Swashbuckling with Interest Rates Could Land You in Davy Jones' Locker - Presented by: Scott Kimball, CFA Frank Reda, CMT
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
March 11, 2014
Swashbuckling with Interest Rates…
Could Land You in Davy Jones’ Locker
Presented by: Scott Kimball, CFA
Frank Reda, CMT
Surely, this short duration journey be bursting with extra yield! 1
Just the facts, Jack!
• Few asset classes have evolved more than fixed income, enabling investors to create
a highly customized allocation for wide range of objectives, e.g. defensive positioning ,
source of alpha
• However, as the exposure to “non-traditional” fixed income increases, the impact on a
plans total risk profile may change materially
• There is no way to “de-risk” fixed income, only shift the risk away from those which
appear undesirable towards another, e.g. less interest rate risk, more credit risk
• Increasing risks in these categories, further weakens the diversification benefits of
fixed income as credit and liquidity are correlated with other asset classes such as
equity
2
Sorry, Jack!
“Are you suggesting, there’s no free rum?”
3
Fixed Income Risks
• Fixed Income Risks
– In a low interest rate environment, investors are concerned with:
• Interest Rate/Duration
• Inflation
– To offset these concerns, investors are increasing their exposure to other risks:
• Credit
• Liquidity
• Contagion
• While increasing yield raises return expectations, is total risk balanced?
• What strategies are an alternative to traditional mandates?
• Will the results be consistent with the role for fixed income?
4
Fear not my Love, we shall
de-risk these foes all at
once!...That’s not Blackbeard
is it???
5
A Look at Alternative Fixed Income Strategies… Release the Kraken?!?! 6
Alternative Fixed Income Strategies
• Combines nontraditional securities analysis
and trading strategies to fixed income
• Categories in which many alternative
strategies fall include:
– Credit
– Emerging Market
– Distressed Debt
– Bank Loans
– Securitized Products
• Increasing exposure to alternatives may be Alt. Fixed Inc.- Multi
referred to as “de-risking” US High MSCI
BCAGG SP500 MSCI EM
– Strategies do not generally correlate with Yield World
traditional fixed income Minimum -0.53 -0.55 -0.35 -0.31 -0.26
Maximum 0.48 0.87 0.76 0.72 0.79
– Most merely trade interest rate risk for increased Median 0.08 0.32 0.35 0.36 0.44
credit and liquidity risk(s) Average 0.02 0.38 0.31 0.34 0.40
7
Emerging Market Debt
• Good diversification of developed market
government bonds, but at the expense of
increased credit risk and volatility
• Returns are largely a function of EM credit
spreads
– Volatility similar to global equity and high yield
– Increases during weak markets
• Diversification benefits are asymmetric
– Good diversification of government bonds
– Susceptible to turbulent markets JPM EMBI
US High MSCI
• Relative to emerging market equity, EM debt BCAGG
Yield
SP500
World
MSCI EM
captures 80-90% of the downside, and 50- Minimum -0.11 0.30 0.06 0.09 0.20
70% of the upside: Where to invest, equity Maximum 0.87 0.94 0.83 0.85 0.86
Median 0.60 0.64 0.45 0.49 0.55
or debt? Average 0.51 0.64 0.45 0.50 0.57
8
Credit Strategies
• Credit strategies generally correlate less with
traditional fixed income but greater with high
yield and equities
• Total return expectations: The more credit risk
the greater we rely on price appreciation and
spread compression
• Credit exposure should be a function of
economic expectations
• Higher growth, higher interest rates: more
spread beta, i.e. a positive business cycle
Alt. Fixed Inc.- Credit
increases creditworthiness; cost of risky US High MSCI
capital declines BCAGG
Yield
SP500
World
MSCI EM
Minimum -0.41 0.45 -0.03 0.07 0.07
• Lower/slower growth, stable or declining Maximum 0.61 0.95 0.88 0.90 0.87
interest rates: Higher quality, e.g. return to Median -0.06 0.80 0.53 0.60 0.62
traditional U.S. investment grade corporate Average -0.03 0.80 0.55 0.60 0.61
9Distressed Debt
• Seeks opportunities in securities where the
issuer has already, or will likely, experience
a credit event
– Creditors have a voice in restructuring or M&A, e.g.
