Unconstrained fixed income

Rapid allocation shifts

Because a strategic credit portfolio is composed primarily of liquid instruments, it can alter its asset allocation rapidly when the situation demands it. Take the UK. In the past few weeks, the Bank of England first poured cold water on rate cut expectations by flagging concerns over wage growth, only to then reignite them with a commitment to being a “a bit more activist”. Expectations for US interest rates have been similarly volatile.

We have been able to adjust our portfolios to reflect these shifts – a tactic that has served us well many times in the past. In late 2023, for example, investment managers of Pictet Asset Management’s strategic credit portfolio saw a tactical investment opportunity emerge in select AT1 bonds – the riskiest type of debt issued by banks, which can be converted to equity or written off if a bank’s capital levels fall below a certain threshold. We were able to secure very attractive yields but were careful to spread the allocation across 14 banks in different geographies to diversify the risk. This was a key contributor to performance through to mid-2024; the strategy was then scaled back; our allocation to AT1 bonds has varied from zero to near to 30 per cent (our cap for such instruments).

Beyond the mainstream

The investment in AT1 bonds also testifies to strategic credit portfolios’ ability to invest in areas that are outside the main asset classes.  

Today, we see several investment opportunities in areas that lie off-the-beaten-track, including certain corporate hybrid bonds which offer attractive carry. 

We are also attracted to corporate bonds issued by some “national champion” businesses in emerging markets. Many offer attractive yields and are issued by firms with sound fundamentals - those that can easily shield themselves from the vagaries of the interest rate and election cycles.

Active cash allocation

Traditional bond portfolios normally face constraints on how much cash they can hold at any one time. A benchmarked fund is usually fully invested at all times and can only typically hold up to a maximum 5 per cent cash on a temporary basis.

Strategic credit portfolios aren’t subject to the same limitations, which means they can use cash as an effective tactical investment.

This was the case over the course of 2022: early in that year interest rates rose sharply as central banks did everything in their power to curb inflation. And as monetary policy tightened rapidly, yields on cash duly rose. By rotating some of the portfolio’s assets out of bonds and into cash, managers of Pictet Asset Management’s strategic credit strategy were able to protect capital through the summer of 2022. This allowed the portfolio to rebuild positions in corporate bonds later on in 2022, which contributed to excess returns in the final quarter of that year.

Flexible fixed income exposure

Due to tracking error constraints, benchmarked funds may sometimes be obliged to hold bonds from issuers or segments of the credit markets that they don't consider particularly attractive.

Indeed, because most bond indices are capitalisation-weighted, the most indebted issuers tend to be the ones most heavily represented in mainstream bond funds. Unconstrained strategies are not sbject to such constraings and can completely avoid, or even go short, issuers or segments of the market that do not offer value. 

For example, in the summer of 2022, our strategic credit portfolio had short positions on the weakest UK retailers which portfolio managers saw as among the most vulnerable to rising interest rates.

The power of duration

It’s not just the types of assets in a portfolio that matter, but also the overall duration.Duration measures the average maturity of a bond’s cash flows (coupon and principal repayment); it is an indicator of market risk as bonds with higher maturities tend to be more sensitive to interest rate moves. Longer dated bonds tend to deliver superior total returns in times of weaker economic growth (and falling interest rates), while shorter dated suffers less during period of rate hikes.

Benchmarked funds will typically be limited to +/- 1-year of duration relative to a benchmark, which in turn will be around the 5-year mark for all maturity investment grade funds. For Pictet Asset Management's Strategic Credit portfolio, duration can range from -3 to +8 years. There are times when conditions dictate that the duration should be at the top end of the range, as was the case in 2023 and 2024, and other times it should be towards the bottom and therefore negative, as occurred in the second half of 2022.

In late 2022, the strategic credit portfolio achieved negative duration by establishing a short position in Japanese government bond futures. This trading strategy was set up in the expectation that Japanese bonds would sell off in response to a tightening of monetary policy from the Bank of Japan (BoJ). As it turned out, the BoJ did what we expected: it stopped capping yields on long-term bonds and the move eventually hurt investors that had remained long JGBs, including those invested in long-only active funds which are forced to hold JGBs in proportions that are more or less in line with underlying indices.

Today, meanwhile, interest are rates heading lower and government borrowing is elevated (the one thing that is likely to hold whatever the outcome of the US election). We therefore see value in playing duration in the 4 to 8 years range, reducing it when yields rally and extending it when they sell off. We believe this can significantly boost returns compared to less flexible strategies. 

Agile portfolio management

While a portfolio can adapt to shifts in interest rates by modifying its duration, rates are only one of the factors affecting fixed income investments. Ultimately, investment managers adapt to the environment and market conditions to deliver the best risk-adjusted returns to investors – and here, too, unconstrained strategies can harness flexibility, whether that is in terms adjusting gross exposure or using one of more of the many hedging instruments at their disposal.

For us, that includes fully hedging out any currency exposure, and using a range of different instrument to protect the portfolio against spread risk. For example, investment managers are able to insure against any potential weakness in bonds of European banks by buying credit default swaps - contracts which pay out in the event of a bond default - on the iTraxx Europe Senior Financial index. An alternative hedging strategy involves buying a put option on the EURO STOXX Banks equity index.

The Pictet Asset Management Strategic Credit portfolio can utilise the full global spectrum of liquid derivatives and public credit markets (excluding CCC-rated bonds) as our opportunity set; we avoid structured products and illiquid investments which, in our view, are not compatible with daily dealing strategies.

Today, the world faces many uncertainties – be that US elections, the health of the global economy, the path of interest rates, the rise of technologies and AI, geopolitical tensions or the challenges of the green transition. By taking a flexible approach, the Pictet Asset Management Strategic Credit strategy is able to tap into the full range of opportunities across asset classes (both long and short) in a nimble manner, while managing duration, reducing risk and delivering strong diversification benefits for investors.