Fixed-income investors have been stuck watching yield evaporate in the wake of the financial crisis, as the world’s largest central banks have pushed interest rates near zero – and even into negative territory. Those who have wanted — or needed — to keep bonds in their portfolios have been moving as a herd, buying longer-dated and/or lower-rated issues in order to achieve their desired returns. While you could construct a EUR portfolio comprised entirely of investment-grade bonds with 4 percent yield-to-maturity in 2012, achieving the same in 2015 requires bond investors to allocate some 90 percent of their portfolio to high-yield bonds, according to Credit Suisse.
A herd can be a fairly innocuous thing until it stampedes. The fear in fixed-income markets is that when the Federal Reserve finally raises benchmark interest rates, as Credit Suisse believes they will in September, there will be a selloff in bonds.The problem is that as fewer banks choose to act as market makers, liquidity has dried up considerably. And high-yield bonds in particular have experienced bouts of volatility characterized by sudden, steep selloffs followed by rapid recoveries ever since the financial crisis. Many worry that in an already illiquid market, a rate hike by the Fed hike could create a situation in which sellers simply can’t find willing buyers – or can only do so by selling their assets for less than they expected. “In case of strong selling pressure, the current market structure will make it highly challenging to absorb strong outflows of various credit asset classes, or only with a substantial price adjustment,” Luc Mathys, Head of Absolute Return and UHNW mandates at Credit Suisse Asset Management, writes in a recent research note. “Credit investors should therefore keep a close eye on the liquidity of their bond holdings or be in the position to stick with a chosen strategy in times of volatility.” If there is a major Fed-induced selloff this year, sticking with the carry-driven strategies that most fixed-income investors have pursued for the last few years doesn’t look like a winning move. Even investors who have tried to diversify by purchasing bonds with different risk profiles may find themselves stuck, Mathys says. Typically, investors flock to government bonds during risk-off periods and high-yield and other relatively risky fixed-income products when risk appetite is running at full-tilt. But as central banks have become the bond market’s primary driver, these different classes of bonds have become highly correlated. When Treasuries sell off, so do high-yield bonds – and Mathys expects that correlation to increase should central bank activity surprise investors to the upside What fixed-income investors should be pursuing is a strategy that breaks away from the herd and offers downside protection in the event of a Fed-induced crash. Instead of choosing to own bonds based on their yield and duration, Credit Suisse suggests that investors follow a particular type of momentum strategy – buying options on interest rates, foreign exchange and credit indices that are following a strong trend up or down. Mathys says a long straddle options strategy – or alternatively a long-short delta 1 strategy with a stop-loss policy – has the potential to outperform when markets are becoming more volatile and trending. In a long straddle, investors buy a put and a call on the same asset, normally with the same expiration date and strike price. The biggest risk to such a strategy is a sideways-moving market, in which the asset price doesn’t rise enough to pay for the loss on the put option (or the stop-loss policy) or fall enough to cover the cost of the call.