Why this investor only plays in government bond markets
It's unusual for a fixed income house to only play in one specific part of the universe. But at Ardea, it's a strategy that pays.
Although there are hundreds of professional fixed income investors in the Australian market, most of them only pull two levers - or tools to make big returns. They either pull the duration lever or the credit lever.
Pulling the duration lever allows an investor to make a bet on the next moves in interest rates through the buying or selling of long or short-duration government bonds.
Pulling the credit lever allows an investor to participate in more than just government bonds - opening investors up to the opportunities available in corporate bonds (both of investment grade or in the high yield market.)
But Ardea Investment Management is different to most of its peers, as its co-chief investment officer Gopi Karunakaran is only too eager to tell you. Not only does it run a duration-neutral strategy (which in itself is relatively unusual) it also does not participate in the corporate bond market. So why are they different and does it pay to be unique?
In this wire, we'll answer both of these questions and more.
Edited Transcript
Hans Lee: Hello, and welcome to another episode of The Pitch, brought to you by Livewire Markets. I'm Hans Lee, and joining me today is Gopi Karunakaran, the co-chief investment officer at Ardea Investment Management.
Gopi, we thought we'd take a look at two common perspectives to fixed income funds, and that's duration and credit. Let's start with duration. You and your team run a duration-neutral strategy. What does that mean and why does it matter?
What "duration neutral" means
Gopi Karunakaran: Sure. So quick refresher on the concept of duration and why it's relevant for fixed income. So duration is a measure of your sensitivity to interest rate fluctuations, to put it simply. So in simple terms, if you buy a government bond, let's say a 10-year government bond and interest rates were to go up or the market pricing of interest rates were to go up, the price of that bond would go down. And so you're going to have a performance impact associated with that.
A duration-neutral portfolio like the ones that we run, does not have that exposure. So our portfolios are indifferent to whether rates are going up, down, or sideways, it doesn't matter. So that's what duration neutral means.
Is short-duration yesterday's story?
Lee: With that said, then, do you think the best days for short-duration government bonds are behind them?
Karunakaran: I think it depends on what you're using them for. If you look at short duration, whether it's government bonds or corporate bonds, in general, they're offering a pretty decent yield these days because rates have gone up. If you are focused on income, that can be quite useful. It can be quite helpful.
Now, other reasons why you have fixed income in your portfolio would be to diversify equity risks. The equity risk is the most dominant in most portfolios, and if you think about that traditional 60/40 portfolio construct, fixed income can help you diversify that equity risk.
That's where it gets a little bit tricky because what you're relying on there when you want to diversify equity risks, say in a recession scenario, is your duration. That's the thing that's going to help you because what happens in a recession scenario is rates typically go down. Central banks cut rates, bond prices go up. If you're in that short-duration segment, you're not going to get that duration component. You're going to get the income, but you're not going to get that duration.
Now, typically what you also find in the short-duration component is there tends to be a lot of credit risk in there because to get those yields without the duration, you have to layer in some credit risk, and that can become a bit of a tricky situation as well. That's because we know that in a down equity market, credit can do badly as well. So it comes down to what are you using this for and I think it's important to be clear about that from an investor perspective.
Lee: And just to clarify that credit risk, how does it show? Does it serve up in the premium that you pay for a bond?
Karunakaran: Yes, so what typically happens, is the idea of a credit spread. So this idea that if you're buying a bond, it gives you a higher yield than an equivalent government bond and that difference is the spread. And that spread is compensation for risk. It's not free money, it's compensation for risk.
What typically happens is when you go into a stressed environment where equities are down a lot, that spread tends to increase. That means corporate bond yields go up, but there's an inverse relationship prices go down, and you're going to have a negative performance impact, and at the tail, you've got default risks. So that's the risk that a company gets into trouble and default, rare, but painful if it happens.
Why Ardea doesn't invest in credit
Lee: I just heard you say defaults there. I do know that both of the major Ardea funds don't have credit investments in them. Is that why you don't want to play in credit markets specifically?
Karunakaran: There are a few reasons why we don't. So you're right, none of our portfolios has any corporate or credit-type securities in them. So why is that?
The first one is liquidity. Our investment style requires high turnover, lots of trading, and so you need reliable liquidity and you need low transaction costs. That is a feature of interest rate markets. It's not really a feature of credit markets. Transaction costs are higher and liquidity can be patchy in stressful times.
The other one is the correlation to equity risk. So we know very well that in a stress scenario when equities are down a lot. So think about COVID. When COVID hit early 2020, credit was going to do badly. We are trying to offer a defensive diversifier to clients. So if we had a lot of that credit risk that's going to behave the same as equities, that does compromise a bit of the benefit that you're getting from defensive diversification.
Lee: I understand. But also, credit spreads are often seen as an indicator of corporate health. I know you don't play in the corporate bond space specifically, but do you have a view on the outlook of them and do you have a view on whether we're in a widening era or a tightening era?
Karunakaran: So you're right, I'm not close enough to have a view on where they're going from here, but what we can see very clearly and what we pay a lot of attention to when we are thinking about risks and tail risks is what's the consensus saying? What's actually priced into markets?
And what we can see pretty clearly when we look at credit spreads is a pretty optimistic, Goldilocks type of outlook that's getting priced in. A very easy way to see that is if you have a look at the spread history of something like a global high yield bond index and look at how it's tracked over time, you can see that where we are today is very much towards the low end of historical ranges.
What that's telling you is markets are not particularly worried at the moment about recession or anything like that, and therefore, the spread being low means markets are not willing to pay a lot of risk compensation for that. So you could call it optimism or you could call it complacency. I'm not sure which one, but that's what we see.
Lee: Well, if we've learned anything in the last four years in markets, it's not to be complacent or you can't afford to be complacent. Gopi Karunakaran, thank you for joining us from Ardea Investment Management. And thank you for joining us. If you enjoyed that episode of The Pitch, do subscribe to the Livewire Market Index websites, as well as our YouTube channel. We thank you for watching.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
Expertise
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