Unhedged Commentary

Friday, December 16, 2016

Unhedged Commentary: When the Bond Bull Run Ends ... Then What?

 Scott Freemon, an investment strategist at SECOR Asset Management.

As yields approach zero, bonds are nearing the end of their 30-year bull run. Against this backdrop, expected returns are down, bond risks are high, and diversification is no longer a free lunch.

The result: Investors must consider new routes to reach their goals.

U.S. yields declined nearly 4 percent in the past ten years — and are down more than 10 percent from their 1980s peak. Near-zero cash yields put pressure on all return-generating investments. Bond investments carry the additional risk of severe negative returns if rates rise sharply. Equities still offer a premium, but that premium has fallen as low yields have increased price-earnings ratios.

With economic stimulus stretched, central banks may find themselves in an increasingly difficult position to combat economic weakness. A natural floor on bond yields at or near zero further reduces the ability of bonds to provide protection in a flight-to-quality equity sell-off.

Stocks and bonds have been negatively correlated since 1998, but this fortunate run is not likely to last. Absent a major recession, we expect stocks and bonds to move in the same direction.

Where does this leave institutional investors, which need to meet often-stringent funding obligations?

It’s possible to increase return targets by loading up on equity beta, but loss tolerances and risk budgets are already stretched. Risk parity represented a huge leap forward in investment thinking, but levered bonds are terrifying in this environment and equal weighting is arbitrary. The rest of the traditional investment universe delivers a return disadvantage to equities, a unique set of risks, and disappointing diversification benefits.

Investors can enhance returns and better manage risks by adding derivative overlays and systematic factor strategies. Both offer enhanced capital efficiency; liquid, scalable return generation; better diversification; and downside risk control.

Using derivative overlays to manage public market beta exposures frees up capital to focus physical assets on high-returning investments, achieves target exposures without using physical allocations, and provides the ability to create asymmetric market risk profiles. By using derivatives to control beta, investors turn market risk into a choice and can manage their portfolios from a risk and factor perspective. Increased oversight of derivatives trading following the financial crisis has created a safer environment to implement derivatives, with much less “career risk” for fiduciaries. Better valuation, clearing, and trading technology have decreased counterparty risk and increased transparency.

Systematic factor strategies can provide investors with risk premia capture (for example, volatility selling), alternative beta replication (trend following), and alpha strategies. These are attractive because they generate liquid, scalable returns with predictable risk and return profiles and strong diversification benefits.

Investors should give equal consideration to beta, hedges, risk premia, alternative betas, and alpha strategies in a single, integrated analysis. These are the building blocks of modern portfolio construction.

Efficient return generation is critical. Leverage, illiquidity, and cash are valuable and need to be used with care. Investors should save their illiquidity budget for high-returning investments like private equity and eliminate anything expected to underperform liquid equities. Similarly, traditional hedge funds should be paired with equity beta overlays, as their returns are too low to justify a stand-alone capital allocation. Most investment-grade fixed-income products can be eliminated because they are lower-yielding and riskier. Similarly, liability-driven investors should consider interest rate overlays.

Efficient risk reduction is equally key. Low-returning allocations should be reserved for true portfolio risk reducers like explicit hedges and hedgelike factor strategies. Trend strategies provide positive convexity and downside hedging without the return drag of option hedges. Options provide reliable downside hedging and can be made affordable by pairing them with income-­generating strategies or spread trades that sell an equivalent amount of optionality. Even if hedging comes at a cost, investors can improve returns if protection supports a more return-­oriented strategy elsewhere.

By expanding the tool kit and adjusting the allocation process, investors can enhance returns, reduce risk, and maintain liquidity and control as they navigate challenging return targets in these difficult times. 

Scott Freemon is an investment strategist at SECOR Asset Management.

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