Chris Brandt outlines how investors can make use of convexity in fixed income portfolios
Institutional investors are faced with challenging market environment. Regulation, liability matching and risk management encourages and obligies insurance companies and pension schemes to hold a proportion of their portfolio in bonds. However, the value of those portfolios will fall as economic conditions normalise and interest rates rise.
For these forced bond investors, an investment which can help to offset the future loss would help to improve the overall return profile of the portfolio. Such an opportunity does exist; a long convexity position which would take advantage of the current peculiar market conditions.
These are unusual economic times. The combination of relaxed monetary policy and asset repurchase by central banks has caused nominal interest rates to fall.
For a long time, short-term interest rates were low, reflecting the prevailing economic policy, but the market had predicted these would rise in the future. More recently, however, the market has become disheartened that these rate rises will ever materialise and the curve has flattened as a result.
The strength of the conviction that interest rates will remain lower for longer can be seen in the falling value of implied volatility. In other words, the market is content to receive lower returns because it thinks there is less risk that the value of these will change in the future.
Accepting lower returns on the assumption of lower future volatility is not ideal. It would lead to a situation whereby, should volatility rise higher than the market currently predicts, returns would fail to capture the move. Instead, by careful consideration of convexity, a better risk/reward trade-off could be achieved.
Assuming interest rates will remain low implies economic growth will remain weak and central bankers will have to keep monetary policy loose. However, current economic data shows a positive picture, which implies an increase in interest rates could be more likely than predicted by the market.
In addition, there are seismic shifts in the operational capacity of fixed-income markets. In particular, new regulations have changed the way banks operate in these markets. Acting as a market maker – where banks hold large bond portfolios on their own books – is no longer an economically viable business activity. Banks now act as agents, matching buyers with sellers.
As a result, liquidity in bond markets has been curtailed. Low volatility exacerbates this further as there is less profit available to liquidity providers so they scale back. At the same time, this fall in market liquidity coincides with an increase in the nominal value of outstanding bonds in both sovereign and corporate bond markets.
The constrained liquidity conditions cause realised volatility to be higher than the market predicts. If data continues to be positive, small changes in macro variables could create large movements in bond prices.
“The market view is that there is little chance the rate at which the value of a bond falls could accelerate relative to the increase in interest rates. But some fund managers disagree and are actively exploiting this undervaluing of convexity”
When small changes in conditions induce larger movements in bond prices, it is called convexity. This is when the relationship between bond prices and changes in interest rates is not linear. Convexity is sensitivity of an interest rate change on bond prices. If bond prices get more sensitive to interest rate changes as rates change, then convexity has increased.
Convexity is currently undervalued in fixed-income markets. The market believes that interest rates will remain low for a long period and there is little risk of sharp changes to the sensitivity of bond prices. In other words, the market view is that there is little chance the rate at which the value of a bond falls could accelerate relative to the increase in interest rates. But some fund managers disagree and are actively exploiting this undervaluing of convexity.
Not only do bonds exhibit convexity – so too do options. An option has convexity because the relationship between the price of the underlying asset and the value of the option is not linear. The option’s value will accelerate or decelerate depending on it being profitable when exercised.
When volatility is low, so is the option’s convexity as this implies price swings will be limited so potential profit is also constrained. But, if the market is incorrect about volatility, this represents an opportunity to profit from convexity being higher than market expectations.
Since the market is underestimating the volatility of fixed-income markets, this means swaptions – options on interest rate swaps – can be used to exploit the market undervaluing the convexity of these instruments.
Swaptions can be used to express a view of how volatility and interest rates will change in the future. As an example, some managers’ view is that it is likely interest rate volatility will rise in the future when the market realises that rates will rise faster than the curve predicts. Then interest rates would increase and volatility would fall as rates remain steady at the new higher rate.
However, it can be expensive to structure such a trade. To make it cheaper, a fund manager can ensure that the trade only goes live once interest rates reach a certain level. As volatility is at a low level, the position looks like it is unlikely to happen so the trade can be purchased cheaply.
Predicting when the market will change its mind is hard and usually results in expensive mistakes. Some fund managers use multiple cheap positions to enable them to still make returns from their belief that the market will correct its view without having to predict the exact timing.
If the timing of trades is wrong and the market has not changed its mind by the time a position expires it will have lost several basis points. And while some money will have been lost on the swaption trade, the long bond portfolio will have made a positive return. This inverse correlation makes this ideal for institutional investors – it provides an ideal hedge for their long bond portfolios. However, if the call is correct and the market behaves as anticipated then the convex nature of the value of an option bolsters returns. As the probability of an interest rate hike increases, then the value of the option starts to rise. In other words, option convexity helps to accelerate the returns that can be made from such a position.
Chris Brandt is the CIO of Markham Rae