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UBP holds portfolios steady through volatility ahead
How should bond investors manage the risk of rising rates?
Norman Villamin, chief investment officer, private banking, UBP: Since late-2016, we have focused our fixed income strategy on protecting against rising interest rates in favour of credit spread-driven returns. Investors have been rewarded for this focus, with strong returns driven by a decline in spreads from 200 bps to less than 100 bps despite a rise in risk-free rates from their 2016 lows.
That being said, while tight spreads are matched by strong corporate fundamentals - including modest leverage, strong interest coverage, stable margins and improving cash flow - they provide little cushion to offset the impact of rising government bond yields on overall returns for investors.
For balanced investors, this has led us to favour equity risk to fixed income within portfolios. However, for bond-only investors, the challenges are much more significant. Having managed interest-rate risk down by pursuing short duration and floating-rate strategies within the credit arena, we have also taken a more active manager approach to allow credit selection to drive returns more meaningfully relative to passive strategies.
With high-yield bonds having performed exceptionally well through 2016 and 2017, we diversified our exposure to other "high-yielding" bonds in mid-2017 to incorporate attractive carry vehicles such as insurance-linked bonds and asset backed securities with less correlation to rising rates and widening credit spreads into portfolios.
In addition, we have started reintroducing alternative strategies with bond-like features, such as merger arbitrage, into portfolios, further reducing reliance on credit spreads as a driver to the "high-yielding" portions of our portfolios. For long-term investors holding positions through the economic cycle, high-yield bonds remain an attractive option. However, for shorter investment horizons, the risk-reward trade-off warrants greater diversification of return drivers across the fixed income universe.
What do rising volatility and rising rates mean for equities?
Fortunately for equity investors, the US Federal Reserve has been open in its communication about its "normalising" policy. As a result, corporates have taken the opportunity both to lock in low interest rates as well as to extend the term of their borrowings, providing a cushion against near-term refinancing risks as well as the immediate negative impact to earnings from rising rates. We do not expect earnings to be negatively affected by the changing landscape in the US bond market, while select sectors should benefit from the rising rate environment.
With strong growth supported by recent tax reform in the US, earnings growth of 15 per cent should be sufficient to drive positive returns in US equities. While multiples likewise seem historically rich in emerging markets, strong earnings growth driven by economic recovery in Latin America and Eastern Europe, combined with ongoing strength in Asian earnings, should provide a more attractive risk-reward dynamic for global equity investors.
As investors have increasingly pivoted their focus to the economy and corporate earnings, the spectre of trade wars and other geopolitical risks remains. As such, equity investors should capitalise upon the rebound in volatility and seek to build capital protection into portfolios, should these tail-risk events transpire.
How should clients view the weakness of the US dollar?
While most have focused on the widening interest rate differential between the US dollar and other key currencies around the world, there had been a number of important inflections in key drivers in 2017 that are now weighing upon the US dollar. Perhaps the most visible was the early-2017 surprise in European economic growth, which left eurozone real GDP growth rates at a premium to US growth rates for the first time since 2011, near the start of the bull market in the US dollar.
In 2017, the eurozone economic recovery and fiscal prudence allowed the eurozone's budget deficit to narrow further to 1 per cent of GDP. In contrast, the inability of US President Donald Trump to deliver fiscal restraint continued to push the US fiscal deficit out further to 3.4 per cent by end-2017, even before the implementation of the tax reform plan passed in December. With the tax reform plan expected to expand the deficit to as much as 5 to 6 per cent of GDP by 2019, greater headwind for the US dollar lies ahead.
How should clients ward off risks of higher volatility ahead?
In the second half of 2017, when volatility fell to all-time lows across many asset classes, we shifted from selling volatility via structured product solutions to buying volatility via options to protect portfolios. With the return of volatility, we have unwound our options positions.
While we will opportunistically seek options protection should conditions warrant, this new volatility regime suggests that conservatively designed structured product solutions will once again become a regular part of our implementation strategy, both to manage risk and support returns in client portfolios in the months ahead.