Analysts towards the end of 2021 were becoming skeptical of the market’s resilience and began to warn of an impending wave of volatility across asset classes. Some on Wall Street even went as far as to recommend volatility as the preferred asset class for 2022. As we have seen during the first quarter of this year, cross-asset volatility not only made its entrance in the first weeks of the year but has also maintained its presence throughout the last months. A combination of the Fed liftoff on rates, the Russo-Ukrainian war, and a 40-year high on inflation have all contributed to poor market performance across all asset classes. Even if investors were prudent enough to allocate much of their portfolio to cash, a 7.9% inflation rate would have them reconsider their decision. The only sub-asset class shielded from the carnage has been short-dated Treasury Inflation Protected securities (TIPs). As we enter the second quarter of the year, investors must come to realize that volatility is here to stay for the foreseeable future and must position their portfolios accordingly to withstand the whipsaw of prices across all traditional asset
classes.
Investors probably have the most complicated task ahead of them. It is not to necessarily predict the direction of the market or find the next great uptrend, but it is to filter out the vast amount of noise in the marketplace. Between the political platforms making use of the war to make their voices heard and theories about changing world order, investors are being flooded with a copious amount of irrelevant information daily. They must focus on the factors that will drive asset prices in the medium to long term. These factors include the Fed’s interest rate policy, earnings growth, and global consumer health (which ultimately drives most earnings in the United States and most developed nations).
The Fed just recently began to raise interest rates, and with the anticipation of this foreseeable hike, markets have behaved erratically to commentary related to the matter. So, what is in store for equity investors with this new regime and should we fear the hike? History tells us there is not much to worry about. During the 2004 to 2006 monetary tightening cycle, the S&P 500 returned 16% during the 2-year period (7.5% annualized), and during the most recent tightening cycle, the S&P 500 returned over 50% between the years 2015 and 2018 (16% annualized). Word from the Fed so far has been that during the next 6 meetings, the committee expects to raise rates to help combat inflation. With the most recent CPI publication of 7.9% and oil prices remaining elevated, the Fed should have plenty of reason to keep this tightening cycle going.
In this first quarterly edition of Investment Highlights, we will cover strategies for both equity and fixed income investors to navigate in this new interest rate regime with the objective of controlling volatility and preserving capital.
Fixed income investors are most at risk when interest rates begin rise. If the investor is holding positions with long-dated maturities, often, the average duration of the portfolio will be high. This poses a risk to the principal of the portfolio to adverse interest rate movements. For example, if a portfolio has an average duration of 7 (often expressed in terms of years) this means that for every increase of 100 bps (+1%) in the underlying interest rate, the average price movement should be a decrease of -7%. Typically, the underlying interest rate for USD denominated bonds is the yield on treasury bonds for their respective maturity. So, a corporate bond with a duration of 10 will respond to movements in the 10-year treasury yield. Below is an example of a bond portfolio with an extended duration along with its projected 12-month return given several interest rate scenarios:
As we can see, when interest rates begin to move against the portfolio at around 60 bps, the 12-month projected return enters into negative territory and there is not enough carry from the interest during the period to cover losses in principal. So where can fixed income investors allocate capital to protect against this rise in rates? The answer is simple: by cutting duration below two years and maintaining an average credit quality around BBB- or better. Benchmark rates for 2-year bonds have risen over 180 bps over the last several months, which provides substantial yield for a traditionally defensive space to defend against rising rates. Below is an example of a bond portfolio with a lower yield but a drastically lower duration being tested against the same interest rate scenarios:
In this example, the range of total returns for all interest rate outcomes stays positive. The short duration minimizes the impact of price shock from interest rates and the investor is cushioned by a positive carry. Investing in short-term maturities can also provide investors with the opportunity to receive their principal back much sooner and reinvest at much higher yields, hence reducing reinvestment risk. If interest rates continue on this trajectory in the medium-term, short-term bond portfolios will be rolling into higher yields and capturing better returns all while keeping volatility at manageable levels.
