Wider horizons to cope with challenging times

Bond investing is less than ever a straightforward buy-and-hold exercise. Benchmark-constrained investors contend with historically low yields as well as increased risk of capital loss. Long term yields from core European sovereign debt are barely in positive territory, while spreads on many credit instruments have narrowed to levels that are unacceptable for many conservative investors. In addition, we are approaching a new era for bonds. The US Federal Reserve is preparing the ground for rate hikes, and the possibility of a liquidity squeeze in the credit space is increasing. The end of easy money will prove challenging for many investors, particularly those with significant allocations to benchmark-constrained bond strategies. Measuring returns against a benchmark clearly has a place, particularly for investors such as insurers and pension funds seeking to match very long-term liabilities. However, for other investors, ultra-low yields are insufficient to meet financial goals, and the prospect of capital losses on fixed income and, perhaps, on “safe haven” bonds too, is unpalatable. Being long duration is fine in some market environments, but in others the inability to diversify by taking sizeable directional or currency views, for example, can really hurt returns. In short, bond investors are increasingly seeking alternatives to traditional bond funds.

Why is total return a preferable strategy?

Bonds form a substantial part of most investment portfolios. Although now may be the right climate for equities, most global asset allocators must include bonds in the mix for diversification purposes. In our view, they can invest in benchmarked bond strategies and hope that the market direction is favourable, or they can adopt a total return approach which gives them access to more flexible strategies. Our total return bonds strategy compares bonds across the whole fixed income spectrum – from safer securities to riskier bonds such as high yield, emerging markets and convertible bonds. It has the potential to find attractive income streams in all regions across the globe at cheaper prices and/or for less risk. This approach allows us to invest outside low interest rate geographies such as the Eurozone and seek higher-yielding assets elsewhere. We can even position the portfolio to be less rates-sensitive in regions where we feel there is the possibility of a rise in interest rates that would impact bond yields.

How does Candriam’s cycle-responsive approach improve investment performance?

Central bank intervention has become a key feature of markets in the aftermath of the financial crisis, and is unlikely to abate in the coming years. This has a powerful and, sometimes unpredictable, impact on both the economy and financial markets.

As such, we believe bond selection could benefit from being more sophisticated in terms of which type of fixed income to hold at which stage of the economic cycle. After all, returns from different fixed income assets are diverse and each bond type responds uniquely to different stages of economic contraction and expansion. Our strategy starts with a proprietary hypothesis: namely that there are three different, but interrelated cycles that affect fixed income performance –the business cycle, the monetary policy cycle and the financial cycle.

The business cycle describes deviations from the long-term economic growth trend as phases of economic expansion and contraction. The monetary policy cycle is best seen – both in terms of length and of amplitude – not by plotting the absolute level of interest rates, but by following the number of actions by a central bank over time. The financial cycle relates the importance of the role of credit and asset prices to macro-economics.

The interdependencies between the cycles provide a valuable strategic tool. By following our selected leading indicators in each cycle and relating them to their trending behaviour, it becomes easier to correctly identify current conditions and imminent turning points. The cycle-responsive approach helps us to size our positions and to reduce correlation between the assets we hold.
The approach does not directly inform security selection, but it does tell us which ocean we are navigating and from which direction the wind is coming. At the moment, the wind is generally bringing in low interest rates, deflationary forces and competitive currency devaluation, but subtle changes are constantly taking place.

What else differentiates your approach to bonds?

Our cycle-responsive approach is the first step of our allocation decision-making process, but there are two other important steps in our strategy: valuation and technical analysis. In terms of valuation, our assessment of fair value on credit spreads leads to an adjustment of the asset allocation derived from the cycle analysis. Meanwhile, technical analysis helps to identify the strength of momentum and likely reversals - in relation to investors’ positioning, as measured by various surveys and flow of funds data.

Beyond the decision related to the choice and ranking of asset classes, the risk calibration is of paramount importance to size positions using risk parameters such as VaR and drawdown.

Finally, our security selection is bolstered by Candriam’s fixed income expertise: our experienced bond analysts, focused on asset class, sector and region, pick the most attractive government and corporate securities across the bond spectrum.

Is your total return approach appropriate for the current economic environment?

We think the strategy is suitable for all environments. It can even benefit from bond market turmoil thanks to its use of derivatives and fairly liquid cash securities, which enable it to swiftly adjust allocation, duration and the currency mix. By contrast, a benchmark-constrained approach cannot effectively perform in all weathers. We think a flexible, dynamic approach to asset allocation within a diversified portfolio can generate positive returns over a two- to three-year investment horizon, across all cycles.

Fixed Income Team