Fixed income: tactical descents, structural opportunities

Diverging paths and political potholes 

	Sandro Croce CIO, Fixed Income
	Philipp Burkhardt, CFA Fixed Income Strategist and Portfolio Manager

 

Need to know: With economic conditions now clearly varying between regions, developed-market central banks are plotting their own routes forward, searching for suitable terrain to create the soft landing markets are hoping for The uncertainty created by rising support for populism and the snap election in France has been reasonably contained. However, political risk is a feature both in Europe and the US given unorthodox policies proposed by some candidates While current conditions are reasonably benign for fixed income, both rate cuts and inflationary risk are in the air. We are therefore neutral on credit and long duration, while staying agile with a strong focus on security selection

 

Having passed the midpoint of the year, two key themes are apparent that have important implications for fixed income. The first is the growing divergence in economic conditions between regions, which is increasingly being reflected in differing monetary policy approaches from central banks. The second is that in a year when more voters than ever in history are going to the polls, political risk is making its presence felt.

 

Central banks go their own way

Despite the intertwined nature of the global economy, even developed markets are no longer moving in lockstep.

In Europe, while economies have recovered post-pandemic, the region is still not back to trend growth. With inflation relatively low (albeit going through similar upswings and downswings as other economies globally) and growth lagging, the European Central Bank (ECB) felt confident at the beginning of the year to tie its colours to the mast regarding rate cuts. However, a reacceleration – among other reasons possibly due to lower inflation creating more disposable income and better demand – has left the ECB to make a hawkish rate cut while refusing to commit to future actions.

It seems the ECB may be wary of provoking a similar scenario to that seen in the wake of the US Federal Reserve’s (Fed’s) pivot in November 2023, when the bank’s forward guidance regarding monetary easing was followed by a market reaction that led to excessive pricing of rate cuts for 2024, a stronger dollar and lower spreads. Ultimately, market pricing boosted investor confidence and fuelled a rally on risky assets, which in turn reduced the need for actual rate cuts.

The Fed, meanwhile, has been dealing with a more volatile and complex situation. Unlike in Europe, economic slack is almost inexistent in the US. Nominal growth is back to pre-pandemic levels, while other data provides mixed indications. This has left the possibility that inflation might continue to run hot, making it difficult to navigate a path and creating a risk of any action from the central bank doing more harm than good. The Fed has therefore adopted a ‘wait and see’ approach, while telegraphing that rate cuts will come in time.

With the Fed at peak restrictive policy, the US case is trickier to handle, particularly when political uncertainty is added to the mix. In our view, though, the US economy is showing quite clear signs of slowing down (see Figure 1). Meanwhile, the fiscal deficit is high, but market participants are buying US debt, and the steepening of the curve has been somewhat limited. All things being equal, we foresee up to two rate cuts in the US before the end of the year, with a steepening of the curve coming from that as the front end moves lower.

 

FIG 1. US growth: easing exceptionalism (left) and US inflation: bumpy road to normalisation (right)

Source: LOIM, Bloomberg at 30 June 2024. For illustrative purposes only.

 

By comparison, Switzerland has seen less inflation, giving the Swiss National Bank more room for manoeuvre. Having been at 1.75% at the beginning of the year, the SNB cut its policy rate again to 1.25% in June – before the Fed has even cut once. The move seems more to counteract currency strength and its effect on exporters than to address any inflation concerns, and reflects the SNB’s confidence in its overall policy mix.

Looking ahead, we believe the SNB could cut rates further before the end of the year. Based on comments made by outgoing Chair Thomas Jordan, at 1.25% we are likely still in restrictive territory, but we expect the bank will need more concrete evidence of easing price pressures before taking any further action.

 

Political risks create potholes, not quagmires

In the US, the result of the presidential elections in November could have significant implications for the country’s economy, and the Fed must stand ready to adapt. The impact of another Trump presidency may be strongly inflationary given his stated policy intentions in areas such as trade policy and immigration, especially in a still-tight labour market. Consequences could include accelerating growth, demand-side inflation due to stimulation, or an impact from tariffs on the supply side.