It is widely known that higher rates equate to elevated discount rates for future earnings in equities. With the anticipation of a higher rate environment, volatility in equities has already made its presence known during Q1 2022. But what can we expect when rates actually rise? Is it as bad as we think? If we were to look back to 2002 and measure the month over month performance when short- and long-term yield were moving higher, we can observe that equity investors have nothing to fear. On average, the S&P 500 returned 0.38% for every basis point rise in the 2-year and 0.36% when compared to a rise in the 10-year rate. If we were to run the same analysis over the Nasdaq and the Russell 2000, we notice both indices also respond well to rise in treasury rates. The Nasdaq tends to react better to a rise in longer term rates, but the Russell 2000 realizes much better performance per basis point rise overall. For investors looking to add a potential boost to their returns in this rising rate environment and decorrelate from the more well-known indices, a tactical exposure to the Russell 2000 is recommended.
This rate movement has been primarily pushed by an “unprecedented” rise in inflation. While trends in treasury yields are an important factor in determining allocations across asset classes, inflation also must be considered. Let us see how the previously mentioned indices would have performed in the same study if we were to substitute treasury yields with break- even rates (the market implied inflation). As a note, break-even rates are also broken down by terms (short and long term).
The only index that withstood the monthly push in implied inflation was the Russell 2000 and with mixed results from the Nasdaq. The S&P 500 does not fair well when both short- and long-term inflation rates are rising. This continues to add on to the investment case for small caps in the current investment environment. We would like to conclude this segment in equities with an overview of the sectors and the correlation of their daily returns against these same benchmarks. This will assist the investor in selecting appropriate sector allocations.
Global investors, especially the ones with access to private markets, have managed to diversify into uncorrelated strategies in the private equity and hedge fund market. These two sub-asset classes make up the majority of what we know as the alternatives market. Primarily available to accredited investors, this market requires an elevated level of due diligence and deep understanding of private transactions. Below we analyze the primary strategies deployed in private equity and their performance since 2017.
With a healthy M&A environment buoyed by low interest rates, buyout strategies have returned a 16.08% annualized total return since 2017. With valuations also maintaining themselves in “rich” territory, growth strategies have returned an equivalent performance of 15.28% annualized during the same period. Real Estate and Private Debt strategies have rewarded investors with annualized performances of 10% but with significantly less volatility.
Hedge funds have also been in the spotlight with recent market volatility. With the primary objective to decorrelate returns and provide elevated risk-adjusted returns, accredited investors allocate to these structures to provide that “Hedge” to their global asset allocation. Unfortunately, hedge funds have not lived up to their expectations. This might be attributed to their high fee structures or a highly correlated cross-asset market where diversification has a marginal effect. When comparing results of the industry’s top hedge funds against a traditional 60/40 portfolio, total returns deviate drastically over time. Correlations on monthly returns also show a lack of a diversification effect from allocating to hedge funds. Thus, investors are beginning to reevaluate their purpose in the investing landscape and unless this sub-asset class does not formulate a more competitive structure, it will be very hard for them to remain relevant.
hat is not to say that there are no worthy hedge funds in the marketplace. Everything must be evaluated on a case-by- case basis. Alternative prove a great opportunity for investors to achieve uncorrelated results in their investment portfolios, but additional overhead must always be considered when conducting the due diligence process.
They are Fixed Income financial instruments whose issuers use as debt securities to attract lenders (investors) and be able to use the capital to finance their operations or economic projects. Unlike ordinary loans, these securities are traded publicly (financial markets), Over-The-Counter (over-the-counter markets) or privately, in all currencies. They have associated interest rates (known as coupons) that the issuers agree to pay in pre-established terms and, commonly, have a maturity date where the investor receives the initial amount of the debt (known as principal).
Entities such as companies, governments, municipalities and state agencies. Generally, investors are subject to the risk of default in which the financial situation of the issuers makes it impossible for them to comply with the obligation to pay the principal. However, bonds issued by governments in their respective local currencies are considered safer since in this case the issuer has the power to issue bills in the same currency and thus meet its obligations. The latter are considered “risk-free debt securities,” like the widely known US Treasury bonds issued by the US Federal Reserve.
