07 Décembre 2016

Risk-free rates matter on the downside

Global rates markets are experiencing one of the largest selloffs in several years. This is all the more striking and painful for fixed income investors as they had only recently reached historical lows – more than a third of DM govies were trading at negative yields last quarter. Importantly, the end of such repricing may not be in sight, as commodity and energy prices have risen sharply and CB’s policies could become less accommodative. In short, there is a clear and present danger of additional rate market dislocation, which in turn will impact other parts of the fixed income market – including our European credit playing field.

In this context, we thought that it would be useful to remind our investors of our investment philosophy with regards to managing interest rate exposure and of the current strategies which we have implemented to do so. In addition, we have tested our current portfolio for two realistic rate spike scenarios. By doing so, we are not expressing a view about the outlook for rates in the next few quarters – this is neither our core competency nor the performance engine of our strategies. We are simply assessing the embedded risk in our Fund and our ability to withstand a large dislocation which could potentially offer highly attractive investment opportunities.

Hedging and reducing rate risk to make money with credit risk

Our basic principle in the Fund is to make money by managing and taking credit risk. As we have little constraints with regards to our universe of investable instruments – be it in terms of currency, maturity, seniority, ratings, etc. – we hedge any significant non-related credit risk embedded in our positions. In practice, we generally hedge the interest rate risk component of any bond we hold to the extent that we assess that such risk could significantly drive the price action on such instrument. Specifically, any IG bond with significant duration held in our portfolios would be hedged shorting some govies futures, whereas we would probably leave unhedged a high-coupon HY security trading in cash price and for which we expect a short-to-medium term workout date. Importantly, interest rate hedges do not always protect a portfolio in synch with the underlying price drop as credit spreads may move in reverse to balance some potential losses or may widen thereby magnifying such losses.

As a result, the practical implications on our current positioning in the Fund are pretty straightforward. First, the hurdle rate for the investment rationale on any position with significant IR duration – even with attached IR hedges – is currently set much higher than in more normal circumstances. Second, we have tried to use floating-rate instruments to express credit views when those are available as those offer much greater downside protection for our long positions. Third, we have focused our research on finding situations with shorter-duration catalysts to avoid extreme price volatility should a bond market crash occur. Then, we have maintained a significant allocation to the bank hybrid capital space as the sector is deemed to benefit from any yield increase/steepening while still benefiting from fundamental improvements of its credit profile. Specifically, many of our positions have relatively short-dated calls which in the unlikely event that they would not be exercised would reset using a much higher interest rate as a benchmark. Last, while we acknowledge the powerful technical forces at play in European credit, we have been concerned for a while about valuation in some segments of the market. As a result, we have retained several short IG positions and, overall, we have maintained a limited deployment in order to reduce risk and keep dry powder in the event of a broader fixed income market dislocation.