Similarly, in Europe, increasing political polarisation and a rise in populism potentially sets the scene for a more profligate approach to governance. The European election results and snap general election in France have seen quite a significant repricing of what are usually seen as reasonably safe assets in the regional context. While the country’s high debt is not a major risk in itself, the potential for a party to come into power with plans for major spending has caused concern.

With politics becoming less comfortable, uncertainty may keep spreads somewhat wider than in the past. On the other hand, the hung parliament in France is likely to moderate any spending sprees pledged during the campaign. At the same time, as has been seen in Italy, extravagant promises made while in opposition tend to be stymied by the practical realities of governing. As a result, while initial uncertainty sees spreads increase, they tend to recover over time as unorthodox measures are postponed or assigned to be lower priorities.

More specifically for corporate bonds, our view is that the selloff has demonstrated the effective functioning of a healthy and generally robust market. Tight spreads mean any uncertainty provokes some repricing, but thanks to sound macro and credit fundamentals, the impact has felt relatively muted, with only limited contagion from sovereign tensions.

 

Keep your hands on the wheel and be ready to change gear

From a risk perspective, in our view the environment is fairly benign, with broadly robust growth and easing inflation providing reasonable expectations for a soft landing. That said, the situation has yet to tip decisively in one direction or the other. It should be kept in mind that softening is rarely linear and can become disorderly, while the nature of any hard landing is that it is not apparent until the impact arrives. Overall, though, it’s hard to see the economic backdrop shifting dramatically in the short term unless a major shock materialises.

As things stand, the market expects a first Fed rate cut to come in September. Investors should position themselves ahead of the start of the easing cycle, as the medium-term view of lower rates and steepening curves is positive for fixed income, taking away the disincentive to invest created by an inverted curve. Staying in cash would mean being locked into a given rate for a short time, creating reinvestment risk; while losses would be limited, so would the upside, since no mark-to-market gains from rates rallying can be locked in.

Fixed-income investors want to have duration, because once policy rate cuts come through, rates across all maturities tend to shift lower, creating a multiplier effect – as happened in during November and December 2023. Despite attractive all-in yields, credit spreads and hence risk premia remain rather expensive from a historic perspective and investors should keep in mind that a recession remains possible. If central banks are pushed to cut rates due to slowing growth, and inflation is low because demand is weak, corporate profitability is likely to feel some pressure and lead to a repricing of credit risk.

The easy case to make is for going long on duration rather than credit, especially when bearing valuations in mind. High rates make it possible to lock in attractive carry, whereas on corporate bonds there is limited additional premium to compensate for the extra risk. However, as John Maynard Keynes famously observed, the market can stay irrational longer than those betting against it can stay solvent. In a relatively benign environment, we see no reason not to seek returns but remain ready to head for the exit should conditions worsen.

Ultimately, we believe the best way to aim to beat the market in the current scenario is by avoiding the losers. The rapid rise and vertiginous fall of CCC credit earlier this year provides a salutary example – we would question whether that level of volatility is desirable for any investor. In an uncertain environment, the importance of fundamental analysis and individual security selection is stronger than ever.

Our position is therefore to be neutral credit and overweight duration. To limit risk, we prefer higher quality credit, avoiding the need to being caught with weaker issuers whose bonds would become illiquid if the situation deteriorates. Finally, with the US election in mind, in our view US inflation-linked securities are worth considering as a means to access duration through risk-free US Government assets, while hedging against potential medium-term inflationary risk and inflation volatility.

Source: LOIM at 30 June 2024.

Long way down: the descent is underway

Nic Hoogewijs, CFA  Senior Portfolio Manager

 

Need to know: Q2 2024 was challenging for sovereign investors, with key central banks backpedalling somewhat on forward guidance regarding monetary easing; however, the descent from peak rates has finally begun for most Political risk should not be ignored, but sentiment towards developed market fixed income is positive and while quantitative tightening is increasing net supply, attractive yields mean private investors are helping absorb this  Looking forward, we reiterate our constructive stance on sovereign fixed income and seek opportunities to add to our modest overweight allocation to lock in yields before monetary easing steps up a gear

 

Fundamentals and macro

The second quarter of 2024 was tricky to navigate for investors in sovereign bonds. Having signalled their intentions to start easing, central banks were hampered by data that refused to definitively support the argument for rate cuts.

