“A Flexible Absolute Return Approach Enhances the Convertible Bonds’ Convex Profile”

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“Un enfoque de rentabilidad absoluta flexible en convertibles puede mejorar la convexidad, limitando más las caídas y captando mejor las subidas”
CC-BY-SA-2.0, FlickrBrice Perin, fund manager at Generali Investments, in charge of GIS Absolute Return Convertible Bond Fund. Courtesy photo.. “A Flexible Absolute Return Approach Enhances the Convertible Bonds’ Convex Profile”

Brice Perin, fund manager at Generali Investments, in charge of GIS Absolute Return Convertible Bond Fund, explains in this interview with Funds Society why it is worthy to use an absolute return strategy in convertible bonds.

What do convertible bonds bring in an environment like the current one?

At Generali Investments we believe that convertible bonds feature an attractive asymmetry between credit and equities, especially in a volatile, uncertain market.

The securities’ hybrid profile automatically adapts to market movements in order to capture on average 2/3 of the market’s upside and limit to 1/3 of the drawdown. In fact, in falling stock markets, the securities automatically lower their equity sensitivity, therefore getting closer to the bond floor. 

In addition, we are convinced that introducing a flexible absolute return approach enhances this embedded convex profile, therefore further limiting drawdowns and aiming to capture the market’s upside.

One of the key needs today is true diversification and decorrelation with other asset classes: can your fund accomplish this challenge?

Yes. In fact, convertible bonds combine various alpha drivers such as equities, bonds, credit, implied volatility, ratchet/prospectus clause, and benefit from different market cycles. These components do not always move together at the same time: depending on the market cycle, some would generate alpha while others could underperform and undermine performance. To optimize the different parameters, we have the ability to hedge partially or totally the unwanted parameters, in order to focus on the ones we would like to isolate and benefit from.

How is the absolute return strategy obtained with convertibles?

An absolute return investment approach applied to convertible bonds fund allows us to add arbitrage techniques in a transparent, rigorous and risk-managed UCITS structure. The GIS Absolute Return Convertible Bond fund aims at generating alpha through from both outright «credit» and «equity» exposure offered by our convertible bonds’ long positions and via hedging strategies (which isolate specific alpha creating components) – whether it is a macro hedge, overlay or a micro hedge at the security level. Moreover, those techniques aim to improve the convexity of convertible portfolios and the downside protection offered.  Put simply, the concept is based on isolating and exploiting a desired parameter, for example isolating an attractive prospectus (“ratchet”) clause – while limiting or removing the unwanted underlying equity exposure.

What are your objectives in terms of returns and volatility?

Our strategy has an absolute return objective of achieving consistent performance across the market cycle, with a target volatility of 6-7%.

What strategies are applied in convertible bonds in general and specifically in your fund ? Arbitrage strategies, volatility … How do they work ?

Besides the standard outright exposure that convertible bond funds offer (mainly directional exposure on underlying equity and credit), implementing an absolute return philosophy within this asset class allows us to introduce some additional arbitrage and hedge strategies.

The latter consist of hedging partially or totally some of the risks, in order to focus only on some of the convertible bond parameters. As an example, we can hedge the underlying equity risk in order to isolate and implement volatility or prospectus strategies.

When implementing a volatility strategy we aim to benefit from the favorable changes in the implied volatility of a convertible bond, or from the favorable change of the spread between CB implied volatility and realized of the underlying equity. By re-adjusting our underlying equity hedges, we “capture” underlying equities’ volatilities.

Whilst, when investing and isolating the prospectus clause, we aim to benefit from, for example, some issuance premium compensation provided in the case of a takeover (that could be undermined by equity performance if un-hedged). Lastly, we can also decide to adjust the fund’s global sensitivities to equity or credit markets via overlay index positions to limit market drawdowns. 

Is it easier to achieve absolute returns with convertibles than with other asset classes? Or more difficult? Why?

