Fixed Income, Investments

Market factors challenge fixed income approach

Fixed income Bonds Risk Pure relative value

The volatility currently afflicting fixed income markets should make investors reconsider their reliance on yield in portfolio bond allocations.

A specialist fund manager has suggested investors should look beyond the traditional tenets regarding fixed income in order to maximise allocations to this asset class in their portfolios.

Ardea co-chief investment officer Gopi Karunakaran acknowledged conventional fixed income investing has to date revolved around two basic elements.

“When you think about traditional fixed income, it’s really focused around the idea of yield and income, so the idea being a portfolio is going to accumulate bonds and most of the return will be coming from the yield you will be getting from that and in return for receiving that yield you’re exposed to some combination of interest rate risk and credit risk,” Karunakaran noted.

“That risk-return profile is inevitably fairly sensitive to things like the broader macro environment.”

He pointed out investors should now consider a pure relative value approach to fixed income allocations to reduce the exposure a portfolio has to economic factors, such as the level of inflation and interest rates, and improve diversification.

“A pure relative value [strategy] is something entirely different. We use the same high-quality government bonds that you would see in a traditional bond portfolio, but we generate returns from them in a very, very different way,” he noted.

“It’s a high turnover trading strategy that is intended to exploit market inefficiencies to generate returns.”

The approach looks to identify securities that are very similar, but priced differently and take advantage of this disparity in price to generate returns.

According to Karunakaran, the strategy eliminates the role the greater economy will play in a fixed income portfolio allocation.

“What’s important is [the pure relative value strategy] risk-return profile is not dependent on the [macroeconomic] factors. It’s not sensitive to whether we have a recession or [high] inflation,” he said.

“And because it is independent of those [macroeconomic] factors, [the investment] behaves differently and that’s where you’re getting your diversification value from.”

He indicated a pure relative value approach reduces the volatility inherent in a traditional bond market exposure and is particularly important right now as fixed income markets are becoming more volatile.

However, he did recognise bond market volatility levels needed to be high for the strategy to produce optimum outcomes.


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