Low volatility risk-adjusted fixed income returns in turbulent times
- 31 August 2023 (5 min read)
When markets get choppy, active, unconstrained and diversified fixed income strategies could help investors smooth out volatility while generating attractive fixed income risk-adjusted returns. Nick Hayes, portfolio manager of the AXA Global Strategic Bond Fund outlines why.
We believe the most important factors to deliver low volatility risk adjusted fixed income returns across the full market cycle are:
1. Allocating across both interest rate and credit spread risk
2. Tactically managing duration positioning
3. Maintaining structural diversification.
These become even more vital when markets are turbulent and the economic outlook is far from certain.
Markets are moving sideways but rates and spreads are negatively correlated
It doesn’t require any special insight to know that markets have been especially difficult in 2023. Government bond markets have swung by 30 to 50 basis points in both directions in very short order throughout the year, while credit spreads have ground tighter, although individual credit events have caused shorter-term spikes. Across the full fixed income spectrum, yields have trended sideways rather than downwards.
While this persistent volatility has been challenging, we have seen a return to the negative correlation between interest rate sensitive and credit spread sensitive fixed income assets over 2023 as government bonds have rallied in the face of credit sell offs and vice versa. This negative correlation is something managers who invest across the full fixed income asset class spectrum can take advantage of.
Negative correlation between credit spread and interest rate sensitive fixed income assets
Source: AXA IM/Bloomberg as at 31 July 2023. Past performance is not a guide to future returns.
We are nearing the end of the rate hiking cycle
All major central banks hiked rates by 25bps at their last policy meetings and emphasised that further moves will be data dependent. And what is the data telling us? Amongst the noise, economic data indicates that inflation is coming down, albeit at different speeds in different markets.
This indicates to us that we are nearing peak rates. We may see a plateau before central banks start to cut –we expect the US to be first, followed by the euro area, while the UK still has some way to go in its fight against inflation.
Being forward-looking by nature, markets tend to become more volatile towards the end of hiking cycles as investors start trying to calculate what the peak, possible pause and eventual cuts could mean. We believe this is what we are seeing now – government bond yields are trending sideways rather than down, and credit spreads pushing out the expectations of a recession.
Active and Unconstrained
The global fixed universe is vast, and we like to think of it as many different sub asset classes, each to some degree driven by one of the two main fixed income risk factors, interest rates and credit spread, or a combination of the two. We do not view one risk factor as more severe than the other, but rather as different types of fixed income risk affecting parts of the fixed income asset classes differently.
The highest quality assets – government bonds and high-quality credit – are more susceptible to interest rate movements. As we move down the spectrum into lower quality credit and high yield, credit spread become more influential.
Where we are in the market cycle also determines how dominant each of these two risk factors becomes. In a slowdown and recessionary phase, rate-sensitive assets will drive fixed income returns; in a recovery and expansionary environment, credit spread-sensitive assets drive returns.
Active managers who take an unconstrained approach can tap into the full fixed income universe and find opportunities throughout the market cycle. From a top-down perspective, we can consider where we are in the market cycle and from a bottom-up perspective, we can consider which risk factors will dominate a particular issuer.
A third consideration for active fixed income managers is duration. Being active and unconstrained means we can choose our outright duration position and where to take exposure. Passive or benchmarked strategies tend to be more of a price taker of duration. With rate hiking cycles coming to an end at different speeds, being fully flexible in this regard is key in capturing the potential upside in markets and avoiding the worst drawdowns.
Diversification
Given the richness of the fixed income asset class, opportunities can be found across the full market cycle. But, avoiding over-exposure to any single fixed income risk factor is the key to smoothing out volatility, particularly in turbulent markets.
Investing across the global fixed income spectrum with powerful diversified risk exposure helps create the greatest potential to achieve attractive, risk-adjusted returns. Managers who ensure structural diversification within the portfolios they manage, gain access to multiple sources of performance but also tend to produce risk adjusted fixed income returns with lower volatility than single-fixed income strategies.
AXA Global Strategic Bond Fund
An unconstrained actively managed global fixed income fund that aims to achieve attractive risk-adjusted fixed income returns with low volatility across a full market cycle.
