AXA Global Short Duration Bond Fund

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  • 26 mins 07 secs
Nicolas Trindade, Senior Portfolio Manager, joins Robert Bailey to discuss the strategy behind the AXA Global Short Duration Bond Fund, risk events in 2018, changes in quantitative easing and volatility, the benefits of investing in this fund and how it has performed since its launch.

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ROBERT BAILEY: Hello and welcome to today’s AXA Investment Management webcast. I’m Rob Bailey. I’m Head of UK Wholesale Distribution. And today I’m joined by Nicolas Trindade. Nicolas is the Fund Manager of the AXA Global Short Duration Bond Fund, and also the Fund Manager of the AXA Sterling Credit Short Duration Bond Fund. Listed on the slide in front of you are all the funds that we manage in this space. The ones highlighted in red are the UK-domiciled funds. So we have three funds domiciled in the UK. There’s the US Short Duration High Yield Bond Fund, the Sterling Credit Short Duration Bond Fund, which is actually now about £750m in size, and the AXA Global Short Duration Bond Fund, which we launched just over 12 months ago. That’s the best ideas of all the short duration bond funds that we have, and it was launched for a specific purpose, and we’ll come on and talk about as we go through today’s webcast.

So, moving on to the next slide, looking at the growth we’ve seen in the strategy over the last 12 months, we can see that the strategy itself is now approximately £350m in size. Nick, you’ve had good success, we launched the UK fund, we followed that with the Luxemburg domiciled CCAV, what kind of investors have you seen investing in these portfolios?

NICOLAS TRINDADE: So far, we’ve really seen two types of investors investing in the fund. The first one sitting on a lot of cash, unhappy with cash returns as they currently are, and keen on taking incremental risk to get better returns. Then the second type of client that we’ve seen is investing in the average corporate bond fund is having allocation to high yield emerging markets, worried about rising yields, worried about renewed volatility and widening of spreads, and keen on derisking their fixed income allocation. And so they move from their high yield emerging market fund towards our global short duration bond fund.

ROBERT BAILEY: I think the story’s very clear and it makes a lot of sense for people taking that additional risk to move out of cash to get a slightly better return in this kind of low interest rate environment that we’re in. Let’s talk a little bit about some of the other macro risks. So the second group of investors that you spoke about, the people who are wanting to reduce their risk and exposure. There’s a lot of macro threats that are out there. There’s a lot of risks that we’re aware of, and clearly there’ll be some that we aren’t. Talk us through some of the risks that you’re most conscious of that are shown on this slide.

NICOLAS TRINDADE: 2018 has definitely been a challenging year so far. And, unfortunately, we expect 2018 to remain a challenging year, and we have quite a cautious positioning for the second half of 2018. If you look at the first half, we had obviously earlier in the year the implosion of the volatility products. We had some turmoil in emerging markets. Here I’m thinking about Turkey and Argentina in particular. I’m also thinking about increased risk around trade wars and also political risk coming back into the European periphery. So it’s been quite a highly volatile first half of the year, and unfortunately we expect the second half to remain quite volatile, because central banks are still on the path of hiking interesting rates. The Fed have just hiked for the second time this year, and we expect the Fed to hike two more times this year. We expect the Bank of England to hike in August this year, and the ECB to end quantitative easing by the end of this year. So we are in an environment where liquidity has been withdrawn, where interest rates have been hiked, and that should lead to higher yields, and that obviously should put negative pressure on total returns.

ROBERT BAILEY: And looking at these risks you’ve highlighted for later on this year, there’s clearly a number of geopolitical elections and events like that that must be at the forefront of your mind.

NICOLAS TRINDADE: Definitely, if you look at developed markets I think most of the stories are about what central banks are going to do for the second half of this year. But when you look at emerging markets it’s more about political risk in elections, because we have elections in Mexico, we have elections also in Brazil and in Turkey. So it’s going to be a very busy political calendar for emerging markets for the second half of this year in an environment that is quite challenging.

ROBERT BAILEY: So let’s dig into the time to derisk idea. So you’re talking about clients here who are derisking from their benchmark type risk that they’ve got. Rising interest rates, we’ve already had two as you say from the Fed, explain how that’s going to impact us going forward.