There are rating agencies, such as Standard & Poor’s, Moody’s and Fitch, which, through financial/economic studies and empirical evidence of the issuers, establish credit qualities for each one of them. Each has its own designations, but they share the same risk criteria: High (AAA to AA), Medium (A to BBB), Low (BB to B and CCC to C), and Default (D). Those of “Investment Grade” are those that have a high credit rating between AAA and BBB-, and the rest are “without investment grade”.
These debt securities can be issued in the short term (a few days or months), medium term (between one and two years) and long term (more than two years). Some even have no expiration date and are used as a purely speculative instrument. These are called “Perpetuals” and the issuers have the only obligation to pay the coupons.
The relationship between the bonds and the capital structures of the issuers are represented by classifications that indicate the payment preference orders in case the debtor cannot meet its payment obligations. In descending order of preferences, these are: Secured Corporate Bonds (corporate debt issued with a collateral asset), Secured Senior Bonds (same as above but creditors will be the first to receive payments in case the company goes bankrupt) , Senior Unsecured Bonds (similar to the previous one except that they do not have a collateral that guarantees them) Junior or Subordinated Bonds (in case of default of the issuers, the creditors will receive the payments once the seniors have received them), Guaranteed Bonds and Insured (guaranteed by third parties) and Convertible Bonds (they have the possibility of converting into ordinary shares).
The established coupons can be fixed -fixed rate that remains unchanged until the expiration date- or floating -the sum of a fixed part and another associated with an interest rate (eg LIBOR)-. Generally, these are paid by the issuer on a semi-annual, annual or quarterly basis. Between the payment periods of the coupons, the bond accrues interest daily and, given a certain date after the bond issuance or coupon payment, the sum of the interest generated between these dates is known as “current coupon”.
There are two types of prices for these debt securities: clean price (not including the running coupon) and dirty price (including it). The latter is the price that investors must pay to acquire them.
Callable bonds are those that the issuer can reduce the debt before the expiration date, by re-purchasing the total amount of the debt in advance. This generally occurs in a bearish interest rate environment. On the other hand, Sinkable bonds are debt securities that are issued with a backup reserve fund which is used by the issuer to repurchase the debt periodically over time, allowing it to reduce the cost of the debt. debt. From the investor’s point of view, this type of instrument is safe, but its yield is uncertain since it depends solely on the variation in the prices of the bond in the market.
Yield-to-Maturity (YTM) is the rate of return the bond offers to maturity given the dirty price, while Yield-to-Worst (YTW) is the lowest possible rate the investor will earn on the investment if the issuer makes a call prior to its expiration.
The Issued Amount is the total debt issued by the debtors, while the Outstanding Bonds correspond to the total amount of the debt that was not redeemed or reduced by the issuers.
The Issued Amount is the total debt issued by the debtors, while the Outstanding Bonds correspond to the total amount of the debt that was not redeemed or reduced by the issuers.
An investor with a conservative profile is interested in buying USD 100,000 of an investment-grade bond from a well-known industrial company, so his financial advisor finds the following bond that best suits his requirements:
Once the advisor has determined the bond and has calculated the running coupon (0.8125%), the advisor proceeds to perform the following calculation to determine the nominal value that does not exceed the maximum amount established by the investor (USD100K):
Amount to Invest / Dirty Price % = xxxxxx ——–> Closest Nominal Value is = yyyyyy
$100,000 / (100.85% + 0.8125%) = $98,352.59 ——–> Nearest Face Value is = 98,000
Once the Nominal Value has been defined, the advisor proceeds to calculate the total (final) amount to be invested by the investor:
Nominal Value x Dirty Price = zzzzzz ——–> Amount in USD that the investor must pay to acquire the bond in question 98,000 x (100.85% + 0.8125%) = $99,641.50 ——–> Total to be disbursed by the investor