THE SEARCH FOR YIELD
Chris Bowie, Partner, Portfolio Manager
The Holy Grail for any fixed income investor is an attractive level of income, or yield, with little or no capital losses and very little capital volatility along the way. Chris Bowie, Portfolio Manager and Partner at TwentyFour Asset Management describes their back to basics approach to fixed income investing.
Not surprisingly, achieving consistently risk adjusted returns is harder than it sounds! Whilst we certainly don’t claim to have found that Grail just yet, we have come up with an approach that we believe seems to stack the odds more favourably towards the investor in terms of the risk/reward trade-off, and this approach is our guiding principle.
Since the financial crisis, many investors have turned towards bond funds seeking absolute returns in the belief that it can generate superior risk-adjusted returns through the investment cycle. Sadly, the reality has not lived up to the promise in all cases, with frequent comments from investors that I meet calling it “the absolutely negative return sector”. Some of these criticisms are valid, as many funds in the sector have struggled to achieve positive returns over reasonable time frames, and often with higher levels of volatility than are appropriate for their return targets.
So when we set about designing an absolute return product, we went for a real back-to-basics approach. We asked ourselves, what if we let fixed income do what it should be best at doing? Simply put, getting your capital back with a decent level of income for putting that capital at risk. That means having income as the dominant driver of those returns, and rejecting other strategies that are harder to be consistently great at; such as shorting, using leverage or complicated derivative overlays. However, in order to keep capital volatility contained, we would need to find the bond market segment that was best at returning income and which consistently kept capital volatility low – and our suspicion was that short dated bonds were the best fit. But would a simpler, short-dated approach consistently work, and work with a high enough level of return to make it attractive?
We found that it would, and often does. The evidence we have for that assertion is twofold: firstly, our extensive quantitative back-testing confirmed what we had long suspected, that short-dated bonds had the lowest volatility, but also surprised us in how good the returns could actually be; and secondly, that experience of running the Fund through some challenging markets we feel the strategy actually works, even within a period when the US Federal Reserve has raised rates for the first time in nearly ten years, and the credit markets had one of their worst months for five years. So, how have we managed to achieve this, with such low volatility?
We spent months designing and then fine-tuning what we invest in, and where it can take the limited risks that it is allowed to take. By looking at daily returns from all areas of credit since the turn of the century, our in-house testing work looked in detail as to where the drivers of volatility reside, and from that we work out how to try to avoid them. But more than that, we also knew from the data where the best returning opportunities were too, and how to exploit them. That critical work, of seeking the very best returns with the lowest volatilities, led us into finding the best Sharpe Ratios (a measure of risk-adjusted return) – and then hard-coding that into our investment process.
When it comes to stock selection, we add in some more special sauce; this time in the form of our custom designed stock picking system, called “Observatory”. What this system does is take a stock level view of just how volatile every single bond that we could buy actually is.
The second part of the answer relies on a little bit of our TwentyFour special sauce of course. This is where we use our in-house asset allocation preferences, within a much defined low volatility universe, to attempt to elevate returns whilst lowering risks even further than the core product design itself would bring. When it comes to stock selection, we add in some more special sauce; this time in the form of our custom designed stock picking system, called “Observatory”. What this system does is take a stock level view of just how volatile every single bond that we could buy actually is. Before we buy anything, we know what its spread volatility and cash price volatility is – and not just for that bond and company, but the average for its peers in that sector, that country, that currency, that rating band, that maturity, that level of subordination etc.
So when we set about designing our absolute return fund, we went for a real back-to-basics approach. We asked ourselves, what if we let fixed income do what it is best at doing?
Right now we think this approach of maximising return in a low volatility context is crucial, as lots of risks and opportunities remain in credit, and fixed income in general. As I write, some hawkish commentary is starting to come out from the Federal Reserve suggesting rate rises may come earlier than many were expecting, and that is pressuring capital values on longer dated bonds. Of course, closer to home, the Brexit referendum later in June could well be a source of volatility, not just for UK fixed income markets, but possibly even more so in the exchange rate.
You should contact the person at JM Finn & Co with whom you usually deal if you wish to discuss the suitability of any securities mentioned.