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Credit and rates expected to contribute to 2014 outperformance

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High price fluctuations with low yields on risk-free investments provide investors with new challenges. Paul Nicholson (pictured), portfolio manager of the Vontobel Fund – Absolute Return Bond, believes his fund has the necessary flexibility to respond to a changing market environment and, for example, to benefit from rising interest rates.

Not only have bond prices rallied in Q1 2014, with yields on US 10-year Treasuries falling from 3 per cent to 2.57 per cent in early February (back up to 2.73 per cent at the time of writing) but also corporate credit spreads remain tight.
It is, however, only a matter of time before interest rates rise, most likely in the US before Europe. Investors recognise the need for diversification and access to investment strategies that can deliver performance in all weather conditions; that is stable, in inflationary as well as deflationary scenarios.
This is precisely what the Vontobel Fund – Absolute Return Bond has been designed to do. There are four different components in a traditional long-only bond fund: the interest rate component, credit component, currency component and illiquidity premium.
“What we do is deconstruct those four factors. We take rates, credit and currency and make them strategies in their own right as alpha generators in the fund,” explains Paul Nicholson, the fund’s portfolio manager. Furthermore, the fund invests only into highly liquid instruments, allowing flexibility to adapt to changing market conditions.
“The US is going through some degree of economic slowdown but we expect it to grow at 2 to 3 per cent annually. We also think Europe is on course to exit its difficult period. I think we’ll see global growth come through in Q2 2014, so from our perspective the prospect of higher rates is real.
“Currently we remain long bonds. Once we see that rising rate trend emerge we will take the opportunity to reverse the position, like we did last May and June.”
This is one of the fund’s key strengths. Not only is it diversified – it trades G10 bond futures and swaps, G10 currencies as well as credit derivative indexes such as the iTraxx Europe Crossover Credit Index (European high yield) – but, crucially, it only builds exposure using the most liquid instruments. This makes it highly flexible and responsive to changing markets.
The aim is to provide investors with investment grade-like bond returns in stable markets and excess returns – Libor plus 2 to 4 per cent – in the event of inflation or deflation. In ’08, for example, the fund generated 6 per cent. In 2013, it generated 2 per cent over Libor.
That flexibility was evident last summer when the Fed started talking about tapering plans of their quantitative easing programme. This prompted US bond yields to shoot up from 1.6 per cent in May to 2.99 per cent in early September. During the summer, Nicholson says that the fund was short credit (buying protection) yet moved to a long position towards year-end.
“In Q4 2013 the strongest performance derived from our credit strategy. The Barclays Global Investment Grade index, for example, had a 3 to 4 per cent drawdown last May and June. We were up through that period. That’s where we add value.”
As well as being overweight high yield credit versus investment grade the fund was also overweight Europe versus the US on the prospect of higher rates putting pressure on credit spreads; a position that the fund continues to hold.
Currently, most of the fund’s risk is in rates. The portfolio is overweight Germany and France compared to the US and the UK. One theme has been to reduce duration risk from 5 years to 1.5 years with Germany, France and Switzerland accounting for approximately 50 per cent of that position.
“For the US we have steepeners in place; long one to 3 year cash bonds and short 10-year Treasuries. We don’t believe that investors are being compensated for 2.75 per cent on US Treasuries on the potential for rates to rise. It depends how things play out but in the second or third quarter we’ll probably see a push for higher rates in the bond markets.
“In that scenario, our portfolio will be reduced to neutral and then outright short duration like we were last summer. We are confident that rates will play an important role in the fund’s performance this year, just as credit will,” concludes Nicholson. 

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