Long/Short - Amplify or Mute

Unconstrained fixed income

Long/Short - Amplify or Mute

Long/short strategies allow managers to take advantage of both positive and negative views on bond markets and currencies and to profit from both up and down markets. This approach can potentially limit downside risks when interest rates and volatility are rising, and amplify returns on securities or sectors where a manager has a high conviction that valuations may rise.

Long/short strategies also allow managers to generate returns with low correlation to traditional fixed income and equity, providing diversification as part of a broader portfolio.

Going short in a mutual fund requires the use of derivatives, such as futures, forwards and credit default swaps. This is very different from hedge fund strategies that can use financial leverage or sell securities short. Implementing such strategies is not without risk, but the size of the bets the manager can take is typically limited by fund guidelines.

In unconstrained fixed income funds, managers may be able to take negative positions in credit (investment grade or high yield corporate bonds, emerging markets or structured debt), in currencies and in duration (allowing the manager to adjust the interest rates sensitivity of the portfolio).

Here are three of the most common ways an unconstrained fixed income manager will take long-short positions.

1) Managing credit exposure: The credit risk in a portfolio can be adjusted by balancing positions in corporate bonds with active management of credit default swaps. The latter are derivatives that allow managers to express a view on an improvement or deterioration of a particular credit or a credit index. Credit default swap indices (CDX) are dynamic, market sensitive instruments whose performance typically mirrors that of the bond market it is linked to.

Bond managers often use CDX that mirror the performance of investment grade or high yield corporate bonds in the US or Europe. A manager who has a long exposure to investment grade corporate bonds, could use CDX as a hedge or protection against potential market weakness. This would help to reduce the negative impact on portfolio performance in the case of spread widening. CDX can also be used as a nimble way of adding credit risk. As they are often easier and quicker to trade than corporate bonds, a manager can quickly add credit risk to a portfolio through CDX rather than buying individual corporate bonds. Similarly, when markets are volatile and managers want to reduce credit risk, CDX can be an attractive tool to use as there is better liquidity than in corporate bond markets.

 

2) Currency exposure:  By evaluating a country’s economic outlook, managers can take short term or medium-to longer term views on currencies. This could be impacted by predictions on inflation, interest rates or the possibility of political event risk. Long-only managers are limited to long or overweight positions in currencies they favour, and underweight or no position in currencies they have a negative view on. Managers of unconstrained funds have the scope to take long and short positions and can therefore profit from strengthening and weakening currencies and express relative value decisions. The opportunity and risk is highlighted by the graph below. 

Managers could express a preference for emerging market (EM) currencies relative to the US dollar based on an expectation that growth in EM should outpace the US. Or a manager who is positioned for a positive global growth scenario could protect a portfolio against a potential slowdown in China by shorting currencies that typically move together with China’s economy. This could be the Chinese renminbi, other Asian currencies or so-called commodity currencies (currencies of countries who are heavily dependent on strength in commodity markets).

 

Major currencies v US dollar

 

One year trailing return March 31st 2017- March 31st 2018. Data obtained through Bloomberg Finance LP, which Brandywine Global believes to be reliable and accurate.

 

3) Duration and yield curve positioning:   Managers can profit by taking long positions in those markets where they expect government bond yields to fall. They can also take short positions in those markets where they view yields to be very low and they expect them to increase. They would typically use interest rate futures and options on government bonds to go short, and can use government bonds, futures and options to go long.

A manager can express relative value opinions between different countries using long short strategies. Combining a short position in German government debt with a long position in Italy has been a very beneficial trade over recent years, as the yield of Italian 10-year bonds has come down towards that of the 10-year German bond (see chart below).

Managers can also take long and short positions along two parts of a yield curve. Take the US Treasury (UST) market as an example. An environment where the market is pricing in the expectation of rising rates, may be negative for shorter dated bonds, but positive for longer dated bonds. Shorter dated USTs tend to be driven by interest rate expectations, while longer dated bonds tend to reflect medium to long term inflation expectations. Rate hikes would be negative for shorter dated bonds as they would see yields increase, but could be positive for longer dated bonds, as rate hikes would dampen inflation expectations and lead to moderating yields. A manager could take advantage of this by having a short position in shorter dated USTs and a long position in longer dated bonds. 

 

10 year German and Italian spreads converge

Source: Bloomberg April 30th 2018

Conclusion:

Long-short strategies can bring diversification to an investor’s fixed income portfolio by allowing the manager to generate positive returns in up and down markets. They allow managers to take advantage of both positive and negative views on bond markets and currencies. This gives the ability to limit downside risks when interest rates and volatility are rising, while giving the opportunity to amplify returns on securities or sectors where a manager has a high conviction of improving valuations.

 

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