By Mike McEachern
Fixed income investing may be reaching an inflection point: markets are jittery about US quantitative easing ending and with ultra-loose monetary policy from the Fed no longer to be relied upon we could be looking at the end of the 30-year bull market fixed income investors have enjoyed amid long-term falling interest rates.
Against this backdrop, many investors are looking beyond traditional longonly strategies to flexible solutions designed to perform during different market conditions and deliver meaningful return during periods of rising interest rates. The hedge fund world has long been home to flexible, absolute return approaches to credit investing which are free from benchmark and sector constraints and now their appeal is growing, giving rise to a newer breed of strategies where performance fees and leverage are absent and more robust risk controls and regulatory frameworks present.
Key features of next generation credit
A good multi-asset credit portfolio should be able to generate returns from a wider number of sources than a traditional strategy, using a range of techniques to capture attractive risk-adjusted returns, avoid out-of-favour sectors, dampen volatility and hedge risk. The absence of standard benchmarks is crucial because they carry interest rate sensitivity by being tied to duration parameters. Removing these gives managers greater flexibility to control interest rate risk and boost returns by allocating to less duration-sensitive assets. Benchmark-free managers are also more able to navigate between credit sectors; the dispersion of returns from major fixed income indices globally underlines how being tied to one or two markets may hamper return potential. European high yield went from being the worst-performing fixed income asset class in 2011 to the best in 2012.
However, this wider scope risks investment managers dabbling in sectors where they lack expertise. The global behemoths may be resourced to cover the entire credit universe, but boutiques should focus on where they can add the most value. In our case, by tactically allocating between global credit markets we can fully leverage the proprietary, in-depth, bottom-up research which underpins all of our credit selection and fulfil our investment and risk tolerance targets without needing to consider assets where we do not have the same high level of expertise.
Hedging
Hedging is important to many global multi-asset credit strategies, creating opportunities to bolster returns through shorting or to dampen volatility and neutralise market beta ultimately improving risk-adjusted and absolute returns. Growing demand for more nimble, multi- asset fixed income strategies does pose some problems for investors, such as how to evaluate an investment with no benchmark. The simplest way to do this is to assess whether the strategy delivers on its investment goals, typically X percentage points above the risk-free rate, within stated risk parameters. For our next-generation strategy, Global Tactical Credit, we are targeting Libor plus 5-7% while also protecting capital in weak or falling markets.
Institutional investors are also puzzling over where multi-asset credit strategies fit into their overall fixed income allocations. At one end of the spectrum they can be seen as anchors around which a portfolio can be built, or even a onestop- shop for global credit exposure that obviates the need for portfolio-level asset allocation; at the other end, those with a more active approach may view multi-asset credit as a component of a wider fixed income allocation designed to enhance overall portfolio returns and reduce volatility. This versatility is really a testament to just how precisely tailored multi-asset credit strategies can be.
How investors will deploy multi-asset credit strategies remains to be seen, but the big question is whether these strategies will deliver? We believe that with the right investment manager and strategy they can and that next generation multi-asset credit solutions will play an increasingly integral part in fixed income portfolios moving forward.
Mike McEachern is a portfolio manager at Muzinich & Co.
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