Absolute Versus Relative Returns
Credit spreads have been resilient for the majority of 2018, outperforming duration-matched Treasuries, as business fundamentals remain sound and new issue supply remains down year-over-year. However, fixed income total returns through May are negative across most sub-asset classes, a function of higher Treasury rates. It’s been five years since the ‘taper tantrum’ in mid-2013 caused fixed income returns to turn negative, but the roughly 100 basis points sell off in 10-year Treasury rates since last fall has created a similar dynamic, and probably a more permanent paradigm shift.
In light of recent events in Italy, which contributed to a rally in Treasury rates, the drivers of higher rates over the past five months (higher oil prices, gradually rising inflation expectations, Fed policy normalization, etc.) appear sustainable over the intermediate term. For those managing against an index, relative performance is what counts, and navigating rising rates can be accomplished via buying shorter duration assets or holding more cash (thus expressing a rate view by being ‘short’ a benchmark).
For those that care about absolute returns — where the goal is generation of positive returns, not just outperformance of an index– it is a much more difficult exercise. In other words, being less negative than an index may be fine in the world of relative value, but that is cold comfort to investors focused on earning a return on their invested capital. This is particularly relevant when that capital can flow into equities and other asset classes.
Generally, two important components of unconstrained strategies are portfolio construction and risk management. With regard to the former, one may make sure all the cross correlations are behaving as expected given the wide variety of different asset classes in the portfolio. From a risk management perspective, crafting position sizes and understanding the liquidity profiles in individual securities are critical, as this frames the downside risk to the portfolio in the event a particular trade goes the wrong way. Also, credit quality should be carefully managed. Year-to-date, the best performing fixed income securities were in the leveraged finance arena. This makes sense during a period of rising rates and low defaults. However, unconstrained strategies that are overweight these types of securities still expose investors to a great deal of credit and liquidity risk over time. There is also a separate question of valuation as credit spreads near post-crisis tights.
A strategy consisting of a variety of fixed income asset classes – ones that are free from index constraints – may offer a way to potentially generate positive asset returns in the current environment. Utilizing a blend of varying fixed income securities, derivatives, and long-short strategies can be useful tools available in an unconstrained toolbox.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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