Risk Management – Macro Overlays

Risk management occurs at every stage of the investment process; whether undertaking a complete assessment of market conditions before implementing a theme or optimising the positioning of the theme through valuation models (i.e. momentum & econometric), units of risk (i.e. tracking error, duration times spread) and theme characteristics (i.e. interest rate sensitivity measures & return correlation) to achieve the desired level of diversification.

In addition, the team expects that credit markets will experience bad periods and implement tail risk hedges, named ‘macro overlays’. In managing the portfolios, they use highly liquid derivatives to try and reduce downside capture during periods of corporate bond weakness; they do this using currency forwards, interest rate futures, options and credit default swap (CDS) on indices (where investment guidelines permit). These macro overlays can be modulated to varying degrees depending on the risks identified, whilst acknowledging that unidentified risks may exist.

For instance, during periods of risk off, corporate bonds tend to exhibit a negative price correlation in comparison to their government bond counterparts. Therefore, in order to try and reduce the downside capture of the Strategy during periods of corporate bond weakness, they can tactically use interest rate futures to increase duration. This means that they do not have to trade in and out of the underlying bonds to reduce exposure to the market which can be costly. By using derivatives to help manage the mark to market risks of the strategy it allows the team to keep the investment themes intact and continue to hold the corporate bonds they want to own over the long term, rather than selling them only to try and purchase them back in future.

Trading in and out of corporate bonds can be costly, especially during periods of risk off, and there is no guarantee you will be able to buy back the bonds you sold. Therefore, implementing macro overlays using derivatives allows them to more efficiently modulate the risks within the strategy. If you would like to know more about macro overlays, please click here.

The result of this approach, we believe, is compelling for three reasons:

1. Potential outperformance of the global investment grade corporate bond universe if correctly identifying investment themes and constructing these around the benchmark accordingly
2. Potential high participation in up markets whilst mitigating negative returns in down markets using macro overlays
3. Attractive risk adjusted returns, a potential by-product of achieving the previous two points.