Volatility looks here to stay
2016 began as we expected it to go on, with consistently higher market volatility on the back of heightened global recession fears, worries over central banks' declining ability to prop-up growth and volatile commodity prices. Uncertainty around policy making continues to be one of the main drivers of volatility.
In the US, the Federal Reserve (Fed) started policy normalisation at the end of last year, causing a strengthening of the Dollar. While the Fed turned more dovish for a while causing Dollar depreciation, it now seems likely that the hawkish members of the Federal Open Market Committee may get the upper hand, thanks to supportive US economic data, and push towards a rate hike in July.
While the timing of the next rate hike seems to be for this summer, other global central banks continue to fight deflation with accommodative monetary policy. The Bank of Japan surprised markets with their renewed accommodative monetary stance earlier this year (introducing negative interest rates). While they were inactive in April's meeting, a depo rate cut remains likely, along with more proactive fiscal policy.
Meanwhile the European Central Bank is also keeping the doors open for additional stimulus this year, following the announcement of a bold package of stimulus measures in its March meeting (including a depo rate cut, an extension and expansion of the asset purchase programme and four targeted longer-term refinancing operations).
The rebalancing of the Chinese economy towards a consumer led growth model, and the continuous deleveraging due to excessive amounts of corporate debt, are likely to continue to contribute to the slowdown of the economy. This will in turn remain a downward pressure on already weak commodity prices, which have had harmful side effects on emerging markets.
The impact of all of this has been heightened volatility, which can be observed in the VIX Index (the CBOE Volatility Index - a key measure of market expectations of near-term volatility), reaching a high this year of 28.14 on 11 February. Volatility has subsided since then, closing at 14.2 at the end of May.
However, several risks lay ahead, including the ongoing impact of China's economic slowdown, a more hawkish than expected Fed, a renewed decline in commodity prices, political instability in the Middle East and Europe (including the Brexit referendum and Spanish general elections) and the possibility of a return of a Greek financing crisis, could all imply volatility returning to noticeably higher levels this year.
Source: AXA IM and Bloomberg as at 31/05/2016
Uncertainty for sterling bond investors
The UK market is not immune from this volatility, especially given the possibility of Brexit, which is a major source of uncertainty in the financial market. With the UK 'in-out' EU referendum looming, we expect the Bank of England to hold off from hiking rates this year, but deliver two 25bps hikes in 2017 in a Remain scenario.
As such, we would expect the trend of higher yields to resume, particularly in the US and UK, as the current low level of yields is not commensurate with macroeconomic conditions. This is all set against an ongoing decline of liquidity in the bond market, compounding the current market difficulties, in particular for sterling corporate investors.
How to prepare for higher volatility
Cautious investors looking to withstand the inevitable market volatility and ongoing threat of rising yields could find a solution in a short duration bond fund (in the sterling market, this means investing primarily in bonds with a time to maturity of less than five years).
The concept of duration is very important for fixed income investors as it essentially measures how sensitive a bond's price is to interest rate movements: the lower the duration, the lower the sensitivity. Buying a corporate bond with a lower maturity provides investors with not only a lower duration but also a lower spread duration. This means that the bond will exhibit a lower sensitivity to changes in government bond yields as well as credit spreads.
Short duration bonds are therefore a very useful tool in managing the risks of rising yields and market volatility whilst aiming to provide investors with consistent, incremental returns, in excess of cash:
• Less sensitive to rising yields. One of the key risks of investing in fixed income is the capital eroding effects of rising yields. Investing in a short duration strategy not only enables you to reduce your sensitivity to rising yields but also to benefit from such an environment, as a higher level of reinvestment from maturing bonds allows for a closer alignment with rising yields.
• Can help reduce market volatility. Not only by nature of a lower duration and spread duration, but also through a strong focus on diversification and active management, a short duration strategy can help to limit the volatility and drawdowns relative to the wider market.
For example, the graphs below illustrate the AXA Sterling Credit Short Duration Bond Fund's performance over the course of 2013 and 2015 (both highly volatile years).
During this time the Fund managed to achieve consistent returns close to that of the IA Sector for both years - but with much less volatility, and having avoided the large drawdowns experienced by the market (6% and 5%) after the "Taper Tantrum" and "Bund Tantrum" in May 2013 and April 2015 respectively, offering therefore superior risk-adjusted returns.
Source: AXA IM as at 31/12/2015. Fund performance is given for the Z Acc share class (income reinvested), net of fees and gross of tax. Cumulative performance has been rebased to 100. The fund's peer group is the IA £ Corporate Bond Sector which is shown here for comparative purposes only. Past performance is not a guide to future performance. Performance is calculated using mid prices.
Additionally, a short duration bond fund can help investors face the challenging liquidity conditions in the sterling corporate bond market. A short duration strategy exhibits a naturally attractive liquidity profile, due to regular cash flows from maturing bonds and coupon income.
By having to not necessarily sell bonds in order to implement active strategies, we can minimise turnover and hence save on transaction costs which is particularly advantageous in the current environment with the average bid/offer as a percentage of the bond's price being around 1% for the sterling corporate bond market.
In conclusion, investing in a short duration strategy is a potential way to make the best of a still challenging year ahead.
Please note, however, that short duration strategies are subject to counterparty risk, credit risk, interest rate risk and liquidity risk.
Nicolas Trindade
Fund Manager, AXA IM
Nicolas Trindade manages the AXA Sterling Credit Short Duration Bond Fund. He joined AXA IM in July 2006 and is a Senior Portfolio Manager within the Sterling Credit team, managing approximately £1.2 billion in assets. In addition to his portfolio management responsibilities, Nicolas leads the Sterling Credit "Alpha Group".
Prior to his appointment within the investment team in June 2010, he spent nearly three years within the Fixed Income Product Specialist Unit, where he was responsible for the development of our UK, US & High Yield product ranges.
Nicolas holds an MSc in diplomacy and international strategy from the London School of Economics, as well as a Master's degree in IT engineering from Telecom SudParis (France), and he is a CFA Charterholder. He also manages the AXA Sterling Credit Short Duration Bond Fund.
Find out more about the AXA Sterling Credit Short Duration Bond Fund.
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