May 2013 will go down in the history books as the month the ‘taper tantrum’ began – when investors woke up to the Fed’s slow withdrawal of QE.
Over the summer the policy shift has clearly had an impact on the strategies of fund selectors all around the world. While the Fed did not begin its tapering process in September as many had anticipated, the topic remains a big issue for asset allocators.
French selector François Rimeu has not taken the news lightly. Already on the convertibles bandwagon, he’s now also upping his equity exposure, especially in Europe.
Renaissance’s Simon Fentham-Fletcher is also well prepared. He thinks the rates debate is a red herring. ‘I want to be allocated before the event rather than reacting in its wake,’ he says, which is why he’s been overweighting convertibles since the start of the year.
Over in Miami, Ignacio Pakciarz of Big Sur Partners is taking a different approach, he thinks convertibles are too illiquid and is instead floating his way out of trouble with a combination of senior bank loan funds and US commercial real estate.
Michael Odermatt meanwhile, used the tantrum to his advantage, finally finding entry points to sterling corporate and US high yield markets on the dip. Rates are rising and the strategies to play it clearly are too.
This article originally appeared in the September 2013 issue of Citywire Global magazine
Michael Odermatt, HelvInvest
We think the Fed will not start tapering US monetary stimulus before 2014 and that investors have been too pessimistic on rates.
Instead of reducing duration because of fears of further interest rate hikes, we believe there are at last better entry points at current levels, for example in sterling corporates or US high yield bonds.
In anticipation of this market uncertainty we started hedging interest rate risk last year by shorting interest rate futures.
We didn’t make this move because we expected higher rates but mainly to control price volatility in our fixed income portfolios. In addition we built up exposure to non-directional investments to benefit from liquidity-driven relative value opportunities, such as pair trades and basis trades.
As a hedge against the much-proclaimed ‘great rotation’ we started investing in convertible bonds in September last year and steadily increased this exposure to about 10%.
Within the convertible space we prefer Leonard Vinville’s M&G Global Convertible Bond fund because of his bottom-up driven, benchmark-free philosophy and Michael Reed’s BlueBay Convertible Bond fund because of his experienced credit research capabilities and fixed income-oriented investment style.
Simon Fentham-Fletcher, Renaissance Asset Managers
The great rotation from fixed income to equities, combined with the inevitable rise in interest rates in the not too distant future meant three things for the fixed income portion of my portfolio: shorten duration, improve credit quality and shift into convertibles.
The rationale was that interest rate risk was becoming ever more real and equities were the better place to be positioned. The first two solutions reduced the risk, while convertibles meant I could extract some of the equity upside in my fixed income portfolio.
The great debate on when rates will rise is a red herring. I want to be allocated before the event rather than reacting in its wake. As such, I have been overweighting convertibles from the beginning of the year. The delta of any convertibles manager is a key factor, and in raging equity markets these managers often let their delta rise to 0.7 or more.
I want funds that keep delta nearer to 0.5, this forces them into selling in rising markets and buying in falling ones – a natural counter to my equity funds that often ride positions longer. RWC Global Convertibles is a great fund which has a similar philosophy and, more importantly, adheres to it.
Ignacio Pakciarz, Big Sur Partners
In the face of rising interest rates, we’re continuing to shorten duration in both individual bonds and managed funds, as well as increasing our exposure to floating rate securities such as senior bank loan funds.
We like the use of risk positioning in Invesco’s US Senior Loan fund, which has consistently outperformed the investable index.
We’ve also continued to adjust our portfolios by adding to direct investments in commercial US real estate, which has provided a steady income in the low yield environment of the past few years.
For example, we have just invested in an office campus leased to an A-rated financial institution, which will give our clients 10% cash-on-cash.
Elsewhere, we’ve adjusted our allocation in equity and fixed income. Following the market’s tantrum with Fed tapering in late May, an interesting thing happened – the correlation between equities and bonds (which is typically negative) is expected to be positive – prompting us to reduce some selective credit exposure, in both high yield and emerging markets debt, in favour of equities. Convertibles look relatively unattractive in today’s environment.
We remain in a world with very low rates where dividend yields in many global multinational company stocks pay well above the 10-year government rates.
This fact makes convertibles, which are typically high yield or cross-over credits, unattractive at present. Additionally, we don’t like the illiquidity of these securities, especially in a flight to quality situation; liquidity dries-up in the thinly traded convertibles market.
François Rimeu, La Française AM
Since May, 10-year US rates have increased by about 100 basis points and the 20-year bond bull market now appears to be at a turning point.
Other interest rates, mainly European and emerging markets, will be affected by these changes so there is a real need to adjust portfolios.
We have maintained a fairly low exposure to the bond market for some time and this approach will continue, particularly in relation to our exposure to core countries’ government and investment grade bonds.
On the other hand, we have increased our equity exposure, especially to the European market. On the convertibles side, our allocation has been neutral since the beginning of the year, reflecting our positive view of the equity market. We have not changed our positioning since and even if convertible bonds are currently expensive valuation-wise, we are keeping our exposure as it stands, focusing on funds with high delta.
Abel Lim, Personal Financial Services UOB
Emerging market bonds have done very well over the past two years and clients have been taking advantage of this trend by investing in funds such as the United Emerging Markets Bond fund.
The outlook for US high yield bonds is also favourable and more of our investors are considering funds that give them exposure to the US such as the Allianz US High Yield fund.
Equities will have a good year, but many clients are not ready to allocate here. As such we’ve focused on helping them create a steady stream of dividends through income strategies.
Preferred picks include the BlackRock Global Equity Income fund and multi-asset products such as the Schroders Global Multi Asset Income fund.
Reiner Konrad, Johannes Führ Vermögensverwaltung
In the run-up to the possibility of Fed tapering, we decided to invest on the side of bonds, particularly flexible bond funds which can target a wider duration band.
These funds can also go short and invest in different kinds of securities. We are also looking at corporate and high yield bonds, and prefer those with a shorter duration.
Overall, equities should benefit as the US economy continues to recover, but not without rising volatility.
To reduce such risks, we have increased our convertible exposure rather than direct equity investment because we like this asymmetric risk profile.
All three managers have a long track record in this market, supported by a very good team. Both funds are investing globally, but we prefer the euro-hedged class.
Alberto Arrambide, Banco Sabadell
The May/June rise in interest rates was a wake-up call for the industry in that even though most professionals acknowledged rates will go up, hardly any meaningful transformation took place beforehand.
The Fed is doing its best to telegraph the tapering, so money managers have enough time to adapt their portfolios.
High yield and convertibles instruments have enjoyed stellar years since 2009 but they are now entering the second phase of the recovery in the economic cycle.
Nevertheless, although the high returns are behind us there are still good alternatives for investors who do not want to take full-on equity risk, but still want to participate.
Schroders Global Convertible Bond fund, which actively manages delta, is a good way to participate, as is the Morgan Stanley Global Convertible fund, which rebalances its delta to 0.50 and therefore tends to be more conservative, especially when the market is over-extended.