Active fixed-income management in a challenging environment
The current market environment presents several challenges for investors. How should they react to high inflation and rising interest rates? Credit Suisse assesses the situation and highlights new opportunities.
Holding bonds requires experience
Rowing a boat or paddling a canoe on a calm Swiss lake is one thing; but when navigating international waterways you need an experienced skipper familiar with the local challenges. Experience is likewise important when it comes to investing in bonds. After years of falling interest rates, dark clouds are gathering on the horizon. High inflation, rising interest rates, and political turmoil – accompanied by soaring energy prices – are a big worry.
The following ideas from Credit Suisse show how investors can respond to these influences and can add value with the help of an experienced captain.
Active fixed income management with rising interest rates
Driven by low or negative interest rates, borrowers have in recent years been issuing longer-term bonds. These instruments are included in bond indices and increase the interest rate risk. For instance, the duration of the SBI AAA-BBB has risen from around 5.5 years in 2007 to the current figure of around 7.2 over the past 15 years. Indeed in the case of Swiss government bonds, the duration – as measured by the SBI Domestic Government – has increased to 12 or so. Global indices meanwhile show a similar trend. The duration of Japanese and UK government bonds, for example, has risen by around 70% since the turn of the millennium.
Active management helps counter this systematic increase in duration – possibly coupled with a customized benchmark with a stable, plannable duration. Duration class is another option, and allows institutional clients to manage their duration exposure individually and change it at any time in a cost-neutral manner. Large clients use interest-rate overlays. Inflation-linked bonds can be used to hedge against inflation surprises. When making investment decisions, it's important to distinguish between realized and expected (breakeven) inflation – calculated as the price difference between nominal and inflation-linked bonds.
Cushioning credit risks with fixed income management
First, the high – and rising – level of government debt is creating uncertainty with regard to global bonds. Second, Japan and the US constitute a cluster risk given that they account for a combined share of roughly 60% of the leading indices (e.g. JPM GBI Global and FTSE WGBI). As an alternative, Credit Suisse recommends a customized benchmark: Rather than being weighted by the amount of their debt (market capitalization), debtors are weighted on a broadly diversified basis that anticipates changes in creditworthiness.
The addition of corporate bonds is recommended from the point of view of diversification and returns, enabling investors to benefit from systematic credit risk premiums. Companies from emerging markets can be another attractive component, given that they are often underestimated due to low country ratings and can produce stellar returns.
Hedging currencies in the case of bond issues
Unfortunately, there is no systematic risk premium as compensation for accepting currency risk. Had a Swiss investor bought a US bond fund ten years ago, they would have received the same price gains and the same distribution as a US citizen but would also have had to buy US dollars and then sell them again later. This could have resulted in currency gains or losses. Due to the lack of a systematic risk premium on foreign currencies, many investors hedge the currency risk. However, the fact that currency hedging can be expensive is often overlooked.
The costs of currency hedging, which is calculated based on the interest-rate differential of the currencies involved, is currently around 1.65% for US dollars into Swiss francs and over the past ten years has been almost 4% at times. As an active manager, Credit Suisse takes account of these hedge costs in its investment decisions and thus creates added value for its clients.
US dollar/Swiss franc interest-rate differential and hedging costs
Last data point: 24.6.2022
Source: Credit Suisse, Bloomberg
