The US Federal Reserve (Fed) is embarking on a rate hiking cycle and the European Central Bank (ECB) is slowing the pace of Quantitative Easing (QE), raising concerns about the impact of higher rates. In our view, while the likelihood of a normalisation of rates to long-run averages from today’s levels seems low, any movement in that direction will likely have a significant impact on bond markets. Even if full normalisation is not a near-term phenomenon, interest rate markets are bound to go through periods of volatility in reaction to rate-raising rhetoric or action.
The strategy is based on unconstrained investing across a broad credit opportunity set, looking for the most attractive risk-adjusted return, while giving the manager flexibility to manage the strategy through different market conditions. The nature of that broad opportunity set is a key element in the construction of a robust and non-rate-sensitive portfolio. For example, sub-investment grade credit, particularly high-yield and leveraged loans, has a strong track record through such periods.
Figure 1: High yield and leveraged loans have performed well in rising rate environments
Source: Barclays, Bloomberg, Investec Asset Management. Benchmarks and time periods as follows: USD IG: Bloomberg Barclays US Corporate Index (31.01.86 - 30.03.17), USD HY: Bloomberg Barclays US Corporate High Yield Index (31.01.91 - 30.03.17), USD Loans: S&P/LSTA Leveraged Loans Index (31.12.96 - 30.03.17).
Duration is an overly simplistic and one dimensional measurement. In essence, duration measures the sensitivity of the portfolio to changes in underlying interest rates. If the portfolio has a duration of 3.5 years, then its value is expected to fall by 3.5% if underlying interest rates increase by 1%. Importantly, the traditional duration measurement fails to account for moves in credit spreads.
For credit markets, the off-setting change in credit spread renders the simplistic predicted price movement of the duration metric far less effective. Indeed, in rising rate environments, credit spreads typically tighten to more than offset any increase in the underlying rates.
Figure 2: A traditional duration measurement fails to account for price changes in credit spreads
Source: Bloomberg Barclays US Treasury 5-7 year Total Return Unhedged USD, Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged, Bloomberg Barclays US Corporate Total Return Value Unhedged USD. Data between 31.03.16 - 31.03.17.
To manage effectively through different market and interest rate conditions, a MAC manager has a variety of tools at their disposal, including, but certainly not limited to:
Just one example, among a variety of possibilities, from the above list is the access to FRNs. This is especially valuable during periods of rising rates, as it allows investors to express a constructive view on the credit without taking the corresponding interest rate risk that is embedded in the fixed rate bonds.
In 2016, a large US bank issued both fixed and floating rate notes with identical maturities. Over the following six months, the yield on 5-year US Treasuries increased by nearly 70bp, causing the fixed rate bonds to fall by 2.6% in price terms. Conversely, the FRNs actually gained 1.6% over the same period, highlighting the ability of FRNs to benefit from credit spread tightening without being hindered by moves in underlying interest rates.
Figure 3: Fixed vs. Floating rate notes – in rising rates, floating rates notes gained
Source: Bloomberg. Prices for both bonds re-based to 100 as of 20 October 2016. Date range: 20.10.16 - 31.03.17
This is just one way that an unconstrained MAC portfolio can add value for clients in a rising-rate environment. You can access an in-depth discussion of the complete toolkit in our recent white paper on our website.
Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income.
Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss.
Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss.
Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss.
Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises.
Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. This may lead to larger financial losses than might be anticipated.
Loans: The specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Many loans are not actively traded, which may impair the ability of the Portfolio to realise full value in the event of the need to liquidate such assets.
The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s (‘Investec’) judgment as at the date shown and are subject to change without notice. The value of investments, and any income generated from them, can go down as well as up and will be affected by changes in interest rates, exchange rates, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets invested in.
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