Since the global financial crisis in 2008-09, the sustained suppression of interest rates by global central banks has contributed to broad-based inflation in asset prices, rewarding investors that have participated indiscriminately in the prevailing yield chase in global bond markets.
Short-term interest rates continue to yield close to 0 percent, resulting in investors suffering negative real rates of return after adjusting for inflation for short maturity holdings. With the Bloomberg European High Yield Index offering investors a yield-to-worst figure of merely 3.4 percent at the time of writing, high yield no longer represents high yield, and investors are being forced to stretch for yield at the expense of duration, credit quality and liquidity.
With 2013 representing a true annus horribilis for bonds – with investment grade bonds suffering their worst year since 1994, registering their first annual loss since 1999 (only the third time in 34 years the asset class finished the year in the red) and long duration bonds suffering heavy losses in 2013, with the Barclays US Treasury Index 20+ Years maturities returning negative -13.88 percent – investors are being forced to reassess risk exposures in fixed income portfolios as the 30-year-plus bull market in bonds seemingly draws to a close.
From May 2 to June 25, 2013, the yield on 10-year US Treasuries went from 1.63 percent to 2.59 percent, causing sharp losses in fixed income portfolios, as investors priced in stronger US economic growth and the withdrawal of Fed stimulus. With consensus forecasts suggesting that the yield on the US 10-year Treasuries will rise to 3.5 percent by the end of 2014, more challenges lie on the horizon for bond investors, as they remain overexposed to interest rate risk. It is against this backdrop that Byron Capital Partners is aiming to provide innovative solutions in the area of absolute return fixed income and relative value credit, with a focus on producing strong risk-adjusted returns while offering investors a liquid alternative to traditional long-only fixed income investing.
Byron Fixed Income Alpha Fund return
The search for yield
Greece, after announcing the world’s largest sovereign debt restructuring in history in 2012, returned to the markets in April 2014 issuing €3bn of a euro-denominated five-year bond. An order book of €20bn drove yields down to a remarkable 4.95 percent, despite Greece’s credit rating (Caa3 from Moody’s and B- from S&P). Spain, rated Baa2 by Moody’s and with net foreign liabilities of 114 percent of GDP, in April 2014 issued a 10-year USD-denominated bond at a record low (since 2004) yield of 3.059 percent.
Not only have peripheral European countries profited from investors’ search for yield, but Pakistan is rated Caa1 by Moody’s and issued its first USD bonds since 2007 in April this year at a yield of 7.25 percent for the five-year maturity and at a yield of 8.25 percent for the 10-year bonds. Weaker creditors continue to come to the market to take advantage of low yields and strong buying from investors, who are desperate for yield. This demand has led to continual over-subscription of new debt issues, resulting in reductions in coupons and protections and less transparency provided to investors (issuers have even refused access to historical financials in some cases). Going further down the credit spectrum in search of return remains challenging, as even distressed names are in short supply. Taking the definition of a ‘distressed credit’ as a name trading in excess of 1,000 basis points over US Treasuries, only four percent of the US High Yield Index trades with spreads in excess of 1,000 basis points over US Treasuries.
Faced with corporate credit yields continuing to touch new lows and credit supply offering inadequate compensation for fundamental credit risks, traditional bond investors have been forced to turn to equities, but their volatility can be problematic. For example, since 1972 the S&P 500 has fallen more than seven percent on 27 occasions. Furthermore, incoming legislation such as Solvency II, which will regulate the €7trn European insurance industry, focuses on ‘asset risk’, forcing insurers to evaluate the assets they invest in from a cost and risk budgeting perspective. Under Solvency II, a capital charge of 39 percent will apply for global equities but debt-related instruments are scheduled to be cheaper at 15 percent, forcing insurers to look to debt assets. However, with yields low and investors being forced to take more duration and credit risk, investors are now being forced to look at absolute return fixed income and relative value credit as alternatives to traditional long-only fixed income investing.
