Fixed Income Boutique

Flex your way to bond profits

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colin_ludovic

Ludovic Colin

Head of Global Flexible Bonds, Senior Portfolio Manager

Rising yields and tighter credit spreads mean that bond markets are losing their ability to perform, or so it appears. Interest rates hit their low in July 2016, since then, bond returns have been in the red (see chart 1).

If we distill down to what bond investors are looking for, we can identify three outputs:

  1. Income
  2. Decorrelation
  3. Performance

That’s basically it. Coupons provide income, decorrelation contributes to diversification and capital gains deliver performance. The problem is that bond markets are losing their ability to achieve these aims.

Chart 1: Barclays Global Aggregate Index

2018-05-31_mp_bga_chart1

Source: Bloomberg, Vontobel Asset Management

The current yearning for yields means that investors have increased duration (interest-rate sensitivity) by purchasing longer-dated bonds and/or increasing credit risk by purchasing lower rated bonds. At a time when the market is listening to every central bank utterance and watching for any signs of a slowing economy, many investors are piling up on bonds that will suffer the most if their fears materialize. For bond investors choosing to follow this perilous path, we give these two warnings:

  1. Increasing duration will lead to frustration
  2. Picking bonds from the gutter will make a portfolio sputter

This is no way to live for a bond investor. But help is at hand, there is a solution.

In the Vontobel Fund - Bond Global Aggregate, we seek to generate alpha to compensate for the yield and spread which are no longer available. To achieve this we focus on four inputs: diversification, flexibility, convexity and liquidity.

Inputs

Diversification

Currently, many benchmark-hugging bond investors are stuck in a binary rut. For example, around 80% of the risk in the Barclays Global Aggregate Hedged index is duration linked (see chart 2 below). It’s a “rates go up you lose, rates go down you win” scenario. At an average yield of 1.8% how far can rates go down? The risk is asymmetric.

Chart 2: From ONE dimension risk allocation...
...to THREE dimension risk allocation
 
2018-05-31_mp_bga_chart2

Source: Bloomberg, Vontobel Asset Management

Moving away from pure duration boosts diversification and can generate alpha. This requires an investment strategy that is able to diversify across the whole of the fixed income markets and combine long-term views with tactical positions. This way, investors can find the opportunities that allow them to perform, regardless of market cycles.

The Vontobel Fund - Bond Global Aggregate allocates 60% of the risk budget to long-term strategic views based on either directional or relative value positions diversified across rates, credit, emerging markets and currencies (see chart 3). The remaining 40% is allocated to tactical management with short-term trades, and both dynamic and tail risk hedging.

Chart 3: Long-term strategic risk allocation (~60% of final risk budget)

Construct directional & RV strategies within the broadest FI universe

2018-05-31_mp_bga_chart3a

* Marginal risk, not using cross asset correlations. Source: Vontobel Asset Management.

Tactical management (~40% of risk budget)

2018-05-31_mp_bga_chart3b

Source: Vontobel Asset Management.

Flexibility/agility

There’s always value on offer in fixed income markets, provided that an investor can take a flexible approach. As an example of this agility, chart 4 shows the six-month rolling correlations for the fund and its reference index (Barclays Global Aggregate EUR hedged). The low and fluctuating correlations with the benchmark are a result of the fund managers’ active views and portfolio construction, creating a portfolio able to maneuver based on market conditions and aimed at delivering alpha. So, despite rising yields, from time to time, we find tactical opportunities to extract value from specific sectors within the bond markets. In fact, currently, this was the case recently: after the recent sell off in US Treasuries market or given the soft patch in Q1 data in the euro zone. At such times, we will increase duration and have a higher correlation with fixed income. At other times, we may be completely absent from this market. In a nutshell, it’s about value.

Chart 4: Six month rolling correlation between the fund (*) & the benchmark (**) as of March 2018

2018-05-31_mp_bga_chart4

(*) Vontobel Fund Bond Global Aggregate (**) Barclays Global Aggregate EUR hedged
Source: Vontobel Asset Management, Bloomberg

Convexity

When implementing our market views and constructing our portfolio, we are always looking for upside capture, while protecting the downside – a convex outcome (see chart 5). This is achievable with the use of highly liquid options, providing the portfolio with a safety cushion. With an option, our downside is limited to the price of the premium and when our market view proves correct the upside remains uncapped.

