By Andrew Lakeman of Atlantic House, a London-based boutique investment manager specialising in derivatives-based strategies.
The fixed income landscape has shifted significantly in recent years, driven by rising inflation, volatile interest rates and economic uncertainty. Traditional fixed income allocations have faced challenges, particularly those with longer durations, and especially those without responsive duration management approaches.
Passive bond exposures are static by design, exposing them to interest rate risks, particularly in times of heightened volatility. Traditional active bond funds, which attempt to predict the path of interest rates, have also struggled, as forecasting interest rates is notoriously difficult.
By contrast, dynamic and systematic strategies, which use quantitative models, rules and leverage to adjust bond duration based on market conditions, are emerging as crucial tools for navigating today’s bond markets.
The challenge for bond investors:
Primarily, it lies in balancing interest rate exposure with inflation expectations. In today’s environment, where economic factors can shift rapidly, fixed-duration strategies can fall short.
Interest rate volatility, once viewed purely as a risk, is now seen as an opportunity to dynamically adjust portfolios, ensuring they remain aligned with changing macroeconomic conditions.
Funds that adopt this approach allow for bond exposure adjustments based on real-time market data, using a systematic, rules-based approach to manage interest rate risk and inflation exposure.
Also read: Fixed Income Favoured Over Term Deposits As Global Rates Fall
The strategy is designed to be flexible, making it suitable for inflationary and deflationary environments with broad application across global markets.
Three key signals guide dynamic decisions. They are:
- Inflation trend: This signal measures changes in headline inflation over a six-month period. If inflation is rising, the fund adjusts its exposure towards inflation, benefiting from the higher expected inflation. Conversely, if inflation is falling, the fund increases its bond exposure.
- Real rates: The difference between nominal and real interest rates provides insight into market inflation expectations. High real rates tend to act as a brake, slowing economic activity. When real rates are high, the fund increases its exposure to bonds, and when real rates are low, it favours inflation.
- Inflation target: This signal compares core inflation to the central bank’s inflation target. When inflation exceeds the target, the fund shifts away from bonds and increases its inflation exposure to protect against rising inflation.
These signals allow a fund to systematically adjust its bond exposure in response to changes in the economic environment. Traditional bond funds typically lack this ability, making dynamic strategies more adaptable in volatile conditions.
Enhancing liquidity and reducing costs:
Funds employing dynamic and systematic strategies use interest rate swaps and inflation swaps to manage duration, allowing it to adjust exposure without directly buying and selling bonds. This approach boosts liquidity and reduces transaction costs, making dynamic strategies more efficient. Additionally, the use of inflation swaps enables the fund to generate positive returns in inflationary environments, providing pure exposure to inflation. This diversification adds value to traditional bond allocations.
Leveraging opportunities in volatile markets:
These funds use leverage to further amplify their ability to capitalise on market opportunities. At its most aggressive, when all signals strongly favour bond exposure, a fund can have up to 200 per cent exposure to 10-year interest rates.
Conversely, when the signals point exclusively to inflation, they can have 100 per cent exposure to 10-year inflation-linked bonds. This flexibility allows a fund to maintain a higher level of interest rate exposure while protecting against rising inflation.
For example, 2022 saw a highly inflationary environment, and the strategy overweighted inflation exposure for most of the year. As inflation began to fall in the second half of 2023, the strategy adjusted and increased bond exposure, benefiting from falling yields as inflation fears subsided.
Navigating uncertainty with a rules-based approach:
Even as inflationary pressures ease, the need for dynamic duration strategies remains strong. Traditional bond funds are still vulnerable to interest rate shifts, and credit risk poses concerns as central banks attempt to engineer a soft economic landing. An alternative approach allows the flexibility required to manage these risks.
By focusing on government exposure, these funds avoid the risks associated with widening credit spreads or corporate defaults during economic downturns, enabling the benefits of duration to be realised.
In today’s unpredictable fixed income markets, dynamic strategies like those employed by the Atlantic House Dynamic Duration Fund are indispensable. By leveraging quantitative models, minimising credit exposure, and systematically adjusting duration, these strategies offer a forward-thinking, resilient approach to bond investing. While inflationary pressures have somewhat subsided, the importance of adaptability and credit awareness in fixed income investing remains critical.
