Unconstrained bond mandate features multiple tools to ride out volatility

Russell Investments' Adam Smears maintains there are ways to manage the risks and even profit from them.

Michael Ryval 27 September, 2018 | 5:00PM
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Central bank tightening has played havoc with bond markets for the past couple of years, and it is likely the trend may continue for another year. But Adam Smears, a long-time fixed income specialist at Russell Investments, based in Toronto, maintains there are tools at one's disposal that can help investors ride out the current volatility.

"The market is generally thinking of two more rate hikes this year in the U.S. and another three, maybe four, in 2019. But the market's view is much less pronounced in Canada on that," says Smears, head of fixed income research and lead manager of the $869-million Russell Investments Global Unconstrained Bond Pool. "There is a view that Canada has some issues, such as a more indebted economy and is more sensitive to rate hikes. The market is pricing in one more rate hike this year and possibly one early next year, but not much beyond that."

Yet the possibility of several rate hikes in the U.S. will have an impact on our currency. This, along with inflationary pressures, may lead the Bank of Canada to "be more aggressive than people are expecting," says Smears, a Toronto native and 21-year industry veteran who has spent the bulk of his career in London, England, and returned to Canada in Sept. 2017.

Smears maintains that inflationary pressures are the main culprit that will influence central banks to continue their tightening policies. "Wage inflation, although muted until now, has the potential to surprise on the upside. The reason is simply this: the U.S. economy is 'printing' maybe 150,000 to 200,000 jobs a month. If you continue to print at that level, you are likely to find unemployment levels will get so low that in order to entice people to take jobs, and increase the participation rate, you will have to raise salaries," says Smears. He notes that Jerome Powell, chairman of the Federal Reserve, has said recently that this is a trend the central bank is keeping a close watch eye on. "This has a lot of momentum. When you see wage growth at a high level it doesn't just dissipate quickly. And especially when you add the stimulus from the U.S. government, this is a time when there are a fair number of factors pushing inflation higher."

Are there places where investors can hide and minimize the damage of rising interest rates? While Smears concedes that this is a very challenging period for investors, he maintains there are ways to manage the risks and even profit from them.

"There are two major risks that you get paid for when you invest in bonds: either you get paid for duration or interest rate risk, or you're getting paid for credit risk," says Smears. "Under a normal environment, those two risks tend to move in opposite ways. If credit is doing well then interest rates tend to do poorly, and vice versa. They tend to have a negative correlation and there are places to hide." Strong credit performance is a reflection of a strong economy; when interest rates are doing well it is a reflection of a weak economy.

"But this time around, it is a little different. Credit is quite expensive and corporate bond spreads are at a historic tight end." Currently, the spread between U.S. high-yield bonds and government bonds is about 335 basis points, which is low on a historic basis. But real yields are also very low given that 10-year U.S. government bonds yield 3.09% and inflation is about 2%. "Rates are pretty expensive even after they have risen so much [in the past couple of years]."

In Smears' view, investors can hide by moving to the so-called front end of the yield curve, where there is much less interest-rate sensitivity, and buy higher-rated credit that has a low risk of default. "We think that mortgage credit offers better value than corporate credit. For the last few years, the latter has become more levered and leverage rates of corporate America are pretty high. Mortgages tend to be a function of individual balance sheets and the U.S. consumer has, in fact, become more deleveraged. Our fund has exposure there. And if there is a sell-off in the bond market, it's likely to hit credit everywhere -- but mortgages are in a better spot than corporates."

Russell Investments Global Unconstrained Bond Pool holds about 20% in mortgages, with a focus on those that have a pre-payment feature originating with U.S. organizations such as Fannie Mae. "These tend to be AAA credit quality with a decent spread but benefit from rising rates, which is rare in the fixed income universe," says Smears, adding that this portion is overseen by Boston-based Putnam Investment Management LLC.

Although the pre-payment area of the mortgage sector is highly specialized, Smears argues it's necessary to be involved at this point in the interest-rate cycle and that Putnam has the quantitative discipline to deliver good returns. "When you are at this stage of the market, where credit and interest are pretty expensive, you need to do something a little different. You have to look harder for the opportunities."

Mortgages represent only one facet of the multi-tool strategy behind the fund, which currently holds about 40% in corporate credits. That allocation is split roughly between leveraged loans and investment-grade structured credit. The former portion is managed by a sub-advisor, Chicago-based THL Credit. The latter portion is overseen by New York-based Voya Investment Management LLC.

There is also about 15% in so-called volatility options, which is an options-based strategy that makes money when volatility rises, which Smears believes is more likely as the world eases itself off easy monetary policies. "This strategy offers strong diversification to traditional credit strategies." There is also 12% in currency exposure (the fund is hedged back to the Canadian dollar) and the remaining 13% in cash.

At some point, Smears may decide to shift some assets into emerging markets bonds, for instance, and retain a specialist sub-advisor. For now, though, he's staying put.

"The construct we have is very appropriate for today," says Smears, adding that he is maximizing diversification by using the volatility strategy and the mortgage pre-payment strategy, for instance. "These [strategies] are thoughtfully-picked to offset other risks in the portfolio so no one thing is driving returns. This fund is not about stretching for high returns, but delivering a stable and increasing level of wealth."

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Michael Ryval

Michael Ryval  is regular contributor to Morningstar. He is a Toronto-based freelance writer who specializes in business and investing.

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