The current tumultuous market conditions and uncertainties make it challenging to achieve absolute returns across all asset classes. The heightened volatility and the frequent periods of strong underperformance in global markets (November 2015 to February 2016) enhance the importance of adopting a flexible and benchmark agnostic investment approach.

As mentioned before, convertible bonds carry a hybrid and asymmetric profile which adapts naturally to market movements. In fact the equity exposure (sensitivity or delta) moves in line with the equity markets therefore moving converts closer to their bond floor in periods of sell-off or to more  equity-like profiles during market upsides and rebounds. From this perspective we consider convertible bonds have self-adjusting features.

In addition, convertible bonds associate other components such as volatility and prospectus (ratchet) clauses. Being able to isolate these, in order to hedge or invest in each component, allows us to identify the sources of alpha and eliminate partially or completely the underperforming components.

For all of the above arguments we believe that the asset class gives more leeway and opportunities to achieve total returns over the market cycle.

When did the strategy was launched and how it has worked in bullish and bearish periods ?

The fund was launched early 2004 as an outright convertible bond strategy; therefore it has a long track record of over 12 years. In 2015 we thought of revamping the investment approach in order to be able to benefit from more sources of alpha and better navigate across all market cycles. From September 2015 we introduced some hedging and overlay strategies with an unconstrained and flexible investment philosophy. In 2015 the fund posted an absolute performance net of fees of 5.82% for a realized volatility of 5.12%.

Since last September we have experienced some extremely distressed market conditions, with some of the main underlying equity markets losing more than  20% at some point between November and February.

Nonetheless the fund  outperformed the convertible and equity markets, as well as the peer group. In fact the fund has realized positive absolute performances since the reshuffle, thanks to an active delta management (mainly via futures and a few contract for difference single name positions) and a rigorous liquidity and credit analysis resulting in a cash portfolio of majorly mainly robust credit names.

Lastly, we have implemented an active risk process and improved our downside risk management, both at the front office and risk management level. Such a process consists of definition of maximum acceptable loss, de-risking mechanisms (implemented with various levels of escalations triggers) and re-risking (activated by loss recovery).

Can the current actions of the ECB help your strategy and fund ?

We believe that the latest ECB intervention will impact the European markets positively. On the credit side it will support valuations within the investment grade space and in certain riskier credit sectors. On the equity side we believe that market volatility could temporarily ease which would also impact on the underlying.

All in all, while we do not think that the recent ECB actions will have a direct impact on convertible bonds, we nonetheless believe that in the short run it will positively benefit the underlying asset classes (i.e. credit and equity), as was the case in the past weeks.  This shall also benefit our convertible bond strategies both outright and absolute return. Having said that, should volatility surge again, our absolute return strategy should fully benefit from it.

Seilern Investment Management Won Four New Awards

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Seilern Investment Management suma otros cuatro premios Lipper
CC-BY-SA-2.0, FlickrPhoto: Thomson Reuters. Seilern Investment Management Won Four New Awards

Seilern Investment Management have recently been acknowledged throughout Europe in the Lipper Awards, for the long-term performance of our funds. On 19th April in London, they announced the final round of UK and Pan-European awards, bringing the total to 14 awards in 2016.

Over the past weeks Seilern Investment Management have won awards for Best Equity Group (Small Company) in Switzerland, Germany, Austria, UK, and Europe and Stryx World Growth has won for Best 5 Year Performance in Switzerland, Germany, Austria, France, UK, and Europe.

“These awards are a testament to the commitment the team has in seeking out companies that demonstrate only the very highest prospects for long-term growth and reflect our consistency in generating returns for our investors. While we are gratified to be recognised, above all, we are pleased that we continue to deliver for our clients”, said Raphael Pitoun, Chief Investment Officer.

Capital Strategies Partners has an strategic agreement to cover Spain, Italy, Switzerland and LatAm market for Seilern Investment Management.

