Stuart Steven

Managing funds in a more volatile market

Stuart Steven

Managing volatility in a tougher bond environment

With rising interest rates creating a tougher backdrop for bonds – and heightened potential for macro shocks, as the last few years have laid bare – volatility management is becoming an increasingly important part of fixed income investing.

While our Monthly Income Bond Fund is not run with an absolute return approach (we are not committed to producing positive returns whatever the conditions), we are seeking to outperform the sector and relevant benchmarks with lower volatility over the medium to long term. A key part of this is identifying events that could result in significant downside risk to our markets and portfolio holdings. In recent years, these events have largely consisted of elections and referendums.

We have endured divisive UK and US elections, not to mention many outbursts of populist voting across Europe, the Scottish independence referendum in 2014 and, of course, the Brexit referendum in 2016. The latter provides a particularly interesting example of the kind of measures we can put in place to try to protect the portfolio.

Going in to the Brexit referendum, we viewed the outcome as too close to call despite the fact markets predicted a 90 per cent chance of Remain winning. Given this uncertainty, we looked to protect the fund as follows:

  • Strategy one: We reduced our duration (sensitivity to interest rate movements) short from three years to one and the remaining position was expressed through German bunds. The theory behind this was that UK government bonds could rally aggressively from yield levels around 1.4% whereas German yields had little room to move as they yielded less than 0.1% pre-vote. In the event of a Remain vote, we planned to increase the duration short on the day of the result and switch back to the UK. This play proved particularly successful as German yields were little changed one month after the vote while gilt yields were nearly 1% lower.
  • Strategy two: In advance of the Referendum, we used the flexibility of our mandate to buy a 5% position (our maximum permitted exposure to FX) in US dollars as we felt sterling would suffer badly on a Brexit vote. Again, this was helpful to performance but we viewed it as a protection strategy rather than a means of generating alpha.
  • Strategy three: We bought credit default swap (CDS) protection via European indices (in the most basic terms, a CDS is similar to an insurance contract, providing protection against specific risks). While this initially helped, it ultimately detracted from performance as the central bank’s commitment to support the economy resulted in a sharp rebound in risk assets.
  • Strategy four: We sold a few positions where although we still liked the bonds, we thought they were close to being fully valued even on a positive outcome so there was little benefit in continuing to hold them given the uncertainty. We then had the opportunity to add risk after the market sold off after the “unexpected” result.

For some of the other events mentioned above, we have used different variations of these types of strategies as shown in the table below.

Event

Risks

Strategy

Outcome

UK Election
(2017)

Financial market weakness

  • Long US dollar
  • Reduced credit risk on fully valued bonds
  • Maintain duration short
  • Small gain on dollar
  • Profit on duration position

US Election
(2016)

Bond market weakness

Financial market weakness

  • Short US 5-yr
  • Buy US high-yield CDS protection
  • Significant positive contribution from reflationary sell-off
  • Small negative as markets rallied

Scottish referendum
(2014)

Negative impact to UK economy

  • Short sterling
  • Small negative on NO result


Having a flexible mandate allows us to implement differing views in each part of our market: being long credit spread duration and/or beta for example while being short duration.

Typically, we use bond futures to synthetically reduce overall fund duration, protecting investors from the risk of capital loss resulting from rising government yields and the volatility that accompanies rate risk in this environment. By buying longer dated bonds, investors can benefit from higher yields and returns can be enhanced by corporate spreads tightening in an environment where the economic backdrop remains supportive of risk assets. 

Given the correlation in these two positions, however, we need to be mindful of the overall risk budget of the fund, which relies on volatility management.

A further important element of this is a tail-risk strategy in place at all times: in essence, we have a short position to CDS indices, typically high yield, to give protection in the event of an unexpected market event. Similar to an insurance policy, this protection comes at a cost but we believe it is worth paying to protect against downside risk and is minimal in the context of long-term returns.

It is worth highlighting that if our long-term outlook is negative for corporate bonds, we will reshape our portfolio to reflect this view rather than merely implementing overlay strategies.

With our exit from the EU on the horizon – although no one knows at this stage if we might have another vote before then – and a continuing round of elections, we believe managing volatility will be key for bond performance as we face more challenging conditions for this sector.

For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Tuesday, October 16, 2018, 3:09 PM