Unconstrained Bonds – Taste the Secret Sauce
Unconstrained fixed income has become a popular strategy. By choosing investments that are free from benchmark constraints and that allow the managers wide-ranging discretion, investors aim to achieve consistent positive performance irrespective of a potential turn in the interest rate cycle. But in a world of low prospective returns, a successful unconstrained bond strategy needs some secret sauce to meet investors’ expectations.
Expectations and challenges
Increasingly, both institutional and retail investors are looking for the same characteristics for an allocation to their portfolios: consistent positive returns, lower volatility and shallower drawdowns than traditional strategies - and on a shorter-term timescale.
But today’s environment poses some unique challenges. Across the investment spectrum, valuations are mostly rich, and drawdown risk correspondingly high. Volatility has been artificially depressed by extraordinary measures from the world’s central banks, but could rebound anytime as policy support starts to taper away.
Secret sauce: The ingredients
In this environment, simply relying on an allocation to credit beta and a diversified but broadly static fixed income asset mix is a recipe for disappointment. We believe that unconstrained bond strategies need some secret sauce. The ingredients? Dynamic portfolio management and effective diversification (which are the true hallmarks of a multi-asset approach) can add return and temper risk. Alpha from best in class managers and strategies makes a meaningful difference in a low return environment. Together with a willingness to allocate meaningfully to cash while waiting for the right opportunity, they help cushion and mitigate downside risk in an environment where rates are rising, spreads are tight, and risks to capital are high.
Drawing on our own unconstrained bond strategies, some recent examples give a flavour:
1. Dynamic Portfolio Management
First comes dynamic portfolio management, the capability to respond promptly to market moves.
On 27th January, we used currency forwards to go long the Mexican Peso (MXN) and short the US Dollar (USD). Our initial trade was at the 1% level and we swiftly increased this to 4% after the Mexican Central Bank raised rates to defend their currency. The rationale was that MXN was trading at the lowest level since the 1994 economic crisis when the country faced hyper-inflation and insolvency. By contrast USD was expensive and looking extended. MXN offered excess yield and had the support of a determined and capable Central Bank. We believed that concerns about Trump’s ‘America First’ policy were likely to be overstated and that policies such as the border adjustment tax would be difficult to implement. Subsequently MXN rebounded from 21 Pesos to the Dollar to 19 and we closed out our position for a profit of over 0.3% at the Fund level.
2. Effective diversification
Second, effective diversification. To be truly effective, a diversifying investment needs to have return drivers that are both attractive and reliably less correlated with traditional risk premia. For instance, one of our diversifiers is a volatility strategy run by H20 Asset Management. H20’s expertise is in identifying and profiting from anomalies in volatility markets. Their approach typically has a bias to being long volatility, which is a useful hedge against setbacks in credit markets. If our fears of credit overvaluation are well-founded, volatility will spike and H2O will play an important part in our EMEA unconstrained bond strategy. Changes in the markets have made them less intermediated and more prone to liquidity-driven swings in valuations. So right now we believe implied volatility provides more effective diversification versus our core credit managers than interest rate exposure, which has traditionally been the key diversifier for credit.
3. Opportunistic allocation
A third and last example shows how, using a dynamic management approach, an opportunistic allocation can not only add value but also bring diversifying characteristics to a portfolio.
Mortgage credit is geared to the personal balance sheets of homeowners, which operate on a different cycle to corporate borrowers. Personal balance sheets are in a de-levering phase which currently makes them look attractive relative to highly-borrowed corporate balance sheets. Putnam Investments have a deep understanding of the US mortgage market, and special expertise in the dynamics of mortgage securities where the homeowners have the option to repay early (‘prepayment risk’). Putnam’s prepayment risk strategy benefits when interest rates rise and mortgage refinancing falls, because this results in homeowners making more interest payments to bondholders than were priced in by the market. This part of the fixed income markets is still relatively less well-understood, and so less efficient. Consequently, pre-payment strategies are looking particularly attractive. That’s why we have built up our allocations to Putnam to 25%, funded from our core credit managers.
Since the inception of our EMEA unconstrained bond strategy in September 2016, the Putnam portfolio has produced consistently positive returns, with a low correlation to both high yield credit spreads and US Treasury yields:
Source: Bloomberg. For the HY OAS, the Global High Yield Index has been used
Secret sauce: meeting targets
These examples help explain why our EMEA unconstrained bond strategy has not only met its LIBOR + 3% target since inception, but has also demonstrated very low levels of volatility relative to traditional strategies.
Today’s challenging conditions call for excellence at all levels – dynamic portfolio management, effective diversification, best in class managers and strategies, and a focus on downside risk mitigation. Read the small print on the label carefully and make sure your manager has the right ingredients.