Serial Inverters, the US Treasury ‘s New Target

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Operaciones corporativas: el Departamento del Tesoro de Estados Unidos endurece la normativa
CC-BY-SA-2.0, FlickrPhoto: Balint Földesi. Serial Inverters, the US Treasury 's New Target

The US Treasury Department has taken new steps to further curtail a popular type of corporate transaction in which a US company merges with a foreign counterpart, then moves abroad to lower its tax bill. The strategy known as corporate inversions technically involves having the foreign company, based in a country with lower tax rates, buy the US company’s assets. Ireland, with its highly competitive 12.5% corporate tax rate, has been a popular place to incorporate, Eric McLaughlin, Investment Specialist at BNPP IP.

The new rules, announced in conjunction with the Internal Revenue Service, take particular aim at foreign companies that have completed multiple deals with US companies in a short period, what the regulator calls “serial inverters.”

The two main points Eric McLaughlin, Investment Specialist at BNPP IP, presents are the implementation of a three-year look-back period for US-based mergers and acquisitions (M&A) and earnings stripping:

  1. Three-year look-back period. This relates to how the Treasury is going to enforce ownership fractions for inversions. If the shareholders of a foreign acquirer own more than 20%, but less than 40% of the combined entity, and the foreign acquirer conducts substantial business activities in the foreign jurisdiction, the inversion technically works. If the shareholders of the foreign acquirer own more than 40% of the combined entity, the inversion works and most of the negative consequences are avoided. The new rules go further, effectively counting domestic acquisitions by an inverted acquirer in the last three years as impermissible. If the value of those previous acquisitions is disregarded, the foreign acquirer becomes smaller and subject to more stringent inversion rules.
  2. A tactic known as ‘earnings stripping’ involves the US subsidiary borrowing from the parent company and using the interest payments on the loans to offset earnings — a cost that is not reflected on financial statements, but which lowers the tax bill. The new rules classify this intra-company transaction as if it were stock-based instead of debt, eliminating the interest deduction for the US subsidiary. This change applies not just to inversions, but to any foreign company that has acquired a US entity and used this technique to lower taxes.
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Implications of the new steps to curb corporate inversions

“We thought the Treasury had deployed the full extent of its regulatory power in two previous inversion updates. The rules recently announced by the Treasury, however, were seen as much more aggressive and expansive and sent shock waves up and down Wall Street,” says McLaughlin. The most immediate reaction was the news that Pfizer plans to abandon its USD 152 billion merger with Allergan – the largest deal yet aimed at helping a US company shed its US corporate citizenship for a lower tax bill. Pfizer executives have made no secret of their belief that renouncing its corporate citizenship and lowering its overall tax bill was their duty as stewards to shareholders.

Yet even by the Treasury’s own admission, the latest rules will not be enough to completely halt the flow of companies seeking to renounce their US citizenship. There is even a question as to whether the Treasury has overstepped its authority. Such a move would be possible only with an overhaul of the tax rules by Congress, which few believe will happen soon. The current political climate also complicates the matter. Corporate tax policy may be a key issue in the fall presidential elections as Democrats have moved to toughen legislation, while Republicans look to lower corporate tax rates.

It remains to be seen what effect the new rules have on the broader equity market. While inversions have not played a dominating role in the mergers and acquisitions, (40 companies have struck inversion deals over the past five years, according to data from Dealogic), this does put additional pressure on investment banks. Meanwhile, in filing a lawsuit to block the Halliburton-Baker Hughes merger, the Obama administration has demonstrated its increasing willingness to challenge giant takeovers, reflecting a belief that the corporate world goes too far in its pursuit of megamergers.

Finally, the tax rate risk facing certain companies just got pulled forward. “The good news is that the anti-earnings stripping rules grandfather all instruments prior to April 4 and appear limited to foreign parents. The bad news is that we expect tax rate creep for US companies headquartered abroad and that these companies have lost their tax advantaged acquirer status. It also makes us wonder if this is the first step towards tighter tax regulatory frameworks globally.” He concludes.