As noted in the lead article of this quarter’s Alphorum, recent months have been marked by regional divergence in economic performance. Meanwhile, data conveyed conflicting signals at times, exemplified in May by US labour statistics; while the establishment survey showed stellar job growth, the household survey showed a 0.6% year-on-year uptick in the unemployment rate to 4%.¹

Despite these inconsistencies, however, the timeliest data such as purchasing manager index surveys remain consistent with a steady global economic growth of close to 3.2%, as pencilled in by the International Monetary Fund for this year and next. Meanwhile, evidence suggests the inflation shocks triggered by post-pandemic supply-chain disruptions and the war in Ukraine have largely unwound; the global annual consumer price index fell to 3.4% in in March 2024, down from a peak of 8% in Q3 2022.

With developed market central bankers more confident that inflation has been tamed, the descent from peak rates has begun in earnest. In June the Swiss National Bank lowered borrowing costs at a second straight meeting, while the Swedish Riksbank, the Bank of Canada and the ECB also kicked off their respective easing cycles. Even the Fed and Bank of England signalled a strong bias towards easing in the next six months, although they await greater clarity in the data.

Nevertheless, the debate regarding whether core inflation will return to a consensus target of around 2% in the coming quarters remains intense. If inflation normalisation remains bumpy, it may dampen the speed and extent of easing cycles in some economies. In this context it is unsurprising that central banks remain data dependent and advocate patience.

On the political front, the announcement of snap elections in France spooked financial markets, with spreads on French Obligations Assimilables du Trésor (OATs) versus German Bunds spiking to levels last seen in the run-up to the 2017 presidential elections. Less dramatically, in the UK general election was announced for 4 July.

 

Sentiment

Upside surprises in activity and inflation data at the start of the year weighed on sovereign bond markets in H1 2024, with the performance of the Bloomberg Global Treasury Index (EUR hedged) in modest negative territory, lagging cash by about 3%². With some central banks already delivering initial rate cuts, Commodity Futures Trading Commission data suggests speculative investors sharply reduced their short positions over the past two quarters. As cash rates peak, appetite to underweight sovereign fixed income is plunging as investors generally look to lock in historically high rates with longer duration.

The wobble caused by the turmoil in OATs did little to dent the consistent easing in financial condition indicators (FCIs) over recent quarters, with equity market performance contributing strongly. The signal conveyed by FCIs stands in contrast to the tight monetary policy stance indicated by the real fed funds rate (i.e., net of inflation), which has risen over the past year thanks to the sharp fall in inflation. We continue to monitor overall financial conditions closely and acknowledge that persistent easing in FCIs could support pricing in a relatively shallow easing cycle beyond 2024. 

 

Technicals

At its May meeting, the FOMC announced it will slow the pace of reductions in its securities holdings from USD 75 billion to USD 40 bn per month from June onwards. By comparison, the ECB will start to reduce its holdings of securities under its pandemic emergency purchase programme by only EUR 7.5 bn per month on average over the second half of the year. Meanwhile, the Bank of England continues to actively pursue quantitative tightening (QT), reducing its Gilt holdings at a pace of GBP 100 bn per year. While the regional dynamics differ, the bigger picture remains that net supply, net of QT, will be elevated for the next couple of years as governments continue to run large deficits.

Fortunately, historically attractive yield levels is allowing private investors to step up and absorb some of this supply, with J.P. Morgan estimating robust year-to-date global bond fund inflows of USD 478 bn³. However, unlike official central bank purchases for the purpose of quantitative easing, private sector bond purchasing is price sensitive. As the recent case of France illustrates, if the fundamental outlook for a sovereign weakens, the risk premium investors command to fund deficit spending can reprice abruptly.

Meanwhile, in contrast to the healthy inflows into developed market sovereigns, emerging market debt funds have seen continued outflows in 2024.

 

Valuations

At this stage in the cycle, with several major central banks still to cut rates, sovereign bonds tend to outperform cash. Given historically attractive yields, we remain modestly overweight in the segment. We also see duration as a good diversifier for credit risk and seek opportunities to add duration exposure, but acknowledge that yields have rallied to the lower end of the recent range following the political drama in France.

