- Negative yields in Europe and in EUR are most likely to become the norm for long.
- Euro aggregate markets are running out of steam.
- The balance of risk and reward has shifted to the downside as euro yields have been plummeting for both EUR sovereign debt and EUR investment grade credit on the back of the ECB policy actions.
- We believe it makes sense now for European-based investors to exit the EUR aggregate segment - sovereign debt and investment grade credit - and shift their allocation to alternative segments offering better Sharpe ratios.
- Alternative #1: Low volatility absolute return strategies in EUR with no reference to a benchmark.
- Alternative #2: USD investment grade strategies hedged back to EUR with a moderate interest rate exposure.
We believe it makes sense now for European-based investors to exit the EUR aggregate segment - both euro sovereign debt and euro investment grade credit - and shift their exposure to alternative segments offering better Sharpe ratios:
- Low volatility absolute return strategies in EUR with no reference to a benchmark.
- USD investment grade strategies hedged back to EUR with a moderate interest rate exposure.
The carry of the euro aggregate market is no longer compensating investors for the interest rate risk that they are bearing: 0.56% yield for 6.6 years modified duration. This unattractive sharpe ratio is confirmed across all risk dimensions: credit exposure (6 years), volatility (3.8%) and rating (AA-). In addition, the credit quality of the euro Aggregate market has also been deteriorating: BBBs accounted for circa 5% of the market in 2010, they now account for more than 30% and the average rating decreased by two notches from AA+ to AA-.
The shift of the risk-reward profile of euro Aggregate markets to the downside has already had concrete negative impacts for investors. In the 2nd quarter of 2015, the euro Aggregate market suffered its worst drawdown since 1996: -5.0% and it took nearly 1 year for the market to recover from this trough. In 2008 – with yield peaking above 5% – the euro Aggregate market experienced a drawdown of -3.8%: it was recovered in 4 months only. At the current juncture, the expected recovery of a 5% loss with a carry of 0.5% is 10 years vs. 1 year in mid-2008.
The “safe-haven” profile of euro aggregate markets is also fading. Euro Aggregate markets now exhibit almost no carry and little room for yield compression. As a result, correlation to European equities is on the rise. From 1996 to 2014 before yields moved below 1.0%, the average correlation was -0.10 (with lows at -0.80). Since August 2014 when euro yields hit 1.0%, correlation with European equities has jumped to 0.40 (with lows at -0.2).
Two segments offer attractive alternative for EUR-based investors looking to move away from euro aggregate markets: low volatility absolute return strategies in EUR with no reference to a benchmark ands and USD investment grade strategies hedged to EUR with a moderate interest rate exposure.
Low volatility absolute return strategies in EUR
- With the yield of the euro aggregate markets at 0.5% benchmark strategies are offering poor sharpe ratio looking at all risk dimensions: interest rate, credit, volatility and ratings
- Absolute return strategies with no reference to a benchmark are well-suited for this zero yield environment as they give portfolio managers the flexibility to invest wherever the best opportunities lie in global fixed income markets without the investment restriction of an index
- A robust absolute return strategy offered as an alternative to the euro aggregate market should exhibit an active allocation to fixed income segments, a low volatility and contained drawdowns
USD investment grade credit strategies hedged back to EUR with a moderate interest rate exposure:
- A technical sell-off triggered by the ECB asset purchase and Brexit are headwinds for Euro investment grade markets
- USD investment grade credit yields are offering a pick-up of 1.5% over EUR credit markets for a similar credit risk: A- average rating and a similar interest rate risk of 4 years
- The expected return - carry & roll-down - for the intermediate segment of USD investment grade credit is 3.5%
- This exposure to USD investment grade could be hedged to EUR: 1.1% hedging costs from annualized 3-month EURUSD forward
- The rate cycle in the US would be gradual and in any case 5-year US forward rates are already pricing in +35 bps rate increase over 12 months
- The strategy’s investment approach is based on a top-down management of the credit, sector and rating exposure with a fundamental bottom-up reach to select issuers. The strategy’s style is one with a focus on large capitalisations, liquidity and with a moderate interest rate exposure of around 4 years
UBP Global & Absolute Return Fixed Income team manages USD 14 bn across global fixed income markets and currencies. The team has a top-down and macro-driven investment approach. Asset allocation – taking long and short views – across global fixed income segments is driving alpha generation. The team has a genuine absolute return DNA, with more than 10 years of consistent excess returns with low volatility and drawdown. Crucial to the team’s absolute return DNA is the focus on risk management at all stages of the investment process: via stress tests when deciding on the asset allocation and constructing the portfolios and via real-time P&L monitoring on a day-to-day basis.
Co-CEO Asset Management
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