The primary driver of returns for the AXA Global Strategic Bond Fund is top-down asset allocation across the fixed income capabilities of AXA IM. Analysis of the macroeconomic environment drives the asset allocation, and subsequent curve positions and sector allocation. On top of this we add bottom-up security selection, supported by our global team of fundamental credit research analysts. The flexibility of the strategy gives our team the opportunity to adapt the way they look at risk, while efficiently capturing value in the market.
Structural diversification in the strategy minimises volatility relative to any of the individual sources of risk from credit or rates. At the centre of this is our proprietary investment framework based around three “risk buckets” Defensive (government and inflation), Intermediate (investment grade credit and peripheral government), and Aggressive (high yield and emerging markets), which are central to portfolio construction.
Within each risk bucket we have wide and transparent investing leeway’s” 0-100% in Defensive, 0-60% in Intermediate and 0-60% in Aggressive. Although this is not a target, the application of investing leeway’s is an active management decision which ensures that we are not overly correlated to any single fixed income risk factor and offers access to multiple potential sources of performance while minimizing overall risk.
We also actively manage duration to take advantage of environments with fluctuating interest rates. With a leeway between 0-8 years, we are able to dynamically adjust the portfolio to determine how much duration risk we want to take, according to the macroeconomic environment. The fund typically has a lower duration position than traditional government bond or higher quality credit strategies which allows the investment team to allocate towards different sources of credit risk. The result is a fund which is diversified across a broad range of alpha sources.
Important information
All investment involves risk and capital is not guaranteed. The AXA Global Strategic Bond strategy invests in financial markets and uses techniques and instruments which are subject to sudden and significant variation, which may result in substantial gains or losses.
Capital at risk. The value of investments, and any income from them, can fall as well as rise and investors may not get back the amount originally invested.
Additional risks
- Counterparty Risk: failure by any counterparty to a transaction (e.g. derivatives) with the Fund to meet its obligations may adversely affect the value of the Fund. The Fund may receive assets from the counterparty to protect against any such adverse effect but there is a risk that the value of such assets at the time of the failure would be insufficient to cover the loss to the Fund.
- Derivatives: derivatives can be more volatile than the underlying asset and may result in greater fluctuations to the Fund's value. In the case of derivatives not traded on an exchange they may be subject to additional counterparty and liquidity risk.
- Interest Rate Risk: fluctuations in interest rates will change the value of bonds, impacting the value of the Fund. Generally, when interest rates rise, the value of the bonds fall and vice versa. The valuation of bonds will also change according to market perceptions of future movements in interest rates.
- Emerging Market Risks: emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. As a result, investments in such countries may cause greater fluctuations in the Fund's value than investments in more developed countries.
- Liquidity Risk: some investments may trade infrequently and in small volumes. As a result, the fund manager may not be able to sell at a preferred time or volume or at a price close to the last quoted valuation. The fund manager may be forced to sell a number of such investments as a result of a large redemption of shares in the Fund. Depending on market conditions, this could lead to a significant drop in the Fund's value and in extreme circumstances lead the Fund to be unable to meet its redemptions.
- Credit Risk: the risk that an issuer of bonds will default on its obligations to pay income or repay capital, resulting in a decrease in Fund value. The value of a bond (and, subsequently, the Fund) is also affected by changes in market perceptions of the risk of future default. The risk of default for high yield bonds may be greater.
- Risks linked to investment in sovereign debt: Where bonds are issued by countries and governments (sovereign debt), the governmental entity that controls the repayment of sovereign debt may not be able or willing to repay the capital and/or interest when due in accordance with the terms of such debt. In the event of a default of the sovereign issuer, a Fund may suffer significant loss.
- High yield bonds risk: These bonds are issued by companies or governments with lower credit ratings and as such are at greater risk of default or rating downgrades than investment grade bonds.
The fund is also subject to geopolitical risk, securitised assets or CDO assets risk and contingent convertible bonds (“CoCos”).
Further explanation of the risks associated with an investment in this strategy can be found in the prospectus.
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Risk Warning
The value of investments, and the income from them, can fall as well as rise and investors may not get back the amount originally invested.