High Yield in the Crosshairs

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¿Compensan las asignaciones estratégicas a los segmentos de menor calidad en la deuda high yield?
CC-BY-SA-2.0, FlickrPhoto: Brian Jeffery Beggerly. High Yield in the Crosshairs

Investing in high yield bonds is not for the faint of heart. That said, the risks associated with below-investment-grade bonds are frequently overstated and couched in hyperbole, believes David P. Cole, CFA, Fixed Income Portfolio Manager at MFS.

Late last year, investors beat a thunderous exit from high yield bonds, which in turn reverberated through financial markets as analysts pondered the implication of deteriorating credit markets on the US economy. More recently, investors have made a U-turn, and high yield has witnessed inflows again and spreads have tightened. Talk of a US recession has similarly subsided.

According to the expert, high yield bonds are subject to a cyclicality that mirrors the economic cycle — and default risk is an important factor in total investment returns. If one understands the cyclical backdrop of the high yield asset class and adopts an investment approach that involves prudent security selection, particularly in the lower-credit-quality segment of the market, high yield bonds can make a compelling addition to a well-diversified portfolio. 

“The asset class has historically delivered a risk-return profile somewhere between higher-quality fixed income and equities, and has exhibited characteristics of both markets over full market cycles. In the period from 1988 to 2015, the Barclays U.S. High Yield Corporate Bond Index delivered a compounded annualized total return of 8.1% — more than the 6.6% return of the Barclays U.S. Aggregate Bond Index but less than the 10.3% return of the S&P 500 Index”, points out.

High yield bonds can offer diversification against interest rate and equity risk. With relatively low interest-rate sensitivity compared with other fixed income asset classes, the US high-yield market may offer a buffer against a rise in interest rates.

Prudent security selection in the lower-quality segment

Volatility in the lowest-rated high yield bonds can be significant. For this reason, it’s important to focus on differentiation in return and risk characteristics by credit quality, as the returns of the lower-quality segment of the market can vary quite meaningful from that of the overall high yield market.

Historically, highlights Cole, investors have not been adequately compensated for a strategic allocation to lower-quality segments of the high yield market, as the perceived carry advantage is often offset by capital losses due to defaults. Compared to the higher-quality portions of the high yield market, the lowest-rated high yield securities (CCCs) have produced lower compounded returns given the variance drain — losses incurred from heightened volatility because of the wealth erosion caused by downdrafts in security prices — associated with their significantly higher return volatility.

“While lower compounded returns argue against a strategic overweight to CCCs, this market segment also displays a greater dispersion of returns than those in the higher-rated BB or B portions of the market. This suggests potential opportunities to add value by selectively investing in CCC securities, especially on the heels of a significant selloff, when credit spreads have widened substantially”, explains the MFS portfolio manager.

Consequently, says Cole, a tactical allocation to the lower-quality segment of the high yield market can be appropriate when one is being sufficiently compensated for taking on the additional price risk. In the current environment, for instance, energy and mining companies may become attractive. However, investments in these lower-rated securities must be carefully weighed against the overall risk profile of the portfolio, as they can be both distressed and highly illiquid.

“December’s headline-driven selloff in high yield, prompted by a small handful of high yield strategies that ran into trouble with overweight positions in commodity sectors and CCC-rated securities, provided a stark reminder of just how important it is to manage credit risk in high yield”, concludes.

For MFS, the high yield market provides an opportunity for investors to gain exposure to the credit market with an asset class that provides diversification and an attractive return profile over time. Investing in this market also requires prudence, an eye for identifying inflection points, and favoring certain names — such as those on the higher-quality tier of the credit quality spectrum — to deliver attractive risk-adjusted returns.

Emerging Markets Equities: Positioning And Opportunities in Henderson’s View

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Henderson: “Resulta imposible predecir cuándo llegará la recuperación cíclica a los emergentes”
Glen Finegan. Emerging Markets Equities: Positioning And Opportunities in Henderson's View

Glen Finegan, Head of Emerging Market Equities at Henderson, provides a detailed update on his strategy covering recent market drivers, performance and activity, and his outlook for the asset class.