Byron Capital Partners launched the Byron Fixed Income Alpha Fund in November 2010, which focuses on absolute return fixed income and relative value credit. Furthermore, the fund operates in a UCITS-compliant (undertakings for collective investment in transferable securities derivatives) structure, domiciled in Ireland. The strategy works well in a UCITS structure, although leverage in UCITS is limited to 10 percent of net asset value so the quality of the asset management is truly tested. In addition, exposure to loans that tend to outperform in a rising interest rate environment are not permissible in UCITS funds.
During and following the 2008 financial crisis, the comparative advantages of UCITS funds manifested themselves and the structure addresses prominent investor concerns such as liquidity, regulation, custody of assets, transparency and risk management. UCITS IV provided the flexibility for absolute return strategies to be run effectively in a UCITS structure with the scope to offer hedge fund-like risk-return profiles in a regulated, liquid and transparent product offering. Both in and outside of Europe, the UCITS directive has evolved into one of the most widely recognised regulatory frameworks of investment funds, allowing investors to access absolute return strategies through UCITS-compliant onshore structures while obtaining increased transparency and liquidity. One of the most effective measures taken by the UCITS directive to provide investor protection is the requirement for UCITS funds to hire independent service providers such as trustees, auditors, administrators and custodians. In addition, UCITS funds explicitly lie outside of the AIFMD scope and already possess a European passport allowing distribution across Europe.
Low risk, low volatility
Now approaching its four-year anniversary in November, the Byron Fixed Income Alpha Fund has won performance awards for 2012 and 2013 from leading industry publications in very different market conditions for fixed income investing. The fund returned 7.43 percent in 2012 and 3.47 percent in 2013 and has run an average credit rating of BBB since inception, thereby not taking excessive credit risk. For the year-to-date through May 15, the fund has returned 2.69 percent.
Duration risk continues to be tightly managed, with the fund running duration at 1.95 at the time of writing. Furthermore, volatility is low at approximately 2.3 percent since inception and a premium is placed on risk management, with monthly value-at-risk at a 99 percent level of confidence currently totalling 1.39 percent. Hit ratios of individual trades (i.e. each trade is monitored for profitability) are monitored and stored for analysis and correspondence with the risk team. A strong emphasis is placed on matching the liquid profile of the investments with investor capital, in line with the UCITS directive. On account of offering investors weekly liquidity, the fund maintains a liquid portfolio of investments in order to ensure there are no mismatches between investor capital and the underlying asset base of the fund.
Importantly for investors looking to mitigate interest risk and diversify their fixed income portfolios, the fund maintains a low correlation against traditional bond indices, with a correlation of less than 20 percent versus the Barclays US Aggregate Bond Index. The selection of securities held is bottom-up driven, with the goal of identifying fundamentally mispriced idiosyncratic risk. Generation and implementation of short side exposure is more top down, macro-driven with the focus on identifying asset class, sub-asset class, sector or sub-sector shorts either to hedge out exposures in the long side of the book or express a negative view on a particular segment of the market. Themes on the short side that worked well in 2013 included but were not limited to shorts in US Treasuries that helped mitigate interest risk. The fund has historically been run with a net long exposure but has the ability to take a net short exposure that should serve it well in a secularly negative environment for fixed income and credit. In terms of current opportunity sets, the investment management team is focusing on selective areas of emerging markets following the re-pricing of emerging market risk in 2013.
With short-term interest rates in the developed world likely to remain low for the foreseeable future, a premium will be put on the ability to generate positive real returns without exposing investors to excessive duration and credit risk, as well as illiquidity. With the 30-year-plus bull market in bonds reaching a denouement and investors under increasing pressure to produce positive real returns from fixed income investments, the prospects for absolute return fixed income, particularly in a regulated structure, look favourable and offer a compelling alternative to a rotation into equities that arguably remain expensive on both a cyclically-adjusted and historical basis.