As mentioned in our lead article, in the US, the Trump campaign’s flagship policies – including tax cuts, tariffs, immigration curbs, and limiting the Fed’s independence – would be inflationary and thus unequivocally negative for bond markets. With betting markets ranking Trump as favourite to win a second presidency, political risk may become an increasing focus over the coming months.

In the Eurozone, France’s primary deficit is among the worst in the bloc, while its debt-to-GDP ratio has jumped more than any other country since the pandemic-induced shock (see chart below). As a result, the country’s credit profile is structurally under pressure – as reflected by the S&P downgrade from AA to AA- at the end of May. Indeed, with France failing to abide by its own debt and reduction targets for the 2023-2027 period, set only a year ago, the European Commission launched its Excessive Deficit Procedure. However, while the widening in French sovereign bond spreads may persist, we see the risk of contagion as relatively contained.

 

FIG 2. Fiscal positions in several eurozone countries are not compatible with debt-path stabilisation

Source: LOIM, International Monetary Fund as at 30 June 2024.

 

France’s hung parliament since elections in June 2022 has been a key factor in the country’s failure to rein in its fiscal deficit and improve its deteriorating credit profile. Another hung parliament should at least limit the risk of further deficit increases as scrutiny from both investors and the European Commission intensifies. However, we believe that sooner or later France needs to rein in its deficit spending from 5.5% towards a nominal growth rate of around 3% (1% real growth plus 2% inflation), or face a gradual ongoing increase in its debt-to-GDP ratio. We think a gradual deterioration of the fiscal outlook is most likely as political gridlock complicates delivering on fiscal targets. However, barring a significant growth shock, we do not expect the situation to spiral.

In emerging markets, yields are generally high, but the yield premium looks tight versus US yields. We therefore remain neutral on EM local currency debt.

 

Outlook

Looking forward, we reiterate our constructive stance on sovereign fixed income, while caveating that political risk, particularly from the presidential election in the US, could prove a negative factor. We expect monetary policy easing to be uneven, but with heavily indebted governments having a vested interest in maintaining low financing costs, central banks will be keen to take the monetary policy stance into less restrictive territory as soon as the data allow. The French situation, with nominal growth important to keep the debt trajectory on a sustainable path, sheds a different light on the same issue. Central banks are walking a fine line, since keeping monetary policy in restrictive territory for too long and undershooting the 2% inflation target would put public finances in jeopardy.

In this context, we seek opportunities to add to our modest overweight allocation in developed market sovereign fixed income. In emerging markets, our base scenario of monetary easing and declining inflation provides support for EM debt. However, there are headwinds in terms of geopolitical instability, the impact of US elections and weaker growth in China, as well as the possibility of rates staying ‘higher for longer’. Political risk is also a factor in the wake of elections in India, South Africa and Mexico.

Sources.

Anyone for bowls?

Ashton Parker Senior Portfolio Manager and Head of Credit Research

 

Need to know: After the dramatic events of the past 18 months, the corporate credit market looks set for a relatively quiet and unremarkable summer. But in the world of fixed income, boring is good In our experience, political churn tends to have a limited impact on credit markets, while gently deteriorating fundamentals are no great cause for alarm beyond the lower reaches of HY In a relatively calm market, we seek opportunities to take calculated risks. With spreads tight and little premium on offer for new issues, a contrarian approach can find some pockets of value in the secondary market

 

Summer seasonality

One of the great joys of early summer is the preponderance of coverage of major sporting events to fill our evenings. As keen sports enthusiasts, we’ve bitten our nails to the quick watching England’s performances in the Euros, celebrated Mark Cavendish’s record 35th Tour de France stage win and were quietly moved as Wimbledon bid farewell to Andy Murray.

We’re also fond of a sporting analogy, however, there’s little in the drama of these major sporting events that we can relate to current goings on in the world of corporate credit – which feels if anything more like the cricket on a rainy day.

 

Politics, as usual

What about the political upheaval, you might well ask? Well, the landslide victory for Labour in the UK was so well flagged as to be a virtual non-event for markets. And while it’s true that corporate spreads widened in June in reaction to the snap election in France, at the time of writing they had seen some rallying since. Although a hung parliament is unlikely to be the most efficient government when it comes to decision-making, we do see this as preferable for credit markets as it avoids the tail risk of a far right or left economic and fiscal policies.

