28 November 2024

Swiss bonds: the importance of managing risk premia

Markus Thöny

Head of Swiss Fixed Income

Philipp Burckhardt, CFA

Fixed Income Strategist and Senior Portfolio Manager

key takeaways.

Risk premia for the same asset can vary significantly over time, underscoring the importance of active risk premium management
We still find corporate bonds attractive in the current market environment, but security selection is growing more important
Active management for Swiss bonds, especially corporate bonds, makes a lot of sense in our view

Investors are usually willing to take risks, but they want compensation for it. There is a wide range of fixed-income risks (e.g., interest rate, credit and liquidity risks), and levels of compensation can vary. A basic principle remains: greater risks warrant higher risk premia.

Generating a decent performance in the bond market requires knowing what type of risks to take at what time. For example, you usually want to assume more interest rate risk when rates are falling, but shorter-term money market investments become more attractive as rates go up.

Why does getting the right mix of risk premia make all the difference to performance potential in Swiss fixed income?

A range of risks

Investors demand different levels of risk premia, depending on market conditions and their assessment of the type and amount of risk involved. As a result, risk premia for the same asset can vary significantly over time.

With risk-free money-market investments, investors usually only expect a premium for foregoing consumption today. They will demand additional risk premia for investing in equities, which exposes them, amongst other things, to country risks, sector risks, sustainability risks, liquidity risks, and of course, company-specific risks. Though there is no guarantee that equities will outperform money market investments in the short to medium term, diversified equity investments should typically perform better in the long run due to the additional risk premia.

Greater investment risks generally come with higher price fluctuations. Investors decide how much and which risks to take based on their risk tolerance and investment horizon. To smooth out the fluctuations in the overall portfolio, they aim to diversify the risks and, if possible, mix in risks that are lower or negatively correlated. That way, not all their investments will perform poorly at the same time, and any partial losses can be offset by gains elsewhere.

Negative correlations

The case for negative correlation applies not only when comparing different asset categories, but also within an asset class. With CHF-denominated corporate bonds, investors essentially seek compensation for three main risks:

liquidity risks
credit risks
interest rate risks

While the first two tend to be positively correlated, credit risks and interest rate risks usually have a negative correlation.

When the economy and companies are doing well, credit risk premia decrease – at least in theory. At the same time, central banks are inclined to raise interest rates. During recessions, bonds lose value because of widening credit risk premia. Unlike equities, though, bonds also benefit from falling rates, which can reduce or even offset the loss in value from credit risks.

The negative correlation between interest rate and credit risks is a key reason why price fluctuations are significantly smaller in corporate bonds than they are in equities.

Reverting to theory

Practice does not always follow theory, however. In the past few years, interest rate and credit risks have often been positively correlated as a result of the pandemic, the inflationary environment and geopolitical risks, leading to unusually large value fluctuations in Swiss bonds.

At the moment, though, we believe we are returning to a normal market environment of negatively correlated interest rate and credit risks. We still find Swiss corporate bonds interesting, despite the already rather low credit risk premia, but security selection is becoming increasingly important. When credit spreads are already quite tight, active management can help limit exposure to vulnerable issuers.

From a long-term perspective, credit risks in Swiss corporate bonds almost always pay off¹. Their high quality, and the good diversification of interest rate and credit risks usually result in the securities outperforming many other more rate-sensitive segments in the Swiss bond market – and even with less price fluctuation.

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Active management

Any discussion of investment risks also must address the difference between passive and active risks. Passive investing does not mean taking no risks; it means reflecting market risks – and in Switzerland, that’s mainly interest rate risk.

Figure 1 shows how our Swiss Franc Credit Bond strategy has yielded a stellar performance thanks to our bespoke active approach to managing credit risk. It compares the strategy with a comprehensive peer group that includes products targeting different market segments and various Swiss bond indices, so that the passive perspective is also represented. We chose the launch of the strategy in 2008 as the starting point.

FIG 1. Swiss Franc Credit Bond gross composite²strategy performance vs peer group^3,4

FIG 2. Swiss Franc Credit Bond strategy synthetic risk indicator⁵

Review your risks

Market risks are not static. They can change significantly over time, and it is essential for passive investors to review them regularly. Active investment risks result from deviations from market risks, and they can also increase or decrease over time.

Passive investing is a type of trend strategy. In an environment of falling interest rates, for example, the interest rate risks of bond indices tend to become longer, which works well as long as rates keep falling. If rates reverse course and start moving higher, the now higher interest rate risk can have a significant negative impact on market performance (see in 2022).

