Active rate management - how it works

Unconstrained Fixed Income Solutions

Active rate management - how it works

Rising rates and bond losses may have been a given in the old days. Now an unconstrained investment approach can help investors lock in profits in both up and down markets. Read how it works.

The actions of central banks have largely driven bond markets since the 2007-08 financial crisis, with multi-billion-dollar monetary stimulus packages and interest rates set to historical lows. Investors were quick to welcome the flood of cheap money from central banks that inflated asset prices, but they are now worried at the disruption which could follow the withdrawal of expansionary policies as growth comes back.  These market fears raise the need for an unconstrained approach that can protect investors in a rate rising world or even help them lock in profits. To achieve this active rate management is paramount - and this is how it works:

 

1)    Assess the direction of rates

Central banks don’t explicitly say what their next rate movement is going to be, but instead give clues – which some of them call “forward guidance.” This communication of future intentions has improved over the past ten years, making some of their changes barely a surprise. In this way the actions of central banks have helped market efficiency and reduced volatility, but they are not always right. In some instances, they have taken decisions now considered mistakes, such as the Eurozone’s two-time increase of interest rates in the midst of the region’s sovereign debt crisis in 2011.

Central banks can also be wrong in their inflation and growth forecasts, which are a major driver of their interest rate decisions. As seen in Chart 1, the US Federal Reserve (Fed) lowered its own forecasts in 2015 and 2016 to a level more aligned with what the market had been pricing in for months.

 

Chart 1: Fed’s forecasts: not always right

Fed Funds Futures

Source: Bloomberg as of 14 February 2018

 

The ability to spot these type of inconsistencies is why asset managers use a substantial part of their budgets on research teams that can analyse data to the last detail. Analysts track monthly growth and inflation data – both among the drivers of bond prices. As seen in Chart 2, the history of rates is the history of inflation.

 

Chart 2: The history of rates is the history of inflation

Federal Funds Target Rate

Source: Bloomberg as of 6 Feb. 2018. PCE is Personal Consumption Expenditure. RHS is Right Hand Side. Please find definitions in the disclaimer.

 

One way to forecast inflation is to look at labour costs.  If inflation expectations rise, when labour costs are not increasing – this could be a sign that markets are overstating their forecasts. Analysts examine thousands of numbers in order to gain a clearer understanding of such trends. Confusing a long-term trend with a one-month data spike may lead to losses, while spotting an unnoticed theme still hidden in the data may generate hefty profits.

 

2)    Choose a position in the curve

Once a manager has reached a conclusion on the direction of rates, it has to assess if the market in general is agreeing with that position or not. If not, managers may take a position as they believe that the market will self-correct and eventually reach the right price. This can be difficult as managers’ views sometimes contradict a central bank forecast, a politician’s vote-winning mantra, or even media headlines, which sometimes draw conclusions or highlight more dramatic, but less essential data elements.

Managers who follow a fundamental approach such as this, based on economic data rather than trading trends, will choose a position, along the yield curve – which shows how much yield one gets for each different maturity. If the manager believes economic growth is weak and may not generate as much inflation as the market is pricing into bond yields, he or she may decide to buy debt with long maturities, as such debt is more sensitive to inflation trends. This is done in the expectation that yields will come down over time as market expectations come more in line with the manager’s view.

Some managers have held this view with success. As Chart 3 shows, while the Fed and other investors’ optimism over future growth and inflation was reflected in higher long-maturity US Treasury yields, which are more sensitive to inflation, the inflation pick-up really never materialised, leading to a drop in long-term Treasury yields. Investors holding 30-year Treasuries locked in significant profits over the period, while those who held short-term Treasuries lost money as short-term yields rose.

 

Chart 3: The yield curve: location, location, location

The Yield Curve

Source: Bloomberg as of 16 Feb. 2018. The yield curve profiled is the US one. Please find definitions in the disclaimer.

 

3)    Decide duration

The direction of interest rates is a large driver of bond returns and the measure managers use to calculate how sensitive a bond is to this movement is called duration. This measure can be used to assess the potential impact of interest rates on their portfolio. Different asset classes have different average duration - global treasury bonds are typically longer in duration than global corporate bonds or emerging market bonds -  although the measure can vary significantly between securities.

 

4)    Use derivatives to enhance position

Unconstrained fixed income managers can magnify a position by using derivatives (financial instruments whose price is derived by an underlying asset). For instance, if a manager believes that bond yields may increase in one country, or a country’s sovereign yields have gone so low that they may not fall any more, he or she may use the derivatives market to have a negative duration position in those markets – with the aim of profiting if yields rise. This trade has been particularly successful over the past decade, as trillions of US dollars of sovereign Japanese and European debt saw their yields fall below zero, (investors actually paid governments for lending them money). This was counterintuitive for many investors, who believed that this made little sense and that those countries’ yields would ultimately rise. Therefore, they adopted a negative duration position, which added value when markets eventually priced in stronger growth and higher inflation, lifting yields.

 

Conclusion

Global markets are slowly recovering from the 2007-08 shock and central banks are treading carefully to leave behind a decade of monetary stimulus without damaging the economy or upsetting financial markets. Investors with an active and unconstrained approach will have more tools to weather the changes ahead, offering a wider set of opportunities for those who either seek protection, profits, or both.

 

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.