The advantages of flexibility in fixed income
The past year has certainly shown the advantages of flexibility in fixed income. Investors have had to deal with the COVID-19 pandemic, a market rotation following positive vaccine results, and, so far this year, the global reflation narrative. While it is vital for investors to understand the importance of events and their implications, it counts for little if you do not have the flexibility to implement a view.
Of course, there are different ways we can think about flexibility in fixed income. Perhaps the most obvious is what you can invest in. Within the global strategic bond space, we have full access to the global bond universe, from safe haven assets such as US Treasuries to higher risk markets such as Asian high yield bonds.
We also need to consider how quickly we can get in and out of positions. Part of this is about the nature of your exposure – do you want cash bonds to implement a view, or is it better to use futures? It is also about having the infrastructure to get in and out of positions swiftly though, with a dedicated trading team helping us to do this.
While we believe a global fixed income portfolio should be structurally diversified across fixed income markets, we can also add value by making tactical asset allocation decisions. As an example, in theory we could allocate completely to government bonds, though the kind of circumstances in which that would happen are extreme. The below three examples show the kind of tactical decisions we have made in the recent past, using our flexibility to take advantage of market opportunities.
1. Government bonds coming into 2020
Governments bond yields were low at the beginning of 2020, with ten-year US Treasuries yielding 1.5%, around half their end-2018 level. We believed they could go lower with the end of the cycle approaching, however, with the Fed likely to cut rates to support the economy.
We did not anticipate a global pandemic providing the economic shock for rate cuts but were well-positioned when it happened. We were at our most defensive in some time by March 2020, with a very positive view on US Treasuries. The flexibility we have to reflect our views means we can adjust positioning quickly, however, and brought down our defensive exposure significantly as policymakers acted to protect the global economy.
2. Taking spread risk following the first stage of the COVID crisis
The flipside of reducing our defensive exposure after March 2020, was an increase to credit risk. We had been cautious on spread risk for much of 2019 and the early part of 2020, preferring to own smaller pockets of value. Following the COVID-sell-off, however, we turned more opportunistic on cheaper valuations in developed market credit, high yield and emerging markets.
3. Using futures to adjust duration
In recent months, we have seen a new stage in terms of the market recovery from COVID-19, with investors getting excited about the prospects of global reflation and bond yields breaking through the second half of 2020’s tight trading levels. We reduced duration in the middle of February 2021 and again towards the end of the month, with yields looking like they had upwards momentum in strength. This subsequently proved correct, protecting against the worst of the move upwards in Treasury yields.
We achieved this by selling futures to short US duration, particularly at the long end of the Treasury curve. By using futures, we can select the currency and part of the curve we want to hedge out and accurately implement our investment views in portfolios. The short US duration has since contributed materially to performance in our strategies, helping us to further offset the negative impact of rising bond yields over the first quarter of 2021.
As hinted on above, however, our ability to react quickly has been vital to all of this. The upwards move in US yields over the first quarter of 2021 was notable for its rapidity. If you cannot change your positioning quickly enough, you risk either losing money or not being able to take advantage of changing market conditions.
We believe that investors can continue to benefit from an allocation to fixed income, especially given the recent rise in bond yields and degree of optimism priced into markets. Flexibility is a critical consideration when investing in fixed income, however, with investors likely to reap the biggest benefits from considering a diversified universe where they have the potential to add to returns through tactical portfolio adjustments as the economic and market cycle evolves.
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