Low rates on government bonds mean anyone holding these assets is effectively calling a recession, according to Russell Investments’ Adam Smears (pictured), a strategy he likened to guessing the next card you will be dealt in a game of poker.
Smears, who runs the Russell Unconstrained Bond fund, said one thing he has learnt during his 20-year career is that fund managers don't make money from being able to predict the future; rather, they make money by building a portfolio that can deliver good returns throughout all market conditions. He compared this to taking a probability-based approach to a game of poker.
“You know what your hand is, you know how much you've got in your float,” he explained. “You know how long you can survive. And you know if you've got a strong hand or a weak hand, but you don't know what the next card is going to be, and you don't know what the other people's cards are.
“You might have a guess. But it's not good to try to build your strategy around guessing their cards, it is better to think about your own cards.”
Smears said that the range of binary outcomes in credit is similar to that in government bonds. With credit spreads in high yield of 370 basis points (bps), but an average long run default rate of 3 per cent, this equates to just 70 bps of excess return. The manager said the only way you can justify investing in this area of the market is if you think there will be continued economic growth, which will keep defaults low.
“But how can you believe that and also justify the current level of interest rates? It's just totally incongruent,” he continued.
“Almost all strategies in fixed income are either long credit or long duration. So when you pick a fund, your success is going to be almost entirely down to whether you picked credit and there was no recession, or whether you picked duration and there was a recession, right? It's actually about as binary as that.”
Russell Unconstrained Bond focuses more on minimising volatility than maximising returns, and as a result doesn’t rely on either one of these outcomes to make money.
It is made up of three elements. The first, the “core yield engine”, will do well if the environment remains stable and volatility is low. It is made up of high-quality high yield bonds, primarily rated ‘BB’, with less than five years to maturity.
“Why?” Smears continued. “Well, in BB-rated debt, you get a reasonable amount of spread because you have a lot of fallen angels, you have a lot of investment grade managers who may have owned a company but have to sell it if it falls into high yield because their mandate says so.
“So you tend to get more yield for the level of risk that you have.”
While high yield bonds can still deliver an attractive return over the long term, they do not do well in times of market stress – they fell 16.2 per cent in 2008, for example.
Performance of high yield vs equities
Source: Russell Investments, ICE BofA Merrill Lynch
As a result, this type of strategy currently only makes up about 40 per cent of the portfolio. The second component is the ‘diversifiers’, or “a pile of strategies that try to make money out of volatility”.
These include cash positions, allowing the manager to take advantage of depressed prices. He said these have currency and interest rate overlays, to help deliver positive returns over the cycle: “Not a lot, but some extra return on cash. But importantly, the way they make those returns has no correlation to credit, nothing.”
He also has options on the S&P that pay off when the index either falls or rises sharply. While holding both these contrary positions may sound like a self-defeating strategy, the manager pointed out this is to hedge credit risk.
“It's like a staircase,” he explained. “When credit blows up, volatility rises. So as long as you've got a staircase pattern, you're making money when credit is not making money. Both strategies therefore contribute to the overall performance of the fund. But at exactly the opposite time, and that makes a very smooth return profile.”
He admitted that buying this sort of protection is not as profitable as being long risk, which is where the final part of the portfolio, the “opportunistic book”, comes in.
At the moment this features interest only strips of US mortgage securities backed by the likes of Fannie Mae and Freddie Mac. These are AAA-rated with a spread of just 30bps, which is compensation for pre-payment risk – meaning they lose value if people pay off their mortgages early, but make money if they don’t.
Smears said the beauty of these instruments is in the reasons why people would choose not to pay off their mortgage early.
“One of the reasons is because rates go up,” he explained. “If rates go up, you're not going to be paying the mortgage because you're like, ‘I've got a good mortgage, why would I move to a higher rate?’
“So what that means is you actually get capital gains from rising rates. Can you think of any bond in the market which pays you a spread and benefits from rising rates? There's none.
Source: Russell Investments, Bloomberg, BankRate.com
“I mean, you can short interest rates, you can go short US Treasuries. But if you go short, you're paying somebody else that carry. With this security, you get paid to carry and you potentially do well if rates rise – not always, but potentially. And so this is just so different from everything else in fixed income, it adds diversification.”
Data from FE Analytics shows Russell Unconstrained Bond has made 6.19 per cent since Smears took charge in September 2016, compared with 1.83 per cent from the Libor GBP 3 month bond index and 7.81 per cent from the FO Absolute Return sector.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
The $746.72m fund has a management fee of 0.85 per cent.