The key active currency strategies of carry and momentum come into their own in a rising-interest-rate environment with greater dispersion of interest rate differentials. Charlotte Moore asks if they have a role in moderating bond-portfolio duration
Every European pension fund knows from experience that ultra-low interest rates have caused its liabilities to balloon. While the revival in the economic fortunes of the developed economies and the prospect of increases in the cost of borrowing will bring welcome relief from a valuation perspective, it raises another problem – how best to handle duration risk in the fixed-income securities these schemes hold to match the volatility of their liabilities.
For while falls in the value of these portfolios will be largely offset by a similar fall in the value of liabilities, most investors would prefer to use their risk budgets more efficiently by getting exposure to growth and rising rates while retaining volatility that looks more like that of a fixed-income portfolio than an equity portfolio.
As such, pension funds have increasingly turned to other fixed-income assets such as corporate bonds. However, demand for corporate debt has caused credit spreads to tighten significantly, increasing their exposure to the interest-rate risk that schemes are trying to avoid. Some have looked to secured loans that pay floating rather than fixed rates – but these assets can be difficult to acquire and their popularity has also caused yields to fall.
With a diminishing choice of fairly-valued fixed income assets at the short end of the curve available to pension funds, now may be the time to start thinking laterally about how to keep a lid on duration risk and consider an active currency strategy.
“As a government bond gets closer to its maturity date, it starts behaving less like a debt obligation and more like cash,” notes James Wood-Collins, CEO at Record Currency Management. “In other words, holding a short-duration bond is very similar to owning currency.”
Two of the key active currency strategies – momentum and carry – respond positively to the same rising interest rate expectations that are negative to bonds so, in theory, it should be feasible to use systematic active currency strategies to mitigate duration in a fixed-income portfolio without foregoing a significant amount of return or yield.
“In a rising-interest-rate environment, currency movements become more volatile, which is potentially positive for active currency managers,” says Alan Dorsey, head of investment strategy and risk at Neuberger Berman, which discussed the idea in a recent note.
The embedded credit risk in bank loans and the equity risk in equity-income strategies provide basis risk versus an asset allocation to high-grade bonds, the note said, whereas “fundamental currency management has fewer of these basis risks and is therefore perhaps a more accurate offset to rising interest-rate risk”.
Bond duration risk and currency volatility appear to be related, the note continued, because the currencies of countries in a rising-rate cycle tend to rise, leading to an increasing dispersion of short-term interest-rate differentials. This “provides for relative yield and fundamental trend following opportunities”, the note concluded.
Some investors are starting to look at these strategies. “We have had discussions with investors about using an active currency strategy to replicate a satellite component of the return-seeking bond portfolio,” says Wood-Collins. “The idea is to have part of bond portfolio allocated to currency that can have the same weighting as the global bond portfolio if duration is to be the only difference, or a different weighting if desired.”
This could be implemented as a separate funded mandate or as an unfunded overlay, using forwards. The currency allocation, like a standard currency hedge, would benefit from any appreciation in those currencies relative to the investor’s base currency, but it would also benefit from any increases in those currencies’ relative interest-rate differentials, which would counterbalance the negative impact this would have on the bond portfolio.
Neuberger Berman had added value to its fixed-income portfolios by implementing an active currency strategy.
“In the six years up to end of 2012, active currency management has added on average about 25 basis points of return per annum to our bond portfolio and helped to diversify returns, especially during times of high volatility,” says Ugo Lancioni, head of currency management at Neuberger Berman.
However, the owner of the bond portfolio will have to be careful about which strategies it uses in this currency allocation.
“While active currency strategies such as momentum, carry and valuation are rationally rewarded over time, they do not have a first-order relation to duration,” Wood-Collins notes. “There is quite a gap between how these different currency strategies behave in different risk environments compared to how a fixed-income strategy would behave in those circumstances. These are not going to be a direct substitute for a bond portfolio.”
Over the long term, carry strategies are moderately correlated with risk-on environments and equities, while momentum strategies appear to be inversely correlated with risk. Value strategies show much less correlation with either risk-on or risk-off environments.
“[Adding active currency management] would be adding potentially unrewarded currency risk to a bond portfolio,” warns Pete Drewienkiewicz, head of manager research at Redington. “Making money in FX markets is not straightforward. Even though it’s likely that a return of volatility to currency markets means greater opportunity to make returns, you’re still reliant on the skill of the manager.”
Drewienkiewicz thinks there is an easier way to manage duration risk that does not add currency risk to the bond portfolio: “It would have made more sense for pension schemes to have bought longer-dated credit and to manage the duration risk by overlaying the portfolio with short-term interest rate futures or an LDI swap.”
But while that strategy has paid off during a period of credit-spread tightening, it is unclear how much juice is left in it today; and while it’s similarly indisputable that it has been very difficult to make good returns from FX in recent years, the reason for that is probably the same reason why credit spreads have become so tight.
“The current global low-interest-rate environment has resulted in a very homogeneous environment,” as Lancioni puts it. “That should be coming to an end soon and a good active currency manager will be able to capitalise on volatility.”
Still, despite the promise of a return to a more rewarding FX investment environment, Drewienkiewicz does not believe those clients looking for a way to mitigate duration risks should look at active currency.
“Rates at the short end of the curve have already risen a lot, so it may be too late. But I would advise that clients consider looking at products which can actively manage duration and use alternative floating-rate credit products such as secured loans and ABS,” he says.
For some pension schemes that find it difficult to find floating rate credit products at the right value, it might be worth considering an active currency strategy as a way to mitigate duration risk. But while currency can be a considered a proxy for short-term credit, it does not have the same relationship to duration and does not necessarily react to increases in risk in financial markets in the same way as fixed income. Investors seeking that out need to remember that they are reliant on their currency managers to get their FX strategy right.