With a rising interest rate cycle appearing increasingly likely, South Africans invested in fixed interest funds should look to diversify their portfolios, as this environment typically has a deteriorating effect on bond prices and bond portfolios.
According to Grant Hogan of Blue Ink Investments, one option investors can use to counter the effects of rising interest rates is by including fixed income hedge funds in their portfolio.
“Fixed income hedge funds offer investors downside protection when interest rates are rising and the All Bond Index (ALBI) is negative.”
He adds that fixed income hedge funds can and have generated good returns in both rising (2006-08) and falling (2008-10) interest rate environments.
“These funds also generally exhibit less volatility relative to the All Bond Index. Since 2006, fixed income hedge funds have generated returns with 3.06% volatility compared with the 6.75% of the ALBI.”
Finally, he says that fixed income hedge funds generally remain uncorrelated to bonds.
“Since 2006, the correlation between fixed income hedge funds and the ALBI was less than 0.01.”
Over the past five years, the opportunity set for fixed income investors has been changed dramatically by traders and managers launching fixed income arbitrage hedge funds. These managers share the portfolio and risk management skill of bond fund managers, but use additional tools that lie outside the boundaries of the traditional bond fund manager.
Fixed income hedge funds offer investors an absolute return focus while utilising the full “toolkit” of fixed income and fixed income derivative products to extract value by maximising arbitrage opportunities. These funds are also not constrained by many investment restrictions imposed by the Collective Investment Schemes Control Act (CISCA).
Fixed-income arbitrage is an investment strategy that exploits pricing differences between fixed-income securities. These funds typically used derivatives to extract value from both long and short strategies across the yield curve. In contrast bond funds typically comprise a number of long only government and corporate bonds of varying maturities.
Hogan says that like bond funds, the performance of fixed income hedge funds over the past three years was helped by falling interest rates.
“However, unlike bond funds, fixed income hedge funds can benefit from both falling and rising interest rates due to the fact that they can short certain positions.
“Furthermore, these funds can also benefit from inefficiencies in the yield curve caused by timing and uncertainty of rate cuts or hikes.”
On average, fixed income hedge funds have returned 19.69% annually over the past three years.
Fixed income hedge funds have many tools and strategies at their disposal to hedge and benefit from rising or falling interest rates, he notes.
For example, when rates are falling they would typically be long bonds, swaps, and received in forward rate agreements.
According to Hogan, bond fund investors typically want diversification to minimise their investment risk and generally achieve this by investing in bonds of different maturities.
“However, as the price of the underlying bonds in the portfolio decrease, so too will the value of the investor's portfolio and this could vary considerably.”
The performance of the ALBI speaks to this point, he adds.
While the ALBI returned 33.39% for the three years up to March, the volatility over the same period was 7.64%. In contrast the average return of fixed income hedge funds (using the Blue Ink Fixed Income Hedge Fund Composite) over the same period was 64.38% with 3.82% volatility.
“Considering these facts, a strong case could be made not only having fixed income exposure in long only bond funds, but for having a fixed income portfolio comprising of both of fixed income bond funds and fixed income hedge funds.”
* The purpose of this article is to inform, not to advise. - I-Net Bridge