Barings urges investors to consider directional strategies to beat market volatility

As the economic environment becomes less supportive for fixed income assets, Baring Asset Management believes investors should use directional strategies.

Directional strategies aim to take advantage of upward and downward market movements through the use of derivatives and 'shorting' and have the potential to make money even when markets fall.

'Over the last 30 years falling inflation, greater transparency on the part of central banks and a decline in the inflation 'risk premium' attached to bonds by investors have meant that investors have reaped the benefit of steadily declining bond yields,' says Colin Harte, manager of the Baring Directional Global Bond Fund. 'However, we believe the investment environment has now changed, and is likely to be less supportive for fixed income assets in the future.

'The long slow ride down in yield levels as inflation worked its way out of the system has already happened. The central banks have already moved to a more transparent approach. And we believe the outlook for inflation is slowly deteriorating.'

Despite inflation remaining at relatively low levels in the US, it has started to show signs of creeping higher, with consumer prices rising faster than expected in April. While the Federal Reserve is thought to be close to the peak of the interest-rate cycle, there is a school of thought that Ben Bernanke could be inclined to err on the side of keeping rates lower for longer than he should. With economic global growth more or less synchronised around the world, Barings believes that inflation could start to rear its head again and that in this environment, the 'risk premium' attached to bonds is likely to rise further, and bond prices fall.

Harte also points out that there is an added complication for investors in the international bond markets - currency exposure. With the rise of China on the international stage, the re-awakening of Japan after decades of slumber, and evidence that the US dollar is finally starting to reap the consequences of the massive current account and trade deficits facing the US economy, it is no longer safe to assume that currencies are a 'zero sum' game, believes Harte.

There are, however, a number of strategies available to minimise the effects of this challenging fixed income environment on performance. Portfolio sensitivity to market movements can be changed, country exposure can be adjusted, and currency management can be a valuable source of additional returns. However, even the most conservative position in a conventional bond fund will have positive duration.

Barings believes that investors concerned about the prospects for the bond and currency markets might wish to consider an investment strategy with the potential to deliver positive returns right through the market cycle, such as that employed by the manager of the Baring Directional Global Bond Fund.

'Until recently, it was not possible to invest in derivatives for anything more than 'efficient portfolio management' in an ordinary unit trust,' explains Harte. 'However, this changed in February 2004, when the 'UCITS III' rules were introduced. It is now possible to invest in derivatives not only to manage the degree of market exposure in a fixed income mutual fund, but also to treat currencies as a separate, diversified source of returns.'

On the 12th March 2004 Barings launched the Baring Directional Global Bond Trust - the UK's first long/short unit trust. This launch was followed in November 2004 with two further funds: the Dublin-domiciled Baring Directional Fund (USD) and the Baring Directional Fund (Euro).

The Baring Directional Global Bond fund targets performance of 4% over three-month Sterling, Euro or US dollar LIBOR per annum after fees, over the course of the economic cycle, and also seeks to deliver a positive absolute return in any given calendar year. Additionally, the fund seeks to offer returns that have a low correlation with traditional fixed income assets, making the fund a potentially attractive compliment to other holdings in the fixed income part of an investment portfolio.

The fund has delivered 5.94% since the beginning of the year, compared with an average of -2.78% for the Standard & Poor's Micropal Global Bond Sector and -2.3% for the Corporate Bond sector. Since launch the fund has delivered 12.5% compared with 5.38% for the Citigroup World Government bond index 5.08% for the Global Bond Sector.

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