How have the emerging markets performed so far this year?

A sharp decline for the MSCI Emerging Markets Index in January was followed by a strong rally during February and March, leading to a gain for the asset class overall during the first quarter of 2016.

Against this backdrop the Henderson Emerging Markets Strategy, outperformed a rising market. The investment in gold producer Newcrest Mining and significant exposure to companies listed in the unpopular Brazilian, Polish and South African markets helped. The strategy’s Egyptian and Nigerian holdings performed poorly and fell during the quarter.
Over the last year the strategy declined less than the benchmark. Our approach of owning high-quality companies with properly aligned controlling shareholders and strong track records of delivery aided relative performance.

What can you tell us about your portofolio allocation?

We added to the strategy’s Brazilian positions during January’s market fall only to reduce these somewhat towards the end of the quarter following a rapid increase in valuation. We are confident the strategy owns high-quality businesses with strong franchises that will enjoy cyclical recovery when it comes. Predicting the timing of this is, however, impossible, meaning we remain extremely valuation sensitive.

Emerging consumption ¿Cómo ha funcionado el tema del consumo en los mercados emergentes?

We fully disposed of the strategy’s SABMiller position during the first quarter. The discount to Anheuser-Busch InBev (ABI)’s takeover offer has narrowed considerably and the deal still has to clear a number of regulatory hurdles. In the unlikely event it should fail there would be substantial downside in this stock.

Our search for high-quality, reasonably-valued consumer companies in India resulted in the purchase of a new holding in leading cement producer Ultratech.

Cement consumption in some less developed markets shares the same fundamental driver as basic fast moving consumer goods, namely improving living standards. Indian cement sales are conducted mostly in cash and demand is largely driven by the need for improved housing. Housing in India is primarily financed by savings and construction is often as wholesome as adding a small room to an existing property. More than 90% of cement sold in India still comes in bags rather than in bulk, indicative of this being a consumer-driven market. Furthermore, per capita consumption of cement remains low, meaning there is scope for this to increase over time.

What is Ultratech’s appeal?

A unique feature of Ultratech is its network of over 50,000 dealers throughout India selling “Ultratech” branded cement. This network is far larger than any of its competitors and has enabled the company to reach an almost 40% market share in rural India.

Ultratech is one of the crown jewels in the Aditya Birla Group, accounting for approximately 10% of group revenues. Aditya Birla is a family-controlled industrial group led by Kumar Mangalam Birla. Since becoming Chairman in 2004, after the passing of his father, Kumar has shown an ability to take a long-term approach to building strong franchises in a number of industries, including cement. He is also recognised as a leading advocate for strong corporate governance in India.

With the backing of the Birla family, we believe Ultratech will continue to take a leading role in the consolidation of India’s fragmented and overly-indebted cement industry.

What about China?

We have continued building a position in Fuyao Glass following a meeting with its Chief Financial Officer. Fuyao is China’s leading auto glass manufacturer and serves well-known carmakers in China and now also in the US and Europe. The company is a governance leader in China thanks to its far-sighted controlling shareholder who has insisted on global auditing standards since listing in 1993 and emphasised research and development investments to protect the long-term profitability of the franchise. We find the company’s current valuation undemanding given its opportunities for growth.

What is your strategy going forward?

Weak rule of law combined with many undesirable political and business leaders mean there are parts of the emerging markets universe that are cheap for a reason. We are not deep value investors and aim to avoid being seduced by low-quality companies trading cheaply. Neither are we outright growth investors and we continue to avoid what we believe are overvalued but growing South Asian consumer businesses. Instead, as bottom-up stock pickers our focus is on combing unpopular markets for good-quality companies trading at reasonable valuations.

