Flexibility always has a place, but its capacity to provide a level of downside protection makes it particularly important given the advanced age of the credit cycle. Here we explain why credit investors cannot afford to just rely on rates and diversification for protection. We also consider the robust suite of tools needed to preserve capital during market sell-offs and help protect our ability to take risk when opportunities are greatest.
In 2019, much of the news flow was dominated by the stock markets' longest - and best ever - bull market in history. But arguably, bonds have been on a general upward trend for much longer. Despite a few significant setbacks, bond prices have risen, and yields have declined for the best part of four decades.
During this time, low interest rates, subdued inflation and muted global growth have prompted investors, searching for ways to generate income in the low-yield environment, to buy longer, riskier durations and rely on diversification for protection.
Over the past century, there have been many stock-bond correlation regimes: the rolling three-year correlation was positive from the mid-1960s to 1998, but it has been almost entirely negative since the late 1990s.
This regime change has been driven by a subdued inflation environment over the past 25 years. Owing to an environment of low interest rates and disinflation, investors wishing to hedge their credit exposure have used rates, accepting much longer, riskier durations in exchange for yield.
Even though longstanding predictions of the end of the bull market have not materialised, it can't last forever. As such, actively managing duration is therefore important, but investors should not rely on the relationship between interest rates and risk assets to provide protection.
FROM DEFENCE TO OFFENSE: BUILDING A MULTI-FACETED STRATEGY
Diversification: still on the menu?
Harry Markowitz, the Nobel Prize winning economist and godfather of modern portfolio theory, famously remarked that diversification is "the only free lunch in investing" - and although multi-asset credit benefits from decorrelation across sub-asset classes, the rise in correlations have eroded the impact of diversification in recent years (see figure 1).
Figure 1. Don't depend on diversification
Fixed income asset class correlation (36m rolling v US government bond)
Source: Federated Hermes, Bloomberg and Bank of America Merrill Lynch as at 31 July 2019. Note: the R coefficient is a numerical output used as a correlation measure tool between two variables.
Of course, there is value in adding diversifying sources of return by investing across different sub-asset classes but, given rising correlations, diversification alone should not be considered an adequate source of downside protection.
Dynamism is vital
To successfully manage downside risk, we believe dynamism is vital. We understand that a long-only exposure to bonds cannot continue to deliver the strong returns of recent years. Dynamic and flexible allocation allows us to respond to market changes with greater flexibility and security - that is, adjusting our portfolios to seek optimal sources of value throughout the cycle.
Another way in which we aim to preserve capital is through our ability to access a broad spectrum of liquid credit. This allows us to leverage our credit view across all debt instruments, gives us the ability to diversify our sources of alpha generation, and respond to changes in the market. We exploit relative value through high-conviction name- and security-selection. We also believe in active management predicated upon bottom-up, fundamental stock picking within a top-down framework. The discipline of assessing and pricing credit, ESG and liquidity risks is deeply ingrained in our investment process. ESG integration is a valuable tool for both downside protection and alpha generation through engagement on key issues that can impact the enterprise value and cash flows.
Broadening the toolbox
We aim to protect capital and enhance convexity by using an expanded set of tools: these include single-name CDSs, index CDSs and options on the index.
Indeed, within our credit team, we express a myriad of different views, and our views of the market will inform whether we use just one or a combination of these products to both seek to preserve capital during broad, adverse market moves and exploit opportunities when they arise.
Effective risk management is also an integral part of the investment process and so, using a centralised hub to manage portfolio risk is essential. Every day, we review our portfolio hedges using a proprietary dynamic duration-management tool that calculates the suggested hedge by currency and part of the curve based on current positioning, market environment, shape of the interest rates curve and correlations. We subsequently review the results and adjust the hedge as appropriate.
Indeed, adopting such a flexible approach enables us to mitigate risk more effectively than solely relying on rates and diversification.
Fighting risk with risk: a simulation study
The long-running bond bull market can't last forever - and so investors must use defensive strategies that have the potential to protect them in the event of a future shock. Should credit spreads widen, naturally investors will want to protect themselves from any extreme scenarios. By simulating the performance of the global high yield market (which is long-only by definition) compared to a global high-yield portfolio that uses options and index shorts as a hedge, it is evident that the latter will outperform the benchmark if spreads widen in the wake of a market correction thanks to the convexity provided by options (see figure 2). Such a simulation demonstrates the benefit of embedding options- and index-based strategies into our portfolios.
Figure 2. Scenario analysis: the appeal of downside protection
Source: Federated Hermes as at January 2020. For illustrative purposes only.
Ready to act: applying multiple lines of defence
As we have discussed already, the preceding decades have stacked up well for bond markets. But from here, investors must work harder - and to do so, multiple lines of defence - not just rates and diversification - will be needed to navigate any changing market conditions. Employing such strategies can not only help to reduce downside risk, but they may also enhance upside growth too.
For more information on Hermes flexible-credit capabilities, click here.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
For professional investors only. This is a marketing communication. The views and opinions contained herein are those of the Credit Team at the international business of Federated Hermes, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.
Vincent joined the international business of Federated Hermes in 2013 and is portfolio manager responsible for short duration strategies and global risk management for the credit portfolios. He also oversees the implementation of non-linear trading strategies, with extensive use of derivatives products such as credit options and indices. He joined from Scor Global Investments in Paris, where we was credit analyst across European high yield. Vincent holds a Master's degree in Banking and Finance with Honours from Pantheon-Assas University in Paris, as well as a Bachelor in Management from Dauphine University in Paris.
 A rise in correlations limit the ability of fixed-income instruments to preserve capital in periods of volatility.