NICOLAS TRINDADE: Yes, I think what’s going to be is that we are in an environment where interest rates are rising, and you can see that very clearly on the chart on the left-hand side. Because you can see that since the beginning of 2017, we’ve seen a structural shift where developed market central banks are hiking interest rates. There are no cuts anymore; they’re just hiking interest rates. And that should lead to higher government bond yields. That’s exactly what we’ve seen since the beginning of the year. The yield on the 10-year treasury hit 3% in mid-May. That was the highest level since 2011. And if you look at the yield on the 10-year gilt it hit 1.6% earlier this year. And that obviously put negative pressure on total returns, and that’s why a short duration strategy is quite attractive in an environment of rising rates, because what you want is to mitigate the negative impact from rising yield on your fixed income portfolio.

ROBERT BAILEY: And it’s not just rising rates that you’re worried about, the other big topic I guess in fixed income is valuations. When you look at, you’re talking about 10-year gilts at 1.6%, a lot can happen over the next 10 years that can really impact your capital return over the intervening period.

NICOLAS TRINDADE: Yes, definitely, and I think looking at government bond yields is only one part of the equation. You also need to look at valuations in credit markets. And if you look at valuations in credit markets, they are quite expensive, even after the slight widening in spreads that we’ve had year to date. And that is something that worries us, because there’s not much room left for further spread compression currently in credit markets, and if anything the path of least resistance is for wider spreads. And the reason for that is because spread performance seems to be more correlated to the flow of QE rather than the stock of QE. That is a very important differentiation to make, because what is going to reduce over the foreseeable future is the flow of QE. ECB is tapering its quantitative easing ending it by the end of this year. The Fed is tapering its balance sheet of investments, so we’re in an environment where there’s less liquidity, and that should impact spread performance.

ROBERT BAILEY: Clearly, the evolution of QE and indeed the unwinding of QE is going to be a driving force for fixed income markets. Where do we sit in terms of our view on this?

NICOLAS TRINDADE: What we believe is that basically with this withdrawal of liquidity, that should mean, and that should trigger, basically put pressure on spreads, that should lead to wider spreads. But also should lead to higher volatility. And that’s one thing also that is very important is that volatility has been artificially supressed by the provision of liquidity by central banks. As liquidity’s been withdrawn, we should see higher volatility. And that’s exactly what we’ve started to see in 2018, a much higher level of volatility. But what it also means, it means sharper asset repricing. And we’ve seen that against the beginning of the year. Look at the BTP, the two-year BTP, it went from a negative yield to two weeks later almost 3% yield, it was a very sharp repricing, and I would expect to see that kind of repricing happening more and more as liquidity is being further withdrawn.

ROBERT BAILEY: And do you expect to see that volatility really as a result of speculation, as a result of people speculating that quantitative easing will change its pattern, or do you actually expect the market to wait for the actual events to happen?

NICOLAS TRINDADE: No, I think what is happening right now is because liquidity is being withdrawn, fundamentals matter much more. And that is the big difference between 2018 and the previous years. The previous years, you could have been excused not to look at fundamentals, because the Fed, the ECB, the BoE, they were all buying bonds indiscriminately across the whole market. Now that liquidity’s being withdrawn, fundamentals are going to matter again. And the issue you have is that sometimes spread and valuations are disconnected from the fundamentals, and that creates sharp repricing. That’s what we’ve seen for example in the case of BTPs.

ROBERT BAILEY: On the subject of derisking and higher volatility here, looking at the graph clearly, you know, we’ve touched on geopolitical risks already, and looking on the left slide here there’s one key geopolitical risk that we’re very conscious of. Talk to us about the right-hand side and the volatility, about what you’ve seen here.

NICOLAS TRINDADE: Yes, so the graph we’ve put together on the right-hand side is to give an idea to investors as to how big the shift in volatility has been so far this year. And in order to talk about volatility we’re using the VIX, which is the most widely used barometer for volatility. And what you can see is that the median of the VIX in 2017 was only 11, the lowest ever recorded. We were in abnormal times last year. And what we’re seeing this year is that the median year to date is already back to 16, which is closer to the long-term average. But if anything we actually expect the median to go even higher, because we do believe that the current market environment should lead to even higher volatility than the long-term average, because of liquidity being withdrawn, but also because of political and geopolitical risks.

ROBERT BAILEY: And do you see that as an opportunity managing a fund of this type, the increased volatility, or is it a threat?