All things considered, in our view election fallout is a transitory phenomenon in corporate credit, especially in the developed world. Once in office, even political firebrands must usually encounter the cold water of practical realities. Governing is full of necessary compromises, and populist politicians are rarely as damaging for their economies as at first sight it might appear they could be (Georgia Meloni in Italy being a recent example). Even Donald Trump’s presidency had a limited impact (positive or negative) on the US economy, as a look at indicators such as economic growth, stock-market performance, unemployment rates and wages shows⁴. And when ambitious leaders really go to town with questionable economic policies, they can often find themselves chastened by sceptical markets – just ask Liz Truss.

 

We’ve got interest cover covered

On our watchlist of possible problems in credit markets, we name the potential for a steady deterioration in credit metrics as companies are inevitably obliged to refinance cheap debt (raised when rates were close to zero) with today’s more expensive debt. As a result, traditional credit skills like interest coverage analysis, which has been largely irrelevant for almost as long as we can remember, are becoming relevant once again.

Most firms at investment grade (IG) are within the ballpark of the accepted standard of three-times coverage of their interest payment obligations. The main exceptions are real-estate names, which have been falling down as low as sub two-times on a forward-looking basis. However, real-estate companies traditionally have a high debt burden for their level of income – the counterbalancing factor is that their income is close to guaranteed over the long term by the durability of their assets. For the weakest companies at the lower end of the quality spectrum, low interest coverage could certainly cause downgrades. But for prudent companies with a well-established debt maturity profile, refinancing shouldn’t be a major issue as interest rates plateau and start to move lower. 

 

Boring is good

In the end, while we might wish for a little drama – if only to have a tale to tell here and the active opportunities it might bring – the current corporate credit environment is best described as a little boring. And that’s no bad thing: the last 18 months have been uncharacteristically eventful for fixed income, but we’re happy to leave equity investors to surf the uncertain waves of volatility, and instead enjoy calmer seas. After all, the whole point of bond investing is to provide a relatively safe harbour by securing a fixed cashflow over a specific period of time.

Having said all that, we recognise opportunities to take some calculated risks. As discussed elsewhere in this issue of Alphorum, with rate cuts looking likely on both sides of the Atlantic in the coming months, now is the time to get out of cash and into fixed income. So, where can the potential for outperformance be found?

 

The benefits of contrarianism

With spreads tight and new issues offering minimal premium, we’ve been trawling the news flow looking for pockets of value in the secondary market. We have noted the steady stream of short-selling reports on a range of different names regularly appearing in our news feeds. However, rather than the kind of classic insight highlighting the sort of fraud or issues that could bring down a company, often these seem to have something of an opportunistic, sensationalist flavour. Ultimately, these missives are useful – although not necessarily for the reasons their authors intend.

In past issues of Alphorum, we’ve repeatedly highlighted fallen angels as the ultimate contrarian trade: a fundamentally robust bond falls from grace and drops from IG to HY, at which point a canny investor will seize the opportunity to buy. In time, strong fundamentals supports recovery and the investor reaps the benefits. The contrarian style in credit investing need not be limited to fallen angels, however.

When a short-selling report is published, the market’s first action is to mark-down the price of the associated bonds. In contrast, our first action is to assess its arguments and conclusions carefully. Is there genuine cause for fresh concern, or is there nothing presented that the ratings agencies don’t already know? If the latter is the case, it probably represents a buying opportunity. Recent names in the frame have included French testing laboratories group Eurofins Scientific, blood plasma manufacturer Grifols, US multinational data centre provider Equinix, and Swiss financial enterprise software firm Temenos⁵.