Schroders Enters into Market for SME Direct Lending Through a Partnership with NEOS Business Finance

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Schroders entra en el mercado de financiación directa para pymes y nombra responsable de Marketing para EMEA
CC-BY-SA-2.0, FlickrPhoto: Moyan Brenn. Schroders Enters into Market for SME Direct Lending Through a Partnership with NEOS Business Finance

Schroders today announces that it has entered into a strategic relationship with Dutch direct lending firm NEOS Business Finance. Schroders has acquired a 25 per cent. stake in the business.

Launched in 2012, NEOS Business Finance provides institutional investors access to an alternative debt financing platform for Dutch small and medium-sized enterprises (SMEs). The company has developed an approach to give SMEs access to small to medium size loans through a standardised issuance and loan terms process.

NEOS Business Finance will provide investment advisory services to Schroders in connection with the management of investment funds of Schroders’ clients investing in SME financing.

NEOS Business Finance has an extensive network and broad client base. To date, NEOS Business Finance has launched one investment fund funded by two large Dutch pension funds. In addition NEOS Business Finance works with the largest Dutch bank ABN Amro to source SMEs in need of financing. This complements Dutch government policy which encourages pension funds and other institutions to actively participate in local economies.

Philippe Lespinard Co-Head of Fixed Income at Schroders said: “Small and medium enterprises (SMEs) in Europe are increasingly looking to obtain debt financing from non-bank lenders. Part of this trend is explained by the decreasing supply of credit in that space by commercial banks who face increasingly onerous capital requirements on loans perceived as risky by regulators and supervisors. On the demand side, borrowers expect faster approval times and lower collateral requirements than afforded by banks’ traditional processes and systems. These conflicting trends open up a space for non-bank actors to provide growth financing to SMEs on simpler and faster terms.”

Repurchasing Confidence: The Potential Benefits Of Stock Buybacks

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Los datos demuestran que las empresas con programas de recompra de acciones superan al mercado a largo plazo
CC-BY-SA-2.0, FlickrPhoto: Susanne Nilsson. Repurchasing Confidence: The Potential Benefits Of Stock Buybacks

There’s no substitute for a well-run company with solid fundamentals, steady earnings growth and a seasoned management team. But investors in even the most profitable firms are always looking to add value. Two commonly used methods for bolstering corporate shareholder value are dividends and stock buybacks.

A company may decide to repurchase outstanding stock for many reasons — to telegraph confidence in the company’s financial future, return cash to investors in a tax-efficient manner (shareholders typically pay taxes on dividends) or simply to reduce the number of shares outstanding. In some cases, buying back shares just makes good financial sense – particularly when a company’s stock is trading at a discount, explains Thomas Boccellari, Fixed Income Product Strategist at Invesco.

A positive buyback performance track record

For these same reasons, investors may wish to consider companies with a propensity for repurchasing shares. A company stock repurchase is like reinvesting a dividend without incurring taxes.

“Consider also that the shares of companies that repurchase stock have tended to outperform and exhibit lower volatility than the broader market. In fact, studies show that buyback announcements have historically led to a 3% jump in stock price on average, and that the subsequent average buy-and-hold return over four years was 12%” points out the strategist.

And he adds, “the chart below shows the dollar amount of share buybacks for companies within the S&P 500 Index since 2004, as well as the performance of the NASDAQ US BuyBack Achievers Index relative to the S&P 500 Index. A rising orange line indicates that the NASDAQ US BuyBack Achievers Index (BuyBack Index) outperformed the S&P 500 Index; when the orange line is falling, the BuyBack Index underperformed the S&P 500 Index”.

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So, according to the expert, while past performance is not a guarantee of future results, you can see that when the dollar amount of buybacks increased, as shown by the purple line, the stock of companies that repurchased shares (as measured by the BuyBack Index) generally outperformed the S&P 500 Index. Conversely, when the dollar amount of buybacks decreased, the stock of companies that bought back shares generally underperformed the broader market.

The benefits of international buyback shares

While stock buybacks have long been popular as a means of returning cash to shareholders in the US, they are also gaining favor internationally ­— particularly in Japan and Canada, poins out.