NICOLAS TRINDADE: Well I think you can look at it both ways. Obviously when you have more volatility that gives active managers the ability to potentially buy bonds at better levels. So from that perspective it is positive. But when you have more volatility you also have the risk of much bigger drawdowns, and that’s something you need to be focused on. That’s why I think being cautiously positioned, well diversified and focusing on downside risk right now is the best position to have in your portfolio, because you will have opportunities to buy bonds at much better levels down the line.

ROBERT BAILEY: Let’s move on and talk a little bit about currencies. One of the key things with the global fund is that you have the opportunity to buy bonds in dollars, in euros, in yen or whichever global currency. One of the messages that we consistently get back from clients from the fact that actually investing in overseas bonds now is actually quite less rewarding than previously because of the cost of hedging; explain to us in these graphs how that actually plays out for you.

NICOLAS TRINDADE: So obviously when you manage a global strategy you need to take into account hedging costs. That is very important, because if you don’t take them into account, then you’re missing the point and you miss allocating capital within your portfolio. So that is very important. And we’ve tried to illustrate that through these graphs. So if you look for example at the one on the top left, what we show here is the yields in local currencies for the short-dated euro, sterling and dollar investment grade markets. And as you would expect the dollar short-dated market yields the most in local currency at 3.2%, when the euro one yield the less at 0.4%. Now what you need to do is you need to look at the same picture but taking into account hedging costs, and hedging all those markets back into sterling. And you can see that on the right-hand side. And you can see that the picture changes quite a lot, because suddenly sterling investment grade becomes as attractive as dollar investment grade, and euro investment grade doesn’t look that expensive anymore when you looked at the previous graph. So very clearly as a global investor I need to look at those hedging costs because they can really change the way you look at markets and the way you allocate capital.

ROBERT BAILEY: So you actually get a hedging gain though on the euro stocks.

NICOLAS TRINDADE: That’s correct exactly because the BoE is kind of in the middle between the Fed and the ECB.

ROBERT BAILEY: And do you see this, I mean this is perhaps more pronounced now than it’s been at any stage that I can remember with the hedging costs, do you see this as a long-term phenomenon?

NICOLAS TRINDADE: Yes, I mean definitely. I mean if you looked at hedging costs dollar/sterling, it would have been close to zero two/two-and-a-half years ago. So it’s been definitely increasing over the last couple of months. And that is because we’ve been having more and more differentiation in divergence between on one side the Fed that keeps on hiking, four times potentially this year, and the Bank of England which may hike only once in August this year. And so as interest rate differentials are increasing, hedging costs are increasing too.

ROBERT BAILEY: And do you find yourself looking more at the markets that are perhaps less [unclear 0:12:20]? So are you investing less in dollar assets as a result of this?

NICOLAS TRINDADE: It will depend on the markets. Quite interestingly actually the short-dated part of the US investment grade market is quite attractive, even after hedging costs. That is because the treasury curve is very flat in the US, and spread is still quite attractive. So actually even after hedging costs the short-dated part of the US investment grade market is still attractive. But [unclear 0:12:45] market potentially because of high hedging costs, you won’t really look at because they’re not that attractive.

ROBERT BAILEY: And when you look at the bottom two graphs on here, we’re looking more at the emerging markets and the euro high yield and the US dollar high yield, the returns really are very similar when you convert them into sterling.

NICOLAS TRINDADE: Yes. I mean as you would expect when you look at EM or high yield, I mean obviously they’re the higher yielding part of my universe. So they provide quite attractive yields. But what is interesting on the bottom graphs is that particularly for European high yield, because in local currency it looks quite expensive, but if you look at it in sterling-hedged terms it’s as attractive as emerging markets. That again creates opportunities, and that’s why for example in the portfolio that I run I have a bias towards European high yield, because it looks quite attractive after hedging costs.

ROBERT BAILEY: So let’s move on and talk specifically about the global short duration fund here, and looking at the benefits of investing in this area. Talk us through this slide.

NICOLAS TRINDADE: Yes, so I think obviously one of the main benefits of our short duration strategy is the fact that you have a low duration. It then means that you can mitigate the negative impact of rising yields. But what I think is also very interesting is the fact that it doesn’t matter in which asset class you do short-duration, investment grade, high yield or emerging markets, because the short duration markets will all exhibit exactly the same characteristics, which is much lower drawdowns versus various respective markets. So let’s take for example the case of the sterling investment grade market. The maximum drawdown over the last five years for the all maturity sterling market was almost 7%; maximum drawdown for the short-dated market, one to five years, less than -2%. And exactly the same story if you look at the other side of the spectrum on emerging markets. Maximum drawdown 6.6% when it was only 2.7% for emerging markets, short-dated emerging markets. So very clearly by going short duration you can massively reduce your drawdown experience, that is something that I believe is quite attractive in the current market environment.

