Paul Nicholson, Harcourt Investment Consulting

How to profit from the interest rate environment

Download the special report Switzerland Hedge Fund Services 2013

Interview with Paul Nicholson – Vontobel Fund – Absolute Return Bond is designed to help clients overcome the challenges of uncertainty in today’s historically low interest environment. The fund’s flexible strategy is composed of four sub-strategies: one in cash management, to produce yield, and three “alpha” producing strategies covering currencies, rates and credit. The objective is to produce a straddle pay-off that allows the fund to generate consistent returns in stable market conditions, but to then generate outperformance in rising and falling markets. 

“In terms of diversification we look to introduce convexity characteristics. The straddle pay-off profile is designed to benefit through large market moves; i.e. if interest rates rise or fall sharply or credit spreads widen or tighten significantly. We can only do that by executing a strategy that is both liquid and dynamic,” comments Paul Nicholson (pictured), Portfolio Manager, cash bond strategies for the fund.

The fund’s performance target is Libor plus 200 basis points. Year-to-date, it is up 0.80 per cent, having returned 3.3 per cent in 2012.

With respect to cash management, the fund mainly focuses on the bonds of G4 governments in addition to looking for yield pick-up in instruments such as Australian semi-government, for example Queensland Treasury Corporation.

The straddle pay-off is only used in the three alpha-generating strategies, where the investment team, led by Massimilano Gnesi, analyses the markets for asymmetric themes to trade on. The fund’s alpha strategies across interest rates, credit markets and currencies, utilise only liquid derivative instruments for implementation.

“If you look at other traditional fixed income funds and some absolute return funds, they take advantage in their return profile of illiquidity premia that are inherent within the corporate bond. This is an attractive carry proposition in stable markets but when markets get stressed the liquidity of these instruments is quite poor and the cost to unwind these positions can be significant. That is why we view ourselves as having an edge over other participants by being more liquid,” explains Nicholson.

The Vontobel fund takes no long-term directional view on the markets, instead reacting to whatever scenario develops and positioning the portfolio accordingly. This is the core concept that allows the fund to be dynamic, and will be long or short duration, dependent on market trends. It has the ability to take advantage of rising interest rates on the one hand, or a potential deflationary episode on the other.

“Should there be an economic downturn, we could see credit spreads widening. The key to our strategy is that it’s flexible. We can be short credit in that environment to add value to investors.”

With 30-year treasury yields at historically low yields, should interest rates climb to 5 per cent within one year, the fund would construct an asymmetric theme so as to provide the straddle strategy for investors to take advantage of.

“The fund implements a technical trading approach, through a trend-following strategy where we wait for entry signals to emerge. Once we get them, the position is entered by the fund. This approach allows us to take advantage, if that trend continues to strengthen and rates continue rising, and hence deliver outperformance in the straddle pay-off profile,” says Nicholson.

“The key message for us is that we can generate absolute returns both in rising and falling interest rate environments. This allows us to offer diversification for traditional fixed income investors that are susceptible to interest rate and credit exposures.” 

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