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Understanding risk and reward in bond markets

4. How can one mitigate duration risk in a portfolio? 

Long-dated bonds have the highest sensitivity to a change in interest rates, and so to mitigate duration risk, an investor would want to avoid longer-dated bonds.

5. How can you take advantage of market inefficiencies?

Markets are inefficient and active investors can take advantage of discrepancies. We often do what we call ‘relative value’ switches between bonds issued by the same company in different currencies or at different levels of the capital structure.

For example, a UK domiciled company could issue bonds in US dollars as well as sterling. At various times the US dollar bonds might underperform and so look more attractive than the sterling bonds. As active investors we would take advantage of the relative cheapness of the US bonds and buy them.

Similarly, when we are analysing a company as a potential investment, we look at its ‘capital structure’ (its different tiers of debt, with their different levels of risk). At times the higher risk (subordinated) bonds might underperform and so we would switch into higher quality bonds issues by the same company. The key to managing risk is to remain active.

6. Where are you finding opportunities in bond markets right now? 

Quantitative easing has been a tide that has lifted all boats for the last decade and with a reversal of this, I expect that there will be much greater dispersion and volatility in bond markets, which is a boon for active investors. We see bond markets behaving irrationally frequently, and increased volatility and dispersion only increases the opportunity set for active investors to take advantage of.

 

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Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice.

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