ROBERT BAILEY: And we talk a lot about risk-adjusted returns, so on the right-hand side here you’ve got the Sharpe ratios. Explain how you utilise that in your thinking.

NICOLAS TRINDADE: Yes, I think in an environment where volatility is increasing I think it’s very important to focus on risk adjustment performance rather than outright performance. And when I say risk-adjusted performance it’s performance adjusted for volatility. That is something that I think is very important, because volatility is going to be much higher. And here again a short duration strategy is quite attractive, because if you look at the case of the sterling investment grade market, you can double your sharp ratio by going from the old maturity market to short-dated one, so quite attractive. Of course, the truth of the matter is in 2017 all funds seemed to be low volatility, because the market environment was really low vol, so all the funds seemed to be low volatility. In an environment of much higher volatility, you’re going to be able to make a real differentiation between the truly low volatility funds and the one where low volatility just because the environment was low vol.

ROBERT BAILEY: So let’s have a look at the portfolio characteristics as they stand. As I say, the fund is £170m in size, what are you, explain how you build the portfolio.

NICOLAS TRINDADE: Yes, so the first thing to understand is the breadth of our investible universe, and it is a global portfolio. We have the ability to buy inflation linked, investment grade, high yield and hard currency emerging market bonds. So it’s a truly global investible universe, and the maturity cap is five years on the portfolio. And on this portfolio, we have three main objectives. The first one of capital preservation, very important, because a lot of our clients will be coming out of cash into this strategy because we look for better returns; the second objective would be to ensure that we have a strong natural level of liquidity within the portfolio; and thirdly we want to maximise risk adjusted performance. So those are really the three main objectives of the portfolio.

ROBERT BAILEY: And when you look at the split, we’ll come on perhaps to look at it, but when you’re looking at the yield and the split between investment grade and emerging markets, how do you tweak that as market conditions change?

NICOLAS TRINDADE: So right now, in the portfolio, we’re quite cautiously positioned, because we have about 28% in high yield in EM. And to understand why it’s cautious you need to understand the limits that we have within the portfolio. And right now, I mean within the portfolio we can invest up to 60% in high yield in EM. So that means that our neutral allocation within the portfolio is 10% in sovereign bonds, 60% in investment grade, 30% in high yield and EM combined. That will be a neutral allocation. Today we have 68% in investment grade, 28% in high yield in EM, so that means that we are cautiously positioned in the portfolio. And the reason why we’re cautiously positioned is because I want to make sure that I have space to add risk into the portfolio, and add risk at better levels down the line.

ROBERT BAILEY: So if we look at the next slide about where you’re allocated currently, you’ve got as you say 68% in investment grade credit. A big chunk of that is still in the US dollar market, is that where you find the liquidity?

NICOLAS TRINDADE: Yes, and that’s exactly, that tallies up with where we were discussing a bit earlier on when I was telling you that the short-dated part of the US investment grade market is still quite attractive, even after hedging costs. And that’s one reason why within our investment grade bucket we still have a bias towards US investment grade because it’s still quite attractive. We also like the sterling investment grade market. It tends to be cheaper than the euro one, so we do have some exposure to it because it’s very important to have an attractive level of carry within your portfolio. When it comes to sovereigns, we have only exposure to inflation-linked bonds. And finally for high yield and emerging markets we have a bias towards European high yield and emerging markets.

ROBERT BAILEY: And when you look at the inflation-linked bonds, I mean inflation-linked bonds have appeared expensive for some considerable time. Are you buying that as a hedge against inflation risk, do you see that as a realistic risk there?

NICOLAS TRINDADE: Yes, so when you look at sovereign exposure 3% inflation-linked bonds, our whole exposure is in short-dated US TIPS. So we do not have any exposure to UK linkers or euro linkers, only US TIPS. And the reason why is because even at the short end you benefit from positive carry in short dated US TIPs, and also because we believe that the inflation market in the US has not reflected yet the future rise in inflation. So we think it’s an attractive asset class to have within the portfolio.

ROBERT BAILEY: And the cash element presumably is just a frictional element.

NICOLAS TRINDADE: Yes, exactly, it’s more like to be able to participate in new issues or meet ongoing redemptions that we may have in the portfolio.

