Do derivatives still have a place within the investment world and can they be used within fixed income portfolios to more effectively manage the risks associated with bond investing?
In his 2002 annual report to Berkshire Hathaway shareholders, Warren Buffett explained at great length his reasons for exiting the derivatives business and expressed in unequivocal terms his concerns regarding the rapidly expanding derivatives market.
Buffett pointed to the demise of Long-Term Capital Management in 1998, which had to be rescued by the US Federal Reserve in order to prevent the contagion spreading and other institutions falling, as an alarm bell that was not being heeded.
It was in this annual report Buffett labelled derivatives as being “financial weapons of mass destruction”, a phrase that has stuck firmly in the public consciousness. More recently, the collapse of the investment bank Lehman Brothers, a major counterparty in derivatives trading, refocused investor attention on the potential risks associated with derivatives trading.
In truth it is a little unfair this neat, four-word phrase continues to be used to summarise Buffett’s 1,800 word exploration on the use of derivatives. Indeed, Buffett himself admitted “the word covers an extraordinarily wide range of financial contracts” and he was referring to a particular type of uncollateralised derivative when he coined his most memorable soundbite.
There are many different types of derivative within today’s marketplace, and not all of them are as risky or as potentially destructive as Buffett would suggest.
Managing interest rate risk
Most investors understand the interdependency between bond valuations and interest rates. When yields rise the capital value of a bond falls. When yields fall, the reverse is true. Interest rate risk is a significant factor for bond fund managers to consider, especially in an environment like today, when interest rates are expected to rise over the coming months.
Fixed income fund managers measure the interest rate risk of a single bond or a bond portfolio through calculating duration. As an example, if yields rise by 1%, a bond with a duration measured at seven years would fall in value by 7%, whereas a bond with a duration measured at one year would fall 1%.
Interest rate futures are derivatives that can also be used to hedge against rising interest rates. They are contracts that reference an underlying government bond, for example the “long gilt future” is backed by the 10-year UK gilt. As the price of the underlying asset rises or falls, so in turn does the value of the future.
Interest rate futures present several benefits to fixed income funds insofar as they allow managers to change the duration measurement of their portfolio at relatively short notice, and therefore take steps to manage interest rate risk. They also allow a fund manager to gain exposure to an asset price without the costly, and often time-consuming, process of buying and selling the underlying asset itself.
Futures are also highly liquid investments, traded on an exchange and consequently have little or no risk that the financial institutions underwriting the contract could default (counterparty risk). After the demise of Lehman Brothers, counterparty risk in over-the-counter derivatives deals – where financial institutions conduct transactions privately with each other rather than going through an exchange or intermediary – became of increased concern for fund managers. Exchange traded derivatives effectively remove this risk.
Using derivatives to manage credit default risk
Any fixed income asset contains an inherent default risk, whereby the issuer is unable to service its obligations. The risk of default is considered to be almost non-existent for AAA government debt, or certainly used to be before the global financial crisis, but can increase significantly the further you move down the credit rating spectrum.
Fixed income investors can give themselves a degree of protection against default through credit default swaps (CDS). CDS contracts are best thought of as a form of insurance against default – a premium is paid so that if a company in the portfolio were to default, a payment is received that would cover the subsequent losses. On the opposite side of the spectrum, a fund manager can increase their credit default exposure by acting as the insurance company – in other words underwriting the cost of protecting against default, and collecting the premium in return.
The value of CDS contracts are updated daily. The implications of this for the insurer are if the risk of default lessens from the level at which protection was agreed, the insurer makes profits, whereas in the reverse scenario, if the risk of default increases, the insurer makes a loss.
Not all fund managers can use derivatives
In just a few years, derivatives have managed to earn both popularity and notoriety. It should be remembered, however, the use of derivatives within mainstream retail investment funds is still restricted to the larger investment houses and those companies with dedicated back office capabilities. European regulators and the FSA only authorise the use of derivatives within funds recognised as ‘sophisticated’ investment vehicles, run by managers with the necessary skills and expertise to trade derivatives appropriately. Having used derivatives within our fixed income portfolios for a number of years now, we view them as simply another tool in the toolbox, albeit a useful one that has served us well during the last couple of years of extreme market volatility.
Warren Buffett’s warning about derivatives being weapons of mass destruction will no doubt live long in the memory, although we prefer the quote by Arthur Leavitt, former chairman of the Securities and Exchange Commission, who believed that: “Derivatives are something like electricity; dangerous if mishandled, but bearing the potential to do good.”
Investors should be reminded they can make money or lose money in derivatives, just as they can with any asset class.
Provided they are used sensibly, we have found derivatives offer a degree of capital protection and can be extremely beneficial in terms of maintaining portfolio performance.
Jenna Barnard, director of retail fixed income at Henderson New Star
