Our clients want many things from bonds: income, diversification, liquidity, outperformance. But one goal consistently rises above the others: stability. Here, our fixed income team discusses how our Strategic Bond strategy offers stability, especially in the current environment of rising interest rates.
For many investors, fixed income plays a clear stabilizing role in their portfolio, so their primary concern is ensuring that their bond investments help them preserve capital.
But as rates have risen over the past few years, investors have started to question the stability of bonds. The 10-year Treasury yield rose from 1.36% in July 2016 to nearly 3% in February 2018; 10-year Treasuries declined by 8.5% over that time frame, no doubt unnerving many investors who look to bonds for stability.
Our Strategic Bond Strategy is specifically set up to provide stability, even in a period of rising rates. The strategy seeks to maintain a low duration, and we use a number of tools to dampen volatility from rates while still providing the income, diversification and liquidity our clients seek. As such, we believe that the strategy can play a valuable role in portfolios at all points during the rate cycle.
EXCHANGING THE UNKNOWN FOR THE KNOWN
The Strategic Bond Strategy uses various credit instruments to garner yield while maintaining a low duration. At its core, the strategy exchanges what we view as “unknowable” macroeconomic risks for more “knowable” credit risks. Duration bets require macroeconomic forecasts, which involve a near-infinite number of variables. But credit analysis is a more concrete endeavor; it involves the study of well-defined assets and cash flows pledged to investors. We put every bond we consider through a disciplined and thorough process to measure default probability as well as projected losses in bankruptcy and other downside scenarios. We believe this process provides reasonably reliable estimates of upside potential and downside risk; these estimates help us choose our investments and guide our capital allocation decisions (e.g., how we size our positions and exposures). The resulting portfolio offers, in our view, a favorable mix of stability and return potential.
As bond investors, we have diverse tools at our disposal to achieve stability, income and other objectives. We use many of these tools across all of our strategies, but with Strategic Bond, we are not constrained by the overarching objective of tracking a benchmark.
Benchmark-driven strategies need to accept interest rate risk almost by definition—either they bet on the duration risk embedded in the benchmark or they make a different bet by diverging from the benchmark. In an unconstrained strategy like Strategic Bond, we can seek returns without being beholden to the direction of interest rates. This flexibility lets us concentrate our portfolio and our research efforts entirely on finding good credit ideas.
Exhibit 1: An Unsettling Foundation
Rising rates in the past few years have led to meaningfully negative returns for 10-year Treasuries. This experience has rattled investors who seek stability from their fixed income investments. As we discuss in this article, we think that stability can be achieved through a low-duration approach.
How does this flexibility help us defend against rising interest rates? With a credit-based portfolio, we can often achieve yield as high (if not higher) than traditional bond benchmarks, but with meaningfully lower duration. Our strategy typically has a duration of between one and two years, vs. the typical four- to six-year duration of most intermediate-term bond funds. Thus, our portfolio is typically less sensitive to rising rates.
FOCUS ON DOWNSIDE PROTECTION
Our investment process focuses heavily on downside protection—this aligns with the priority that we and our clients place on stability. Simplistically, bondholders want to collect attractive income and get their principal back; our process seeks to ensure that a bond’s yield and valuation compensate us fairly for the downside risk of principal loss.
In this process, we rigorously examine the probability of default, and we also put every bond we consider through a thorough bankruptcy valuation. Not every manager takes this latter step, as it is time-consuming, but we think it is essential. Not only does this enhance our understanding of a given credit and its issuer, but it provides us with a better analysis of “gap risk,” or how far the bond might trade down given an adverse event. With duration risk largely removed, credit risk is the primary source of volatility, and our focus on downside helps us control this risk. A bond’s downside volatility will be lesser or greater depending on its asset coverage and other factors that influence projected losses in default or bankruptcy. This is true even outside of a worst-case scenario. If two companies have similarly bad quarters, the bonds of the company with greater asset coverage will, in most cases, decline less than the bonds of the company with weaker asset coverage.
DIVERSE AND RELIABLE TOOLKIT
Beyond our general emphasis on lower-duration bonds, we use three main tools to promote stability and protect our portfolio from rising interest rates.
Hedging with U.S. Treasuries. We directly hedge against rising rates by using simple Treasury futures. The concept of hedging often brings to mind a variety of specific risks, but we note that the Treasury futures we use are highly liquid, trade on public exchanges, and generally provide a transparent and flexible method for countering interest rate risk found elsewhere in the portfolio.
Amortizing bonds. Some bonds actively pay back principal over their term, such as asset-backed car loan bonds. Most of these loans are originally five or six years, but generally the securitized bonds that we buy are designed to pay off entirely within two years. Because these bonds are rapidly returning principal, they tend to be more stable and less sensitive to rising rates. We also benefit from the return of principal, which we can then reinvest at higher yields. In Exhibit 2, we show how several bonds performed as interest rates rose between July 2016 and February 2018—as mentioned, the 10-year Treasury generated a negative return (approximately -8%) during this period. We owned a Santander AA-rated auto bond during this period with an average life of about two years that returned +2.6%, while two-year Treasury yields rose from 0.55% to 2.26%.
Exhibit 2: Tools of the Trade
This chart shows the different outcomes of various investments over the past few years as interest rates have risen. 10-year Treasuries have produced a negative return, but instruments such as amortizing bonds and floating-rate bonds—illustrated below by the Santander and Och Ziff examples, respectively—have performed well.
Floating-rate bonds. The coupon rates of these bonds periodically reset based on short-term interest rates (they are usually tied to LIBOR). Because of this, their prices remain stable when rates rise. In recent months, 40–50% of the strategy’s portfolio has been invested in floating-rate bonds. We should note that this choice has not resulted in any sacrifice of risk-adjusted return; recently, our analysis has indicated that in many asset classes, floating-rate bonds—again, with nearly zero interest-rate risk—are offering comparable yields to intermediate-term fixed-rate bonds.
In the chart below, we highlight another bond from our portfolio, a floating-rate, Aa2-rated collateralized loan obligation (CLO). During this period, the CLO’s coupon rose from 2.71% to 3.87%, while its underlying price also rose from $98.80 to $100.70.
Most traditional fixed income benchmarks do not include floating-rate bonds and have very few of the aforementioned actively amortizing asset-backed bonds. Because of this, many strategies that track traditional benchmarks avoid these sectors for fear of increasing tracking error. This is not an issue for us; the flexibility of this strategy’s unconstrained approach gives us greater freedom to pursue value where we find it.
PUTTING THE PIECES TOGETHER
With our flexible mandate, we can invest wherever we identify value. Thus, bottom-up valuation of individual securities is a major driver of our capital allocation across sectors. Since we put all bonds through the same upside/downside process, we can compare value across disparate sectors—for example, we can judge whether the risk-adjusted spread on a corporate bond is more attractive than that of an asset-backed bond.
Importantly, this allows us to allocate capital without making macroeconomic predictions. Getting big macro calls right can usually boost returns, but getting them wrong leads to instability. We try to keep our focus on “knowable” drivers of risk and reward, and allocate capital where we see the most favorable balance. We are always allocating capital to those securities that we believe offer the best risk-adjusted returns based on our fundamental credit analysis and proprietary risk pricing model. While this process allows us to opportunistically move down in quality as value opens up in wider-spread environments, it also dictates that we allocate capital to safer assets when spreads are tight. Put another way, the process seeks to mute volatility during periods when credit is selling off, and embrace opportunity when the credit markets offer it.
We believe that this low-duration, credit-driven process puts us in a good position to offer our clients an attractive blend of income, performance and—last but certainly not least—stability.
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