 

FIG 3. Sold short: Temenos bonds recover quickly

Source: LOIM, Bloomberg at 08 July 2024. Past performance is not an indicator of future results. For illustrative purposes only. Please note: Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

 

While some of these claims are too recent for us to be 100% confident of their veracity and/or impact, the example of Temenos⁵, which was the subject of a short-selling attack by US financial research firm Hindenburg in February, is instructive. A report by Hindenburg alleged Temenos had committed accounting irregularities and manipulated earnings. As well as wiping out nearly a third of the company’s stock market value, Hindenburg’s allegations hit Temenos’ bond valuations – the firm’s 2025 maturity bonds dropped 16 points to 83, while its 2028 maturity issue dropped even further, from 102 points to 80. However, in April, following a probe involving two different law firms and forensic accounting firm Alvarez & Marsal Switzerland, Temenos published a firm rebuttal to Hindenburg’s attack. Since then, the firm’s bonds have all but recovered to their prior valuation, with the 2024 issue being repaid.

As you can see, in the end, we always manage to find a little drama somewhere. However, rumours that we prefer short-selling reports to the intrigues of elite sport can be neither confirmed nor denied…

Source.

Hedging credit risk with rate volatility

	Anando Maitra, PhD  Head of Systematic Research and Portfolio Manager
	Jamie Salt  Systematic Fixed Income Analyst and Portfolio Manager

 

Need to know: Diversification is often touted as the only free lunch in investing; however, in fixed income, the diversifying properties of Treasuries to risk (credit) exposures have proven to be dependent on macroeconomic regimes Long duration exposure will only hedge downside credit risk in a growth shock. Hedging downside credit risk across a broader range of macro environments requires allocations to less traditional instruments Our research shows that the systematic purchase of rate volatility acts as an improved systematic hedge for credit risk across a range of market regimes and shocks, with minimal cost of carry when markets are benign

 

Harry Markowitz famously touted diversification as the only free lunch in investing – but it is possible to find competitive meal deals, in our view.

Within the multi-asset allocation framework, the pursuit of diversified portfolios brought widespread prominence to the 60/40 portfolio⁶. In developed markets, this formula proved a tough benchmark to beat for long-only allocators, becoming the gold standard for almost 30 years. Within the fixed-income world, the parallel has been the use of duration exposure as a diversifier to credit risk.

As is now well documented, this formula’s long reign of superiority collapsed in the wake of the Covid crash and recovery of 2020-21, as inflation unwound the negative correlation of government bonds to risk assets, with both selling off in tandem (and in volume) through 2022. Ultimately, the diversification benefits of duration against risky assets had been dependent on a secular bull market in government bonds. That market had been fuelled by consistently subdued inflation and highly accommodating monetary policy – in the form of ultra-low central bank rates and quantitative easing programmes. But as inflation soared and central bank rates climbed steadily higher, the reality became clear: duration alone is not the best systematic hedge for credit risk through all cycles after all.

With the fatal flaw in this allocation approach exposed, a simple question arises: is there an alternate hedge for credit risk? Here we explore the use of one such hedge, the systematic buying of rate volatility (long rate vol). We present the case that long rate vol acts as an improved systematic hedge for credit risk across differing market regimes and shocks, without excessive carry costs when markets are benign.

 

Accessing rate vol exposure

Before delving into the investment case, we should first explain the broad methodology employed to access rate volatility⁷. Accessing pure volatility exposure requires the use of derivatives in the form of options or swaptions within the rates space – specifically, a combination of delta-hedged at-the-money⁸ call and put option positions known as a ‘straddle’. This approach allows for a strategy whose returns correlate positively to the volatility of the underlying rates instruments (referred to as positive ‘vega’ in options terminology).

There are two key advantages of using rate options as opposed to credit options. First, we have long-dated options in rate markets as opposed to credit markets, which allows options to be much more sensitive to rate volatility⁹. Second, long-dated options demonstrate comparatively low implied volatility, combined with a downward-sloping volatility curve that provides positive carry – an anomaly in options markets¹⁰.

We recognise that many asset owners will lack access to the specialist implementation this method for accessing rate volatility requires. Such a strategy would therefore be most easily implemented via a structured product.

 

A hedge for all regimes

The breakdown in negative correlation between duration and risky asset performance over the past three years has been well documented. The crux of the matter is that duration hedges negative performance by risky assets only when inflation is contained. In contrast, in periods of heightened inflation – such as the post-Covid world and in the 1980s – this correlation turns positive.

