Duration: In it for the short-haul
Was it just ten years ago that the likes of Hank Paulson and Tim Geithner were household names and strange acronyms such as CDO were common parlance?
Ten years ago, the collapse of investment bank Lehman Brothers was making headlines around the world. Today, we remember it as the most high-profile casualty of the financial crisis – an event that exposed the dangerously symbiotic relationship between the financial sector and the global economy. The world’s key central banks worked in tandem to lower interest rates, striving to soften the recessionary fallout. And for investors in fixed income, it marked the start of a new era – hallmarked by a decade of low rates and unprecedented central-bank asset purchases. The age of QE (quantitative easing) had begun! In a sense, the period since the GFC, underpinned by the flow of QE, has been ‘easy street’ for investors in security markets. Exposure to risk assets has been all-important; selection of those assets much less so. However, this may all be about to change, and a discerning, more fundamental and discriminating approach is likely to be required.
New challenges and new solutions
Investors are now faced with a different set of challenges: the support harness of QE is gradually being cut, the comfort of rock-bottom interest rates is disappearing and it appears that we are in the later stages of the current economic cycle.
With this in mind, what options are available to fixed income investors? Short-duration global high-yield offer higher relative yields but limited interest-rate risk, with globally diversified issuers.
In terms of positioning, Figure 1 shows the high relative yield that a short-duration global high-yield strategy can achieve in comparison with other sectors of the market.
Figure 1: Solution 1 - Short Duration Global High Yield
Duration (the sensitivity of a bond’s price to changes in interest rates) is a key consideration for investors. With interest rates on the rise – most evidently in the US but also in countries such as the UK, Canada and India – reducing interest-rate risk is clearly an appealing strategy. And while high yield has tended to perform well when interest rates are rising given the spread cushion and lower levels of duration, short duration currently offers a similar amount of risk for around half the amount of duration risk.
Short-duration bonds have another advantage in that they are less sensitive to changes in credit spreads, which are as tight as they have been since the GFC. This suggests that valuations are high. And short-duration bonds can help protect value in this environment.
High valuations do partly reflect the low default rates currently prevailing in the market. Whether this current backdrop survives a slowing global economy and changing dynamics around credit risk remains to be seen.
Figure 2: A sound fundamental backdrop
An active approach
Nevertheless, it seems clear that these low levels of default and elevated correlations across the fixed-income market has resulted in investors becoming less discriminatory. Faced with a potential shake-out, especially one in which correlations naturally begin to break down, investors would most likely benefit from being exposed to active management. Such an approach – diligent and focussed selection of the most promising issues – should limit exposure to the worst of any market turbulence.
Our short duration approach offers superior risk-adjusted returns, with lower volatility and drawdowns than the index.
Looking back to see forward
The GFC created many deep and varied fissures in the economic and financial system. QE was the cover-all remedy and has allowed the world to recover and regain its strength. However, the addiction to easy money is still there and at some risk of relapse as the patient is slowly taken off the medication upon which it has become perhaps too reliant.
As we enter this phase of tightening monetary policy and potential economic slowdown, it is important to take stock of one’s positions and not sleepwalk into capital losses through duration-heavy investments. The short-duration flavour of global high-yield may not answer all the questions posed, but it does offer a practical and ready-made strategy against an uncertain backdrop.
The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.
Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.
These strategies use derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the strategies may suffer significant losses.
These strategies may invest in other strategies, which means the overall strategy charges may be higher.
Certain assets held in these strategies could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at September 26, 2018. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment. In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000