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Eve Tournier, Loren Sageser
How many times have you been in the middle of a project, only to discover that you lacked a critical tool for completing the job? Most of us have improvised at one time or another, using a screwdriver as a chisel, or perhaps a nearby rock as a stand-in for a hammer. But as Dad used to say, there’s just no substitute for “the right tool for the job.”
Some fixed income investors today have already begun to plan ahead in anticipation of a future rise in interest rates, seeking the right combination of investment tools to balance interest rate risk against the need to earn attractive investment returns. While PIMCO believes a meaningful rise in interest rates is unlikely to occur prior to 2016, some investors may want to explore the full range of investment strategies designed to minimize the portfolio impact of rising rates. In addition, many investors focused on asset allocation or asset/liability management may require investment tools which offer precision in terms of the type of exposure they provide, benefiting from the improved ability to isolate and control duration risk separately from other types of market exposure.
Investment strategies for managing duration risk There are a wide variety of fixed income investment strategies which can help investors to manage duration risk, either through portfolio design or by targeting specific types of investment exposure. Actively managed core bond strategies often have the flexibility to diversify a bond portfolio’s sources of total carry to include credit, currency, and other non-duration-based components. Short or low duration bond strategies target bond investments with maturities which fall below a certain threshold, such as two or three years. Floating rate bank loans also offer a solution for generating attractive levels of income with minimal duration risk, since they have LIBOR-based coupons which adjust up or down depending on the movement of interest rates. In the current environment, investors may also want to consider absolute return-oriented strategies, which provide the manager with greater flexibility to position portfolios based on forward-looking views on the path of interest rates.
PIMCO’s Floating Income Strategy is another option for investors focused on generating attractive income and total return with an eye toward managing interest rate risk. To accomplish this, the strategy is designed to invest in a highly diversified portfolio of global credit issuers and then use duration hedging instruments to reduce overall duration exposure to approximately zero years. At first glance, this approach may seem unique among fixed income strategies. However, bear in mind that this is merely an extension of what most bond managers do for traditional fixed income portfolios: a portfolio of bonds is selected, and instruments such as U.S. Treasury futures or interest rate swaps are used to adjust overall duration to within a target range, such as within one to two years of a designated benchmark. In the case of Floating Income, the target duration is simply reduced to zero.
Unlike sector specific strategies, PIMCO Floating Income invests in a wide spectrum of global credit asset classes, including investment grade and high yield bonds, emerging markets debt and floating rate bank loans. Since it is not constrained to buying only floating rate instruments the strategy can build a highly diversified portfolio. The strategy’s portfolio is highly similar to PIMCO’s Diversified Income Strategy, but with most of the duration risk hedged.
Hedging duration exposure – not as complicated as it sounds Duration hedging has been around for as long as the fixed income markets. Because of the enormous demand among insurance companies, pension managers, banks and other fixed income investors for duration hedging solutions, the market for these instruments is one of the broadest and deepest in the world. U.S. Treasury futures, interest rate swaps and other similar instruments have been available for decades.
Consider the following example. An investor purchases a Treasury note with a seven-year maturity and six-year duration. To reduce overall portfolio duration, the investor could then sell a seven-year U.S. Treasury future. If interest rates fall, the Treasury note should rise in value by roughly the same amount that the futures contract should fall (all else being equal). The investor has hedged the duration exposure of the portfolio.
Instead of going short Treasury futures, the investor could also enter into an interest rate swap. In this example, the investor would agree to make an ongoing fixed payment tied to the current seven-year Treasury rate, and in exchange would receive a floating payment tied to short-term interest rates realized in the future. The net effect would be the same as the example with the Treasury future – if interest rates fall, the seven-year Treasury note should go up in value, while the value of the interest rate swap should fall in value by roughly the same amount (again, all else being equal). In both cases, the effects of changing interest rates on the Treasury note have been reduced.
The same approach can be applied to a full portfolio of bonds including corporate and emerging market bonds. In those cases, the manager would simply hedge the duration risk at the overall portfolio level. Of course, derivatives are complex instruments requiring careful management.
What about income? In today’s low yield world, income-starved investors instinctively ask about the effects of duration hedging on a portfolio’s income-generating potential. Put simply, in a world characterized by an upward-sloping yield curve, duration hedging reduces portfolio income levels. For instance, in the case of an interest rate swap where a fixed rate is paid in exchange for receiving a floating rate, the fixed rate paid is higher than the floating rate received because the market expects interest rates to eventually rise. This ongoing cost, which varies based on the steepness and curvature of the yield curve, acts as a drag on overall portfolio income. However, duration hedged portfolios of global credit issuers, such as the Floating Income Strategy, can still provide investors with attractive income opportunities by seeking to capture the credit spread received on the underlying bonds.
In its simplest form, a bond’s credit spread is the difference between its yield and the interest rate on a Treasury security of equal duration. In the current interest rate environment, which is low by historical standards, the coupon payment for many corporate securities is often dominated by this spread. For this reason, the Floating Income strategy can still offer the potential for a compelling ongoing yield despite the loss of income from hedging duration.
A word on risk While Floating Income and similar duration-hedged strategies can be a useful tool for investors, it is important to consider the attendant risks. First and foremost, if you look back over the past few years, hedging duration risk would have been unproductive – you would have lost ongoing income from the interest rate hedge and you would have missed out on the tremendous tailwind that falling interest rates provided for all fixed income investors. And currently, PIMCO still believes that interest rates will stay low well into 2016.
Another point to consider is the historically inverse correlation between interest rates and credit spreads. Put simply, when interest rates rise, spreads tend to narrow, and vice versa (although this is not always the case). This makes intuitive sense – generally speaking, rising rates tend to reflect improving economic conditions, which tend to mean better conditions for corporations (and thus tighter corporate spreads). During 2011, spreads for many credit sectors widened due to an uptick in risk aversion, exerting negative pressure on bond prices. However, interest rates fell during the same period, as investors flocked to the relative safety of Treasuries. This served as a positive offset for credit bonds, mitigating the impact of widening spreads. During this period, duration hedged strategies such as Floating Income did not receive the positive benefits of the fall in interest rates.
A potentially useful tool PIMCO’s Floating Income Strategy is an investment tool designed to help investors achieve a specialized set of objectives. It can be useful for investors focused on generating income through targeted exposure to credit investments without interest rate risk. However, the strategy tends to defy traditional ranking systems which are based on categorizing bond strategies into broad risk buckets. For this reason, it may be overlooked by many investors, particularly those who rely on third-party screening systems.
While PIMCO does not believe that markets are due for an imminent rise in interest rates, many investors have begun to think about options for a post-QE world. In addition, investors may also desire greater ability to fine-tune the duration exposure of their portfolios as they pursue a broader set of objectives. In either case, PIMCO’s Floating Income Strategy may be worth a closer look.
Absolute return portfolios may not fully participate in strong positive market rallies. Floating rate loans are not traded on an exchange and are subject to significant credit, valuation and liquidity risk. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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