We believe that an active approach to Swiss bonds – and especially CHF-denominated corporate bonds – can provide investors with the added returns. The better diversification between interest-rate and credit risks also means that Swiss corporate bonds tend to outperform the more rate-sensitive investment segments in the long run.

Not all risk pays investors off equally. As mentioned above, risk premia can change depending on various factors, and there are certain times when it’s better to take certain types of risks. That underscores, in our view, the importance of actively trying to time when to incur a particular type of risk, rather than passively tracking the market.

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5 sources

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¹Refers to the historically low default rate in Swiss investment-grade corporate bonds. Past performance is not a guarantee of future results.
²Composite performance report presented in compliance with GIPS
Composite and Benchmark Definition
The strategy invests into CHF-denominated corporate and credit bonds with an SBI rating between A and BBB. The strategy uses financial derivative instruments not only for hedging purposes or for EPM, but also as part of the investment strategy, subject to pre-defined limits. The composite benchmark is a portfolio-weighted average of the included portfolios’ own benchmarks, rebalanced monthly using the beginning-of-month portfolio market value. The individual portfolio benchmarks include sub-indices for every asset class they are invested in. The total average composite weight of each index in the composite benchmark as at the latest year-end is disclosed below. Indices used are the SBI Domestic A-BBB TR and the SBI Foreign A-BBB TR. Base currency is CHF. This composite contains two Lombard Odier strategies, the Swiss Franc Credit Bond and the Swiss Franc Credit Bond (Foreign). Base currency is CHF
Management Fees and Other Information
All returns are presented gross of strategy total expense ratio. The maximum TER for this strategy is 0.95% based on the PA share class (investment above CHF 1 million), with a management fee of 0.35%.  All accounts in this composite are charge in the same manner.  Withholding taxes on dividends and interest are presented from a Swiss institutional investor’s point of view, whereby the Swiss recoverable withholding tax is added back to performance. Further information on calculation methodologies and composite management procedures is available upon request.
GIPS Firm definition
Lombard Odier Investment Managers (LOIM), the institutional asset management unit of Lombard Odier worldwide comprising all discretionary institutional mandates and all Lombard Odier public investment funds managed at the LOIM unit, but excluding Private Equity mandates and funds and the 1798 Hedge Fund family (as of 01.01.2013) as subject to a different management process.   LOIM Exchange Traded Funds (ETF's) have been included since launch in April 2015.
Past Performance
Past performance is no guarantee for future results.
Firm Definition
The firm definition was recently changed by mentioning the non-inclusion of the LOIM Private Equity portfolios and the exclusion of the 1798 Hedge Fund family as of January 1, 2013.  This change was done for accuracy purposes and involves no change in the composite list or no material change in the assets under management figures.
Significant Cash Flow Policy
The firm applied a Significant Cash Flow Policy for this composite until December 31, 2010 whereby portfolios were temporarily excluded from the composite on any significant cash flow occurrence.  This practice was abandoned on January 1, 2011 and no portfolios were excluded for significant cash flow reasons as of that date.
³ Source: LOIM, Bloomberg. As at 31 October 2024. Past performance is not a guarantee of future results. For illustrative purposes only. Composite performance shown serves as indicative performance of the strategy.
⁴Strategy performance is based on a composite, starting from 1 July, 2008. Peer group comprises 37 actively managed Swiss bond funds and four market indices that represent passive solutions. For peers with a shorter track record, we supplemented the missing data with the track record of our Swiss Franc Credit Bond strategy. The peer group methodology cited herein is provided for information purposes only and may be subject to change over time. No fund/benchmark/index is directly comparable to the investment objectives, strategy or universe of our fund. This document has been prepared by LOIM employees who are encouraged to raise assets for their strategy and may have a conflict of interest. Information relating to peer group methodology is available on request.
⁵ This summary risk indicator (SRI) is a guide to the level of risk of this product compared to other products. Where there are less than 5 years worth of data, missing returns are simulated using an appropriate benchmark. The SRI may change overtime and should not be used as an indicator of future risk or returns. Even the lowest risk classification does not imply that the Sub-Fund is risk-free or that capital is necessarily guaranteed or protected.

important information.

For professional investors use only

This document is a Corporate Communication for Professional Investors only and is not a marketing communication related to a fund, an investment product or investment services in your country. This document is not intended to provide investment, tax, accounting, professional or legal advice.