approve a strategic buyer
– Bankruptcy: purchase debt for a price beneath true
value of assets
• Very low correlation with traditional fixed
income; value and activist investing
– Most securities are not paying interest
– Equity-like payoffs and highly illiquid Distressed Debt
US High MSCI
BCAGG SP500 MSCI EM
• Capital Structure Perspective Yield World
Minimum -0.55 0.21 0.05 0.17 0.35
– Assets= Liability + Equity Maximum 0.43 0.90 0.89 0.93 0.89
Median -0.11 0.59 0.58 0.67 0.66
– Healthy Company: Equity = Assets-Liabilities
Average -0.12 0.61 0.56 0.64 0.65
– Distressed: Liabilities (Creditors)= Assets
10Floating Rate Strategies
• Utilize debt securities whose coupon rates 1.7
Floating Rate Strategies 3 Mo. Total Return (%)
periodically reset, usually based on: 1 or 3 1.5
month LIBOR + Issuer Credit Spread 1.3
– Duration near “0” 1.1
0.9
• Bank Loans 0.7
– Senior in capital structure 0.5
– Usually HY, costly to trade, illiquid 0.3
• Floating Rate Notes (FRNs) U.S. HY- Traditional U.S. HY Loans U.S. HY FRNs U.S. IG FRN
– Senior and Subordinate
– Higher quality, better liquidity
U.S. HY- U.S. HY U.S. HY U.S. IG
• Strategy should be a function of liquidity and 2007-2012
Fixed Loans FRNs FRN
volatility Annual Return 8.72% 5.22% 6.03% 1.57%
Volatility 24.1% 16.1% 24.1% 3.7%
– IG FRNs: Cash management, diversification within Range 53.7% 28.9% 35.6% 8.0%
longer duration mandate Correl. w/ HY-Fixed 1 0.73 0.59 0.21
– HY FRNs/Loans: Interest Rate Hedge + Alpha Correl. w/ U.S. Trsy -0.22 -0.14 -0.13 -0.16
11Securitized Strategies
• Typically invest in securities collateralized by
consumer or commercial loans
– Non-Agency MBS, ABS
– i.e. No Fannie Mae/Freddy Mac
– Investor exposed directly to credit risk
• Returns are based on collateral performance–
underlying loans
• Excellent diversification benefits relative to
traditional fixed income and other risk assets US High MSCI
BCAGG SP500 MSCI EM
Yield World
• Peaks in correlation vs. HY usually isolated to Minimum -0.42 -0.01 -0.28 -0.28 -0.24
forced selling following a downgrade in credit Maximum 0.60 0.76 0.64 0.64 0.63
rating Median 0.06 0.35 0.20 0.24 0.21
Average 0.08 0.36 0.17 0.20 0.19
12Will the Seas Remain Calm?
• Nearly all alternative strategies involve some increase in credit and liquidity risk
• Contagion Risk: As credit risk increases so does volatility and correlation with other asset
classes (lower diversification)
12.31.2012 AA A BBB BB B
Yield (%) 1.90 2.41 3.22 4.69 5.80
Avg Retruns (12 Mo) % 9.31 9.75 10.98 12.48 11.73
Volatility (12 Mo) 8.33 10.91 12.34 14.06 14.95
Correlation w/ US Equity 0.20 0.31 0.28 0.33 0.51
13Staying the Course? • Since 1976, the bond market has only experienced 3 years of negative returns • In both 1995 and 2000– the years following negative returns– fixed income returned double-digits! 14
Bonds Are Back?
• 2013 returns were negative, thus far in 2014 interest rates are lower and bonds are
approximately +2%
Diversification properties remain
strong
15The Treasure Chest… • For those seeking an anchor to the wind, stick with traditional fixed income! • History has shown us that a credit squall is far worse than an interest rate one! 16
Most importantly… • When are alternative ever better than the real thing? 17
Disclosure
This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect
our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the
accuracy. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an
endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any
specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment
strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment
involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or
fall. Accordingly, investors may receive back less than originally invested. Investments cannot be made in an index. Past performance is not necessarily
a guide to future performance.
Taplin, Canida & Habacht, LLC is a registered investment adviser and a majority owned subsidiary of BMO Asset Management Corp., which is a subsidiary
of BMO Financial Corp. BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide trust, custody,
securities lending, investment management, and retirement plan services. Certain of the products and services offered under the brand name BMO Global
Asset Management are designed specifically for various categories of investors in a number of different countries and regions. Products and services are
only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of
Bank of Montreal (BMO).
Investment products are: Not FDIC Insured | No Bank Guarantee | May Lose Value
©2013 BMO Financial Corp.
18You can also read