Ultimately, we would argue that the premise of duration hedging credit risk is partially true but needs to be caveated; essentially, a long-duration exposure will only hedge downside credit risk in the event of a growth shock. For credit risk linked to an inflation shock, the appropriate hedge is actually a short-duration exposure, but for a systematic hedge this would involve timing directional bets, which is much easier said than done.

Yet rather than directional rate moves, a commonality between both scenarios is rising rate volatility. Figure 5 shows that rate volatility (as indicated by the MOVE index¹¹) has spiked concurrently with all credit drawdowns in the last 20 years. A systematic exposure to rate volatility, rather than a pure long-only duration, should therefore act as a much more suitable hedge.

 

FIG 4. MOVE index versus high-yield excess return drawdowns, 2004-2024

Source: Bloomberg, LOIM calculations at 30 June 2024. High-yield excess return drawdowns uses the Bloomberg Global High Yield Index. Past performance is not a reliable guarantee of future results. For illustrative purposes only.

 

To demonstrate the benefits of this approach, Figure 6 compares the rolling correlations between rates and credit, and between long rate vol and credit, between 2007 and 2024. As you can see, up until 2022 the two correlations were comparable and negative. However, as expected, while rate-credit correlations spiked into positive correlation during the post-Covid inflation shock, long rate vol-credit correlations remained stable and negative across both USD and EUR markets, demonstrating the persistent hedging properties of the strategy.

 

FIG 5. Three-year rolling return correlations for rate vol-credit and rate-credit, 2007-2024

Source: Nomura, Bloomberg, LOIM calculations at 30 June 2024. Correlations calculated using monthly return data. Credit returns and excess returns of Bloomberg US and Pan-Euro High Yield corporate bond indices. Long rate vol returns are calculated using aggregate indices for a Nomura 10y20y rate swaption straddle, for USD and EUR markets respectively. Past performance is not a reliable guarantee of future returns. For illustrative purposes only.

 

Performance through the cycle

We have successfully demonstrated the favourable correlation behaviour of long rate vol, but how does this translate into performance? To help us answer this question, Figure 7 shows the conditional performance of a long rate vol strategy across different performance deciles of US rates and HY credit returns, moving from the worst decile of Treasury or CDX HY performance on the left to the best decile on the right¹². As you can see, the results indicate that the correlation translates into a favourable return profile.

Unsurprisingly, long rate vol exhibits a highly convex return profile, performing extremely well in both the lowest (0-10%) and highest (90-100%) deciles of rate performance, as these tails are clearly where volatility is highest. However, more importantly, the hedging profile versus credit performance is almost perfectly monotonous, performing best in the lowest CDX HY performance decile and only posting notable losses in periods of extreme positive returns from credit (represented by the top decile). This is a rather ideal outcome for such a strategy.

 

FIG 6. Conditional performance of long rate vol strategy by rate and credit performance deciles

Source: Nomura, Bloomberg, LOIM calculations at 30 June 2024. Deciles are based on 20-day rolling returns from 2004-2014 and use the same indices as Figure 2. A US-only strategy is shown, but similar results are obtained in European markets. For illustrative purposes only.

 

Another requirement for a hedging strategy is managing the downside, or ‘bleed’, experienced when the market environment is benign or risk-on, as this can be highly detrimental to the long-term performance of the strategy. During these periods, the positive carry of long rate vol highlighted earlier becomes vital.

As Figure 7 demonstrates, positive carry helps mitigate the losses of long rate vol, both in the higher return deciles of credit and during low volatility periods around the median point in rates. In periods of ‘regular’ performance, a long rate vol strategy will not therefore adversely impact overall portfolio performance. In fact, while the details are beyond the scope of this research piece, in our view the long rate vol strategy can be enhanced even further to maximise positive carry and create an even more favourable return profile.¹³

 

Conclusion

The breakdown in the negative correlation of rates and risk assets in 2022 shook allocation frameworks, emphasising the need for truly diversifying strategies that are independent of larger macroeconomic trends. Often, this is likely to require allocations to less traditional instruments and strategies. As we have demonstrated, long rate volatility represents an improved hedge for credit in the long run, ensuring a consistently negative correlation while limiting drag through benign periods. Overall, we would argue that there is no truly free lunch in investment, but that long rate vol is the best-value meal deal out there.

Sources.