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Bond Investors Walking ‘Tightrope’ Have Second Chance to Diversify

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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.

Importantly, the manager must demonstrate a flexible investment style that is nimble and opportunistic, with an ability to be materially net long when economic and credit market conditions warrant and materially net short when they do not. Their ability to adapt to a constantly evolving environment, understand the technical environment (such as capital flows), and dynamically adjust their positioning is critical to creating a defensive portfolio.

With a 30-year bull market in bonds as a tailwind, investors have become accustomed to expecting safety from fixed income. In more recent years, however, they have not been adequately compensated for risk as they have moved up that ladder in search of yield. Many investors now have the problem of facing “danger in safety,” as what was traditionally the safest part of their portfolios might be the most dangerous. At this point, investors still have the chance to diversify traditional interest rate-sensitive bond portfolios if they act before rates rise.

We have seen time and time again how the markets can turn sharply and without warning, thereby wiping out gains very quickly. We have to look no further than Ben Bernanke’s statement in the summer of 2013 that triggered the so-called “taper tantrum” to see that even a single comment can cause a significant sell-off in credit markets. We believe we’re likely to see more sensitivity as investors have taken on more risk, and that just the fear of an impending hike could be enough to spark a sell-off.

The implications of entering into this rising-rate environment have perplexed most bond investors. While it remains unclear when the Fed will embark on its rate hike, it’s safe to say that investors can anticipate volatility and dispersion to continue to surface this year. But instead of succumbing to taking on more risk for less reward, investors do have another option. We have reached the point in the recovery cycle in which the credit beta trade is coming to an end and an opportunistic long/short credit approach can flourish.

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