When most fund managers discuss fixed income investing, particularly in credit markets, many will unsurprisingly stress the importance of security selection. Indeed, when trying to beat a benchmark, there is no doubt ‘picking the winners’ and ‘avoiding the losers’ is crucial.
But is this the only way of generating attractive returns from fixed income markets? Our multi assets team does not believe so. The fixed income portfolios managed by our team are benchmark unconstrained, so we are free to explore opportunities across a wide range of asset classes.
Instead of trying to identify winners and losers within thousands of individual securities, we believe that another equally rewarding opportunity lies in combining attractive risk premia across the fixed income universe. However, with no benchmark, risk becomes a key factor.
Within fixed income in particular, our first objective is to identify the exact risks we want to be exposed to – such as duration and credit spreads. We then look to combine risk premia able to generate attractive returns in risk-on environments, with risk premia able to deliver positive returns in risk-off environments.
Obtaining pure exposure to duration and credit risk premia
For example, risk premia we are currently working with, among others, are US high yield spreads and Canadian duration. High yield spreads are a typical risk-on ingredient, performing well with the economic cycle when credit spreads are high and default risks are low. On the other hand, duration is a risk-off ingredient, which particularly works when the yield curve is steep and there is a weak macroeconomic growth and inflation momentum. Once we have determined the desired premia, we then need to identify the financial instruments best able to deliver the required exposure.
In order to achieve the desired level of US high yield credit risk, we use the most liquid derivative instrument in the market – a credit default swap. Credit default swaps offer a synthetic replication of credit risk that can be traded in significant volumes at low costs. Again, we are looking to deliver on a market risk/return profile and therefore do not need to engage in security selection.
Similarly, we use liquid bond futures and benchmark bonds when obtaining exposure to duration, such as our current position in Canadian duration. Our proprietary models track the duration level of high-quality developed market bonds across different tenures, such as 5-year, 10-year and 30-year. Based on the level of duration suggested by the risk budget and the volatility levels of the tenures, we then seek the best market and tenure combination in order to achieve the desired duration exposure.
We have long spoken of multi-asset managers who repeatedly need to make the right macro calls in order to deliver returns through the cycle. This has often proven to be a difficult investment approach for many managers. In a similar vein, we also do not subscribe to the view it is a necessity to ‘pick the winners’ in order to achieve robust returns from fixed income markets. Instead, we choose to rely on our risk balancing approach, which allows us to be well positioned in any market environment and therefore generate stable and positive returns over time.
Karsten Bierre is lead manager of the Nordea 1 – Flexible Fixed Income fund