It’s not easy for any bond investor to decode current economic data or the ambiguous messages of the Federal Reserve, let alone determine which defense will best protect fixed income allocations in a rising-rate environment.
What they do know is that rates will inevitably rise and that there’s a lot more downside than upside in the credit market at the moment. Driven by unprecedented global monetary policy, with aggressive stimulus not only from the U.S., but from central banks all across the world, investor willingness to take on uncompensated risk in their search for yield has been alarming. As a result, we have seen a lot of “tightrope walking” in the fixed income markets, as investors cautiously move up the risk ladder in search of new sources of yield to counter interest rates at historic lows. We are now six years into the recovery cycle, and inching up that risk ladder — or walking that tightrope — to reach a decent return has become increasingly difficult.
This approach results in investors taking on higher risk for less reward, often without an appropriate hedge to balance out their long exposure. True long/short credit strategies are well-positioned to take advantages of cracks in the market, investing both long and short in credit instruments and adjusting portfolio exposures to capitalize on different environments. The short side of these portfolios is particularly important, as it can act as both a hedge and a return enhancer. An experienced manager who understands the credit cycle and can move the portfolio’s exposures accordingly can implement this approach with the goal of achieving positive returns across different market environments. The combination of an effective short strategy with a long portfolio can serve as an attractive alternative for investors looking for credit exposure that is agnostic to market direction and interest rates.
Short opportunities, however, require some digging (as do the long positions in current environment). Shorting credit in the last few years has been difficult. Managers must possess a razor-sharp eye to fundamentally analyze companies and spot winners and losers in varying economic cycles, and then expertly apply their skill and discipline to constructing a book of long and short investments.