Volatility is the new normal for fixed income – here’s how we manage it
February 20, 2025
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10 min read
Source: Bloomberg, NIM Solutions as at 31/01/2025, S&P 500 total return vs US 10 year US Treasury bonds
This means that investors cannot blindly rely on fixed income to act as an effective hedge. Investors that rely on passive exposure to fixed income should take into account the greater risk of negative returns.
Adjusting to the new normal
We believe that the best approach to bring reliability back to fixed income is to proactively manage this exposure by:
- Setting stringent risk management practices
- Having genuinely flexible strategies which can take advantage of multiple different scenarios and responding quickly when things change
- Paying greater attention to the price they pay for assets
At the core of our risk management and asset selection process is our proprietary bond valuation tool, which is actually an improved version of the Sharpe Ratio. We call it our Risk Adjusted Term Premium (RATP). In general terms it gives us an indication of whether the returns we expect from an asset are worth the risk we take on from buying it, risk vs reward, but it also helps in other ways.
Why RATP helps us avoid over-paying
For active investment managers, there are few things more important than price when selecting assets. While countless investors aim to buy low and sell high, it is an incredibly difficult thing to do consistently – especially in the current environment, where certainty is low, volatility is high and many of the strategies that have worked in recent decades no longer seem so predictable.
Getting one’s macroeconomic calls right is a crucial part of successful fixed income investing, which is why we spend around 80% of our time focusing on it. But, while we like to think we have a strong, in-depth understanding of the macroeconomic environment and its drivers, we also know that it is impossible to be right all the time. So, what we needed was a way of ensuring that when we get it wrong, we lose as little as possible and when we are right, we stand to gain as much as possible – both when going short and when going long.
So, once we have our macroeconomic views, we put all the potential investments that spring from that view, through our RATP tool. To calculate the RATP we take the excess yield above the three-year swap rate of the asset we are considering, and divide it by the historical volatility of the same asset.
We look at the three-year swap rate because all central bank forecasting is done on a three-year window – largely because looking further out than three years becomes almost impossible. What we get from this is an idea of how attractive an asset is at its current price in terms of its yield as well as its level of volatility.
Trusting to the process
For a AAA/AA sovereign bond, a RATP above 20 basis points is an indication that the asset is attractively priced. As such going long would make sense, while taking a short position would be very hard to justify. On the contrary, if the RATP is below zero we believe the asset is expensive. In such a case, a short position would be easy to justify, but going long would expose the portfolio to more risk than we would usually be comfortable with. And, if it is between zero and 20, this essentially means that the yield curve is more or less flat and there may be not enough incentive to be positioned either way. In such instances, we are more comfortable leaving potential returns on the table, than we are risking our clients’ money in the hope that we are right on the macro.
As with everything in investing, the trick is acting consistently on that information, especially when you are convinced your macro call is going to play out. That is not to say we always invest if we find an asset with an extreme RATP, but rather that we need both our macro view and our valuation tool to be in alignment.
This is for two reasons:
- If we are right on the macro, there is no guarantee that assets will move within the timeframe we were expecting, or by as much as we were expecting. So by finding the cheapest assets that align to the macro view we maximise the potential upside available.
- And, on the opposite side, when we are wrong on the macro, the amount we stand to lose is lower than it would have been otherwise as we have only invested in those assets that we believe are attractively priced.
A worked example – the 10-year bund
At the start of 2024, many market participants believed there would be a recession in Germany by June of 2024, however we were not so sure. There were no macroeconomic indicators moving us towards that assumption. However, once we had plugged the 10-year German Bund through the RATP metric it quickly became clear that at the start of 2024, German bunds were more expensive than they had been in 25 years3.
So, if we wanted to make money from a long position in German bunds at that point we had to believe two things:
- That there would be a recession in Germany by the midpoint of the year
- German debt was likely to get even more expensive than it already was.
We didn’t believe either of those things so we did not go long. But, we did see a short opportunity, because not only did we not expect a recession, but also the asset was already expensive.
Surviving fixed income’s year of reckoning
As mentioned earlier, 2022 was one of fixed income’s worst ever years. Global bonds lost 31 per cent and most fixed income funds and portfolios returned a negative result for this year4. We however managed to avoid this scenario, mainly through two positions we took.
Early in 2022 we determined that inflation stemming from Covid and the outbreak of war in Ukraine would drive inflation to higher levels. The fund had held long break-even inflation for some time, and when the extent of the rise of inflation was recognised, these positions were increased. In the face of such a rapid rise in inflation, it was likely that central banks would need to start raising interest rates in an aggressive manner. So we took a short position on G10 government bond markets, such as Germany and the US. As central banks quickly hiked rates to combat inflation, bond prices fell and we profited from these short positions.
However the real key to our success during this challenging year was our flexibility. We were able to quickly adjust our positions as the market environment evolved. For example, once the Fed and ECB signaled a pivot on rate hikes we quickly covered our Treasury shorts to lock in those gains. We continued to rapidly reposition the portfolio throughout this challenging and volatile market.
Furthermore, our analysis indicated that inflation would not return to central banks’ targets in the short term. Hence our break-even inflation positions were translated into long inflation-linked bonds (TIPS) mainly in the US.
And this is why we believe that the combination of risk management, flexibility and price sensitivity is so powerful. When we get things wrong on our macro calls our RATP tool gives us the peace of mind to know that we are unlikely to suffer the worst of the consequences. And our flexible strategy and price sensitivity leave us optimistic that we will be able to reorient our positions and so aim to deliver a positive return whatever is happening in the market. As fixed income managers in a persistently volatile modern world, we believe this is a powerful platform for long-term success.