ROBERT BAILEY: And moving into the selected local overweights and underweights, again here just emphasising where you’re positioned now and how that works into your process.

NICOLAS TRINDADE: Exactly, because when you put together such a portfolio the first step is obviously to decide your asset class allocation. Once you’ve decided your asset class allocation you need to decide which, I mean in each asset class whether you want to be overweight or underweight. So for example within the inflation-linked space as we discussed we buy US TIPS, because that’s where our team sees value. Within investment grade, we have a bias towards financials, banks, insurance companies, because again that’s where we see the most value. Within emerging markets, we have a bias towards Latin America. That’s where our EM team sees the most value. And finally within the high yield space we’re up in quality, we are more defensively positioned.

ROBERT BAILEY: And in terms of asset allocation, you hold most of these bonds to maturity. How much flexibility do you have to reposition the portfolio?

NICOLAS TRINDADE: To understand the flexibility you need to understand how we structure the portfolio. And we structure the portfolio in the way that we have 20% on average of the portfolio maturing each year. So we benefit from a very strong natural liquidity profile in the portfolio. And what it means, it means that it gives me the ability to naturally rebalance asset classes in the portfolio, and that’s something that’s quite attractive. But what it requires, it requires for all the asset classes to gradually mature over the years, and that’s exactly how we structure the portfolio.

ROBERT BAILEY: And so one of the other elements where you can take an advantage of being an active fund manager is when you find pricing anomalies. Clearly when we’ve been in a period where the markets have been less volatile returns are lower, finding those anomalies must be difficult, but talk us through this particular example here and how you deal with that opportunity.

NICOLAS TRINDADE: I mean this example is maybe a bit of an extreme example, but it still gives a really good illustration of what we’re trying to achieve within the portfolio. When I buy issuers, I’m agnostic when it comes to the currency. I don’t care if I buy the issuer in sterling, in euros or in dollars; I just want to buy the issuer in the cheapest currency. And if you look at the case of Intesa Sanpaolo in the summer of last year, actually the sterling bonds were much cheaper than the euro bonds. The January 2022 Intesa bond was 80 basis cheaper than the equivalent euro bond for exactly the same underlying credit risk, even after hedging costs, so very clearly very attractive to buy Intesa in sterling rather than in euros. So that’s what we did, we bought.

ROBERT BAILEY: How often do those kind of opportunities arise, are they frequent or?

NICOLAS TRINDADE: I wouldn’t say they are frequent but they do arise. They do arise, and then it’s up to us as active fund managers to try to find them, and try to benefit from them. And that’s exactly what happened in the case of Intesa Sanpaolo, because three months later the mispricing was arbitraged, and the sterling bond was trading back in line with the euro and the dollar curves.

ROBERT BAILEY: And are these caused by forced sellers or are they caused by specific local reasons?

NICOLAS TRINDADE: In terms of mispricing, particularly for the sterling market, it could come to the fact that firstly in the case of Intesa Sanpaolo the issue size was quite small, so less liquidity in the bond, so more difficult to find the bonds. It’s also obviously not a domestic market to issue in sterling than in euros. So sometimes you can have a bit of mismatch due to that. And that’s where we try to come in and try to benefit from that mispricing, because at the end of the day I plan to hold bonds until maturity. So I don’t mind being paid for that liquidity premium.

ROBERT BAILEY: So finally let’s come on to how the strategy and the fund have performed over the 12 months since launch. The blue line in this graph is the global short duration bond fund. The green line is the sector. From point A to point B it’s performed pretty much in line, because as you can see there’s a lot of volatility that’s been avoided by holding this kind of fund.

NICOLAS TRINDADE: Definitely, I mean last year has definitely been challenging, and the time since we’ve launched the fund has definitely been challenging. But we’re quite pleased with the performance of the fund, because it behaved in line with expectations, which is that it’s been able to limit volatility massively whilst still performing in line with the IA global bond sector. And what it means, it means that we avoided quite large drawdowns. I mean if you look at the maximum drawdown for the IA global bond sector over the last year, it’s almost 6%; the drawdown of our fund over the last year as you can see is maybe ½%. So very clearly we’ve been very successful at limiting the downside and that has led to much higher risk-adjusted performance.

ROBERT BAILEY: Brilliant, Nick Trindade, thank you very much. And thank you for watching today’s webcast; I hope to see you again next time.