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15 Apr 2013

Is it possible to protection against inflation using a low risk fixed income portfolio that does not have high interest rate risk or poor credit quality?

This used to be easy: just keep rolling over 5 year government bonds and relax! Well no longer, Government bonds of most developed countries are now destined to underperform inflation for many years to come. There is just too much money in the system, central banks are printing it to buy up their own government bonds in order to keep yields low. Taking the US as an example, inflation (CPI all urban) was about 2% for the last year whilst the yield to maturity of the 5 year treasury is currently 0.76% and the 10 year is 1.86%, still negative in real terms.

What can you do? Longer maturity is not the answer. Holding the 20 year Treasury bond to maturity yields 2.7% currently but who knows how high inflation might be in a few years. Also, if interest rates do start to rise, for every 1% rise the bond will lose almost 20% in mark-to-market terms. Yes, it will pull back to par eventually but it will be tough to stomach such volatility for so many years.

Introducing lower credit quality, whilst popular currently, is also not the answer. Credit spreads have reduced as investors have gone in search of higher yields and now you have to buy BBB or lower rated bonds to achieve above inflation yields and still accept maturities in excess of 5 years. Lower duration alternatives are available but usually from issuers you may not have heard of from countries you have never been to. The problem is not necessarily that these issuers will default, though some will, it’s the potential liquidity trap. It is possible that when the herd of investors that have gone into these often smaller issues want to come out, they will find less people willing to buy them and will be forced to hold to maturity and cross their fingers the principle is repaid in full.

Using different currencies can be a way to increase yields but passive currency exposure comes with the added risk of not knowing who’s going to win the “race to the bottom” as central banks try to devalue their currencies to boost competitiveness.

So how can you achieve positive real returns with low risk? QLAB has a simple but rather robust approach: we take a small set of highly liquid fixed income assets: cash, short term government bonds and a few G10 currencies and actively manage them according to a highly disciplined and systematic risk management process. The result is called Fusion TFX, now live for over 2 years allowing us to analyse its success.

The investment universe or opportunity set comprises a basket of competing assets:

The strategy exploits behavioural aspects in the market and targets persistence in return driven by herding, greed and fear amongst investors. The model uses a relative performance measure and robust risk-budgeting principles to determine individual asset weightings in a low-frequency monthly rebalancing process.

In practice this means that the 2 year and 5 year bonds only receive allocations whilst they are outperforming cash. Similarly, each currency pair is treated independently and also only receives an allocation whilst outperforming cash. This simple process automatically varies duration between 0 years and a maximum of about 4 years as interest rates move providing a good hedge against rising interest rates. Theoretically the allocation could go to 100% cash which would preserve capital should interest rise rapidly. The FX exposure provides diversification and yield pick-up potential due to investors seeking safe havens or central banks manipulating their own currencies.

The result is a dynamic and defensive asset allocation which exhibits intuitive behaviour.

The resulting performance (live since 1 July 2010) shows that Fusion consistently keeps pace with inflation or outperforms it. Fusion also outperforms the passive benchmark which comprises the same opportunity set rebalanced monthly. Interestingly the passive benchmark has not beaten inflation over the last 3 years during these difficult and policy driven markets, a sign that the days of easy passive bond investing are over.

Fusion risk properties are low with 3% volatility and the worst drawdown less than 3%. The return distribution also has a healthy positive skew due to the defensive nature of the asset allocation.

Finally, Fusion is extremely liquid and easy to implement using futures in managed account form at very low cost. It can be hedged into any currency and also customised to create properties to suit different fixed income needs or investment policies.

Download this article in pdf format FIXED_INCOME_INFLATION_PROTECTION.pdf

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DISCLAIMER: This document does not constitute an offer, a solicitation, an advice or a recommendation to purchase or sell any investment products associated with the material described herein. The purpose of this document is to describe the principles, research and ideas behind the QLAB Invest strategy indices. Prior to an investment in any product tracking a strategy index, you should make your own appraisal of the investment risks as well as from a legal, tax and accounting perspective, without relying exclusively on the information provided by QLAB Invest. Investment products tracking the indices must be issued or/and marketed by a regulated company. This document is strictly for informative purpose. The single source of the underlying asset data is Thomson Reuters Datastream and QLAB Invest cannot guarantee the correctness of the underlying asset data and cannot be held legally responsible in this regard. Any references made to historical performance up to the official live inception do not reflect actual live performance and can be subject to selection, curve fitting and other statistical biases. Performance in investment products linked to the indices may be reduced by the effect of commissions, fees or other charges in excess of those already factored into the index calculations. The level of the indices will fluctuate due to the volatility of the underlying exposures and past performance or volatility is not necessarily indicative of future results.