Research

Rising rates: Re-thinking traditional fixed income allocations

For more than 30 years global investors have enjoyed strong returns from their traditional fixed income allocations.

Over this period falling yields resulted in capital gains, with coupons providing a steady income. However, the global consensus of rising yields in 2014, and beyond, from ultra-low levels, has led investors to rethink the defensive portion of their portfolios.

At Aurum we believe that it is important for investors to re-examine the composition of their portfolios and apply some contemporary thinking to their asset allocation process. We are advocates of implementing a more compelling solution, where we encourage investors to look beyond traditional fixed income investing and towards alternative strategies. This approach can address the concerns that many investors have in terms of the impact that rising interest rates can have on their fixed income portfolios.

The Aurum Isis Fund has achieved a low-volatility return stream for over 15 years by employing a consistent philosophy and approach to investing in alternative strategies. A noteworthy characteristic of Aurum Isis's return stream is the particular resilience that it has demonstrated during period of rising interest rates and has shown low beta to other asset classes1.

  1. Since Mar 1998 inception, CAR = 6.5%; beta to S&P 500 = 0.04, beta to Barclay Global Agg.Bond = 0.07.

TRADITIONAL versus FORWARD THINKING

"Investors may find that their bond portfolio has not evolved with fixed income markets" Goldman Sachs Asset Management, "Perspectives", Feb 2014

We fully agree with the above statement. We recognise that the dynamics within the global capital markets are very different today than they have been at any time over the past 20 years, and perhaps portfolio theory has not kept up with modern developments.

Notably, a passive approach to fixed income investing typically leads an investor to 'hug' a benchmark, often one that tracks the performance of US or global government bonds. While this approach has delivered good results in a falling yield environment, this tactic also makes losses unavoidable when yields begin to rise. In the past, investors have received an income as well as a capital appreciation component of total return from their bond portfolios. While the former component is now at very low levels, investors are now threatened by rising yields to their second component, which may result in portfolio losses in the coming years.

With the development of fixed income markets around the globe and the evolution of trading strategies, we feel that investors have many more options at their disposal in order to achieve a defensive-like return stream, rather than simply relying on traditional portfolio theory techniques.

Global investors now have the benefit of:

  • Increased liquidity and access to a wider range of markets;
  • Rapid development of derivative markets which provide the ability to structure attractive risk-return profiles as opposed to long-only exposures;
  • Availability of products to explicitly gain from rising interest rates, such as ETFs, swaps, and futures;
  • Access to more trading-orientated strategies that were previously the exclusive domain of bank trading desks, and
  • Access to robust risk management policies that have developed over time

THE IMPACT OF RISING YIELDS ON PORTFOLIOS

The global fixed income market has never been in a state of such prolonged ultra-low interest rates, especially in the US, Japan, and Europe. While there have been periods of rising long-term interest rates in the past, this has occurred from more normal yield levels. With the current low-rate environment, increases in interest rates can quickly eradicate up to a year's expected total return in just a few days.

The effect of rising rates on bond portfolios was clearly seen during the "tapering" months of 2013:

"Tapering" months

Rise in US

10yr Yield

Equivalent Capital Loss*

May 2013

46bps

-3.70%

June 2013

36bps

-2.62%

December 2013

28bps

-1.99%

*as measured by the Citi US Treasury 10 yr Index

PRACTICAL EXPERIENCE: AURUM ISIS

Aurum has been in investing in alternative managers for nearly 20 years. Many of these managers specialise in strategies that are designed to withstand directional and cyclical moves in key markets, such as global interest rates. Our manager selection process avoids beta-oriented strategies such as equity long/short, credit, and event driven.

 We favour active trading strategies in three primary areas:

  • Global macro
  • Multi-strategy
  • Systematic / Statistical Arbitrage

While manager selection and portfolio construction are important factors, we place an emphasis on strategy selection of investment styles that can endure, and even prosper, during inflection points in the markets.

This is shown in the below chart, which compares the performance of the Aurum Isis Fund to the US 10 year Treasury yield and the official Federal Reserve target rate. It clearly shows a demonstrable record and ability to generate strong risk-adjusted returns through a variety of market environments, especially during periods of volatile and rising interest rates.

CONCLUSION

Over the past year or so we have noted that a number of our clients, as well as our underlying portfolio managers, have begun to prepare for an era of rising interest rates. This development could have a profound impact on a range of asset prices and investment strategies.

Perhaps the most vulnerable area to rising rates is the traditional view towards fixed income investing, which typically involves a benchmark approach and long-only exposure. We have seen from last year that rising interest rates can result in losses in these portfolios. These losses become particularly pronounced when prevailing rates are at a low point - which is where we find ourselves today.

At Aurum, we have achieved strong risk-adjusted returns over a variety of monetary cycles by applying strategies that can benefit from rising as well as falling interest rates. Notably, we have been prominent investors in the global macro sector since 1994, a strategy that is well structured to benefit from evolving economic cycles

2013: A Case Study of Rising Interest Rates

After a multi-year bull market for global bonds (both sovereign and corporate), the last 12 months may come to be viewed as a pivotal year for global bond performance.

Over this period Aurum Isis firmly established itself as vehicle able to produce non-correlated, alpha-based performance.

Our focus on flexible trading strategies allowed the fund to post positive performance, even when global bonds suffered, as highlighted during the three distinct periods below. In addition, this was achieved while maintaining negligible equity beta, consistent with our portfolio construction approach.

This performance was achieved by exposure to a number of specialist absolute return strategies that are specifically designed to be immune, or even potentially profit, from rising interest rates and corresponding under-performance from the bond sector.