Chart 5: Upside capture and downside protection

Target Performance Trajectory

2018-05-31_mp_bga_chart5

Source: Vontobel Asset Management

Liquidity

The ability to trade what you want when you want is a key risk control factor for investors. Fixed income markets, in general, provide good liquidity. However, this liquidity, depending on market sector and sentiment, can come and go – it might not be there when you most need it.

Therefore, the issue of strategy comes up again; many bond managers can only invest in a few specific sectors within the fixed-income markets. This constraint can lead to problems when there is a lack of liquidity in the area they cover. A benchmark-agnostic approach allows us to allocate broadly and have constant access to liquidity. In the case of the Vontobel Fund - Bond Global Aggregate we are able to take advantage of market liquidity through geographical and sector allocation (see chart 6 below).

Chart 6: Vontobel Fund - Bond Global Aggregate (as of 29.3.2018)

Country weighting

2018-05-31_mp_bga_chart6a

Source: Vontobel Asset Management

Portfolio structure

2018-05-31_mp_bga_chart6b

Source: Vontobel Asset Management

Outputs

Income

We seek value wherever it may exist and whilst not an “income fund” per se, the portfolio does receive yield and income from its bond holdings. Right now, we see value in income, resulting in a 4.5% yield to maturity for the fund (see chart 7). One important driver is that emerging market debt yields are now above those of U.S. high yield, offering better income with a superior credit quality.

Chart 7: Constant higher yield to maturity compared to benchmark

Income: fund vs reference index

2018-05-31_mp_bga_chart7

Source: Vontobel Asset Management, as of 30.04.2018

Decorrelation

As chart 8 shows, the fund delivers low and even negative correlations across the major asset classes providing investors with true diversification.

Chart 8: Correlation parameters with 2-year rolling data as of March 2018

Fund Global
High
Yield
Euro
Corporate
US
Dollar
US
Corporate
US
Treasury
Euro
Aggregate
Euro
Stoxx 50
EM HC Barclays
Global
Aggregate
VT-BGA
Vontobel-Bond GL AGGR-IA 0.06 0.15 0.34 -0.04 -0.09 0.08 0.09 0.01 0.00 1.00

Source: Vontobel Asset Management, Bloomberg.

Performance

Finally, let’s look at performance. After interest rates hit a low in July 2016 (U.S. Treasuries at 1.35%, 10-year Bund at -0.19%), global bond market returns have been negative (-3%). During the same period, the Vontobel Fund - Bond Global Aggregate, has returned a relative outperformance of over 5% (see chart 9). This outperformance is the result of our focus on diversification, agility, convexity and liquidity.

Chart 9: Superior performance since July 2016

Vontobel Fund - Bond Global Aggregate I EUR vs. Barclays Global Aggregate EUR Hedged

2018-05-31_mp_bga_chart9

Performance data does not take account of commission or costs charged when units are issued or redeemed. Source: Vontobel Asset Management, Bloomberg, normalized weekly returns, timeframe 01.07.2016 - 18.05.2018

Below, chart 10, shows the long-term graph illustrating that it’s possible to generate performance in both positively and negatively performing bond markets.

Chart 10: Indexed net return since inception, as of 30.04.2018

2018-05-31_mp_bga_chart10

Disclaimer: Past performance is no guide to future performance. Performance data does not take account of commission or costs charged when units are issued or redeemed. Source & Copyright: Vontobel Asset Management, Bloomberg.

So, in closing: Remain agile and your bond portfolio will no longer be fragile.

 

Rolling 12-month net returns (in %)

  Fund Benchmark
01.05.2017-30.04.2018 0.77 -0.84
01.05.2016-30.04.2017 1.65 -0.04
01.05.2015-30.04.2016 2.15 2.45

Disclaimer: Past performance is no guide to future performance. Performance data does not take account of commission or costs charged when units are issued or redeemed. Source & Copyright: Vontobel Asset Management, Bloomberg, Morningstar I Share Class as of Oct 2017. Extract KIID, source: Vontobel Asset Management.

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