, toward the end of a credit cycle, credit default swaps may be used more broadly to effi ciently hedge credit risk in the entire portfolio. Effectively, we would purchase CDS on part of the portfolio s credit exposure and pay premiums in exchange for partly hedging the portfolio from declining credit prices (widening spreads). In this respect, CDS would be used primarily for risk management purposes and not to introduce excessive risk/leverage into the portfolio. Currency Risk When discussing interest rate risk, we highlighted how interest rate futures could be utilized to hedge a corporate bond s interest rate risk exposure while preserving its credit risk exposure. While most spread sectors have a degree of credit and interest rate risk, foreign bonds denominated in currencies other than the U.S. dollar also posses currency risk. In certain instances, we may determine that some non-dollar bonds offer attractive yields although our view on the bond s actual currency is negative. Just as derivatives can be used to hedge a bond s interest rate risk exposure, they can also be used to hedge its currency risk. In the example described above, if our view on the bond s currency was negative, we could enter into a forward currency contract to sell that particular currency and buy U.S. dollars. As such, we could lock in the current exchange rate between that currency and the U.S. dollar, to help minimize the impact of currency movements on the bond s future returns (thus isolating its attractive yield). Broadly speaking, the use of currency forwards is fairly common across asset classes and is also utilized on a limited basis by many international equity managers. Conclusion Almost any type of security can be utilized to take excessive risks within a portfolio. However, Manning & Napier fi rmly believes that exposing a portfolio to certain risks is only prudent when the compensation for taking those risks is attractive. Likewise, we believe that fl exibility and the ability to utilize a wide variety of investments is key to meeting investors long-term objectives. Given the challenges faced by fi xed income investors in the current low interest rate environment, we believe incorporating limited exposure to certain derivatives increases our set of risk management tools and can help investors achieve their long-term goals. 4
Analysis: Manning & Napier Advisors, LLC. Manning & Napier Advisors, LLC (Manning & Napier) provides a broad range of investment solutions including separately managed accounts, mutual funds, and collective investment trust funds. For more information about any of the Manning & Napier Fund, Inc. Series, you may obtain a prospectus at www. manning-napier.com or by calling (800) 466-3863. Before investing, carefully consider the objectives, risks, charges and expenses of the investment and read the prospectus carefully as it contains this and other information about the investment company. All investment strategies involve risks and there is no guarantee of a profi t, or protection against a loss. Investments in derivatives can be highly volatile and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation, and liquidity risk. Also, the use of leverage increases exposure to the market and may magnify potential losses. There is an inverse relationship between bond prices and interest rates; as interest rates rise, bond prices (and therefore the value of bond funds) fall. Likewise, as interest rates fall, bond prices and the value of bond funds rise. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Duration is a measure of the expected life of a fi xed income security that is used to determine the sensitivity of a security s price to changes in interest rates. The prices of fi xed income securities with shorter durations generally will be less affected by changes in interest rates than the prices of fi xed income securities with longer durations. For example, a 10 year duration means the fi xed income security will decrease in value by 10% if interest rates rise 1% and increase in value by 10% if interest rates fall 1%. Manning & Napier provides investment advisory services to Exeter Trust Company (ETC), Trustee of the Manning & Napier Collective Investment Trust funds. The Collectives are available only for use within certain qualifi ed employee benefit plans. The Manning & Napier Fund, Inc. is managed by Manning & Napier. Manning & Napier Investor Services, Inc., an affiliate of Manning & Napier and ETC, is the distributor of the Fund shares. Approved CAG-ALL-PUB004 (7/15) 5