Manager Insight

Hedging strategy reduces duration risk to near zero, manager says.
By Michael Ryval | 15/02/18

The concept behind First Asset Enhanced Short Duration Bond (FSB), says manager Barry Allan, is offering investors the potential to earn higher returns than other short-duration fixed-income strategies while having similar duration risk.

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

"It's designed to help people lower the risk in their portfolios without giving up much of the yield that they are seeking," says Allan, president and founding partner of Toronto-based Marret Asset Management Inc. Marret is an affiliate of the exchange-traded fund's sponsor, First Asset Investment Management Inc., since both are subsidiaries of CI Financial Corp.

Holding about three-quarters of the portfolio in U.S. securities, the $272-million ETF was launched last September. The Canadian-dollar-denominated units are fully hedged back to the Canadian dollar, but there are also U.S.-dollar-denominated units, trading under the symbol FSB.U.

The ETF typically has about 50% exposure to investment-grade corporate bonds, although currently a sizeable proportion of this half of the portfolio is held in cash. The remaining 50% is allocated to high-yield securities. Though the investment-grade bonds generally have maturities of three to seven years, Allan hedges out interest-rate risk by short-selling government bond futures. Overall, the ETF's duration is only about half a year.

"All we are doing is isolating the credit spread. We are doing that because we are targeting low volatility," says Allan. "In effect, we can keep roughly 75% of the yield and only have 25% of the volatility. Second, this (strategy) lowers the duration to (almost) zero. This long/short combination helps to protect us from interest-rate risks."

The other half of the portfolio consists of high-yield bonds that have a duration of under one year. "Once there is less than one year to maturity the certainty of default goes to almost zero," says Allan. "Second, these bonds have virtually no correlation to interest rates. And third, they have zero correlation to equity-market movements. What we don't want is a fund where we have removed all the interest-rate risk but created a bunch of credit risks that are highly correlated to equity markets."

Eventually, when there is an economic recession, investors will want to own long-duration assets, says Allan. But right now, he believes that duration risk -- the risk that rising interest rates will drive down bond prices -- is the biggest risk in the fixed-income market. "In this late cycle, when central banks are raising interest rates, the risk is that rates will rise more than the market is anticipating."

Interest rates were at their lowest levels in the U.S. a couple of years ago, notes Allan, before the Federal Reserve started raising rates in late 2016. And when rates are low, duration risk is high.

The manager adds that if rates rise sufficiently from current levels, equity markets could move in the opposite direction. "That's what we are trying to protect against: rates rising quickly and inadvertently and causing equity markets to fall," says Allan, who worked previously at Altamira Investment Management Ltd. before establishing Marret in 2000.

"You don't want this fund to go down when equities go down," says Allan. "This is the core thesis in managing the fund: to be extremely short duration -- half of one year -- with zero correlation to interest rates and equity prices."

The strategy of the First Asset ETF is modeled after the $309-million Marret Enhanced Tactical Fixed Income, which was launched in November 2014 and is sold to accredited investors.

"We have managed this strategy though periods of high volatility, especially during the first quarter of 2016 when oil prices hit US$26 a barrel and the last quarter of 2016 following the U.S. presidential election," says Allan. "The Marret fund has had positive returns in both rising interest-rate periods and negative equity markets."

That's not to say that the ETF is immune from the market's ups and downs. "There is some volatility around FSB's net asset value," says Allan. "It's more of a substitute for short-duration fixed income funds. You can get very low duration and volatility, but generally much higher yields than short-duration bond funds."

Allan admits that high-yield bonds may be in for a rough ride this year, with interest-rate spreads widening versus U.S. Treasuries. Spreads widen on lower-credit-quality bonds when investors bid down bond prices, demanding higher yields to compensate them for investing in riskier credits.

But Allan does not believe that high-yield bonds will experience anything like the steep declines they suffered in the 2008-09 period. "I anticipate it will be more of a normal situation, where high-yield credit spreads will go to about 1,100 basis points (bps). They are around 350 bps today. Don't forget they went to 2,200 bps in 2008."

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