Key points:
- In light of policy shifts in the U.S. progressing and beginning to take shape in Europe, the transformation of investors’ fixed income exposures across alternative strategies has now become a reality.
- Recognizing the need of investors for income, this paper highlights solutions that could help a portfolio position against a rise in interest rate volatility:
- A liquid Discretionary Global Macro strategy capitalising on fundamental upward and downward trends in interest rates, credit and currencies;
- A Senior Secured Loans solution acting as a pure positive carry strategy and bringing protection in a rising rate environment;
- Insurance-Linked Securities solutions characterised by attractive yields and a true diversification power to all assets. - These solutions are to be considered as “diversifiers” within a global portfolio, finding uncorrelated return drivers in specific markets with a moderate risk budget.
A regime change in progress
The end of 2016 represented a period of transition for global markets and it seems that we are currently in a new paradigm, particularly in the U.S. This regime change is from a slow growth environment, dominated by low inflation and accommodative monetary policy, to one where we expect growth rates should be faster fuelled by fiscal easing, tighter monetary policy and a transition from deflationary to inflationary expectations. Outside the U.S., the ECB should begin tapering its quantitative easing (QE) program in a near future, and the Bank of Japan has already admitted the limits to QE by shifting to a yield curve targeting policy.
While the falling interest rate/rising bond prices have historically provided a ‘cushion’ for portfolios in the face of equity volatility, rising interest rate volatility is expected looking ahead. As a result, this ‘cushion’ or diversification effect may at best be less pronounced or potentially not be available in the months and years ahead. If this transpires, by default, volatility of portfolios would necessarily rise, exposing investors to higher levels of risk without compensating return prospect. Should bond yields continue to rise as they have done in recent months, the harmful impact of this new environment on portfolios may be more apparent.
In light of this development, most investors have already been exploring options to begin the process of transforming their traditional fixed income exposure in order to be better positioned to respond to this new regime change.
Liquid alternatives defined as ‘diversifiers’ definitely belong to the proposed options. Either by taking advantage of their investment flexibility or by simply capitalising on a relatively nichy market or sector, these ‘diversifiers’ have the potential to find uncorrelated return drivers in specific uncrowded markets. Targeting a moderate risk budget and exhibiting a reasonable liquidity profile, they act as risk reducers within a global portfolio by lowering volatility, drawdowns and correlation to traditional assets.
In this paper, we propose three liquid alternative investment solutions, which are particularly well suited to complement a traditional non-risky allocation under the current market conditions. They are:
- a Discretionary Global Macro solution
- an European Senior Secured Loans solution
- an Insurance-Linked Securities (ILS) solution
Their rationale and competitive edge are detailed hereunder.
Global Macro strategy
Access to a liquid Global Macro manager capitalising on fundamental trends in interest rates, credit and currencies worldwide
Our 1st liquid alternative solution is a pure Discretionary Global Macro strategy, which can trade both sides of the market (long and short) mainly in rates, currencies and credit. Hence it can combine risk-on and risk-off books across those asset classes, scouring the world for growth and transformation themes on one hand (risk-on), or simply using shorts and portfolio hedges on the other hand (risk off). The portfolio only trades highly liquid instruments.
The strategy has three main competitive edges: (i) a strong fundamental research where the street views are not taken as granted; (ii) a portfolio approach that relies on the ability to efficiently expand the investment opportunity set to specific markets and regions (e.g. emerging markets); and (iii) a medium size allowing a certain level of investment flexibility and an accountable expression of trades compared to larger macro funds which appear to be over capitalized today.
What to expect from our Global Macro strategy in a rising rate environment
Because of its investment flexibility to go long and short markets, the Global Macro strategy is agnostic about where we stand in the rate cycle. For instance, the portfolio’s current rates exposure has a balance between developed markets where rising yields are expected and a few select emerging markets with the potential for significant rate cuts. The potential to express views on plenty of countries that are disconnected with the U.S., European or Japanese interest rate cycles can add many dimensions in terms of portfolio construction. And historical P&L has shown that performance could be generated from both rising and declining rate opportunities.
Olivier Marion
Senior Investment Specialist - Alternatives