From the January 2014 issue of Investment Advisor • Subscribe!

December 23, 2013

Time to Diversify in the Face of Interest Rate Risk?

Shorting bonds can provide diversification, but clients need a skilled manager

(Illustration: C.J. Burton/Corbis) (Illustration: C.J. Burton/Corbis)

Let’s talk about bonds—more specifically, shorting bonds. Frankly, I’m mystified why there’s not more discussion about how shorting bonds can offer investors potential diversification when interest rates rise.

I think we can all agree that the great Bond Bull that started pawing the ground more than three decades ago is dying. To pick a benchmark, rates on 10-year U.S. Treasuries have declined from a record 14.59% in 1982 to around 2.75% today, give or take a few basis points. Even if rates stay the same or go lower, the best that bonds can provide in that scenario is a safe haven for cash, but little income. If rates go higher—a much more likely scenario in the months ahead as the economy continues to recover—bondholders may suffer.

Higher rates aren’t all bad. Pension funds trying to find 8% returns to fund their liabilities would welcome them. However, rising rates wreak havoc on bond prices. As a general rule of thumb, a fund that has a duration of 4.5 years—in effect, a metric derived from how long it takes for a bond to mature—will lose 4.5% of its value for every 1% rise in rates. A rate rise of 2% would cause a 9% decline in the bond fund’s value. This hypothetical example simplifies a rather complex concept and ignores other factors that affect bond prices such as credit quality or coupon rate; nevertheless, duration is an important measure.

That brings me to long-short bond (also called long-short fixed income) funds. They are designed to potentially minimize interest rate risk if interest rates rise, but also to potentially generate returns if they don’t. As investment vehicles go, long-short fixed income funds fall in the category of “liquid alternatives,” combining the key attributes of both mutual funds and hedge funds. That is, they offer an efficient way to buy and sell shares on a daily basis like a mutual fund—that’s the “liquid” part—with the investment tool kit of a hedge fund—that’s the “alternative” part.

Shorting bonds is not something investors should try for themselves. To carry out the short element in a long-short fixed income strategy takes a manager in the most complex part of our industry. First, shorting is always risky—the upside is always limited, while the downside on an uncovered short is infinite.

Second, the process of directly shorting a bond is not easy. Since shorting a security typically means having to find someone to lend it to you, the process is made difficult when the underlying security is thinly traded. While the bond market is enormous and liquid, that doesn’t mean the market in a particular bond is deep—just ask anyone who has tried to find a buyer for a bond at the “market” price. Imagine how much harder it would be to find an owner willing to lend a specific bond for a short sale.

There are various strategies that can be used, but many long-short fixed income managers turn to the derivatives market’s esoteric brew of futures, options, credit default swaps, forward foreign currency exchange contracts, repurchase agreements and the like. There are numerous risks including substantial loss. These instruments can go unexpectedly wrong, as the events of 2008 and 2009 demonstrated with credit default swaps.

That is not to say that good managers cannot master these challenges. Indeed, as is often the case, it is the difficult market that separates excellent managers from the merely good ones. That’s especially true in the alternatives space—and why investors need to be rigorous in selecting, vetting and monitoring alternative investment managers. Selecting a slate of managers, instead of just one, also helps reduce risk.

Notwithstanding the potential benefits, this strategy may not be suitable for everyone. Potential investors in long-short fixed income need to consider investment objectives and risks to see if they are aligned with their own tolerance for risk, liquidity needs, tax obligations and investment goals.

In our view, the reasons to invest in a long-short fixed income strategy come down to using hedges because of their potential to mitigate volatility and to profit in a changing interest rate environment. Seemingly, too many investors settle for a “one and done” strategy, as one of my colleagues puts it. Investors may think having just one long-short strategy in the portfolio is good enough. To us, that’s like insuring the downstairs of a house, but not the upstairs or the attic or the basement. We think the whole portfolio needs protection against the vagaries of markets.

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