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“Investing in international companies with a history of buying back outstanding shares offers the added advantage of international exposure — including geographic diversification and, in some cases, more attractive valuations than US-based companies. With both interest rates and stock valuations currently low, I believe international companies will increasingly view share repurchases as a sound investment proposition and a means of enhancing shareholder value”, concludes.

The PowerShares International BuyBack Achievers Portfolio tracks the NASDAQ International BuyBack Achievers Index and provides diversified exposure to international companies that repurchase their own shares.

Revenge of the Bonds – Why a US Inflation Scare is Looming

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Presupuesto de riesgo: gasta con sabiduría
CC-BY-SA-2.0, FlickrPhoto: Scott Hudson. Risk Budget: Spend It Wisely

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair” – Sam Ewing (baseball player)

According to Aneet Chachra and Steve Cain from Henderson, discussing inflation far too often devolves into a cage match between the “deflation forever” team versus the “hyper-inflation is coming” camp. The former has gained the upper hand with ECB President Mario Draghi pushing through a comprehensive easing package while Google searches for “helicopter money” are surging.  However, based on recent economic data and the stabilization in commodities, a moderate pickup in inflation is more likely ahead. Meanwhile, the US Treasury Inflation-Protected Securities (TIPS) market appears to systematically underestimate future inflation due to structural reasons. Thus, bond markets and the Federal Reserve could be “behind the curve” necessitating two or more rate hikes in 2016 with a knock-on effect on medium-term yields. This is not a call for persistent, surging inflation, but rather a view that fixed income markets are overly optimistic in disregarding the risks of higher inflation.

February headline consumer price inflation (CPI) in the US was just +1.0% year-over-year (YoY), however core CPI (which excludes food & energy) rose +2.3% YoY, its highest reading since 2008. This wide differential was mainly due to lower commodity prices, especially crude oil which fell -32% YoY through February 2016. However, the March 2016 decline is much smaller at -20% YoY, and the futures curve projects that oil’s year-over-year change will turn positive during the fourth quarter of 2016.

Another deflationary force has been the rising US dollar which gained 20% over the last two years, reducing the cost of imported goods. But the year-over-year change for the dollar index just turned negative for the first time since mid-2014. This will gradually make imports more expensive for US consumers, although with a typical lag of 6-12 months.

Importantly, lower unemployment is finally driving higher wages with companies passing on some of the post-crisis profit margin expansion to employees. Fourteen US states have raised their minimum wage in 2016, with California (the most populous state) poised to further increase its minimum from $10/hour to $15/hour over the next five years. Labour markets have recovered not just in the US and the UK, but the unemployment rate in Japan is below pre-crisis levels. European unemployment remains elevated but has been improving since 2013.

Given all the above factors are widely known – why do TIPS still only forecast annual inflation of about 1.6% over the next decade? Perhaps TIPS prices are biased. There is an argument that TIPS should be expensive relative to nominal bonds as they are one of the few ways to directly hedge inflation risk.

But the available evidence since TIPS were launched in 1997 shows the exact opposite. Even with fairly benign inflation over the last 20 years, realized 5-year and 10-year inflation has averaged above TIPS-implied forecasts at issuance. The average gap has been about 0.35% per year ie. TIPS buyers have generally outperformed nominal bondholders.
 

Despite their valuable inflation protection qualities, why have TIPS historically been under-priced? Two reasons stand out. The first is their liquidity is poor relative to regular US bonds – traders joke the acronym really stands for “Totally Illiquid Pieces of Stuff”. Secondly, inflation expectations are often highly correlated to equity market moves particularly during large sell-offs. Hence TIPS do not provide the diversification to risk portfolios that other bonds do.

The generally negative correlation of nominal treasuries offer significant hedging benefits and are likely expensive to reflect this “crisis alpha” value – especially in the era of Risk Parity funds. Thus nominal treasuries are overvalued, TIPS are undervalued, and both distortions artificially compress the implied inflation rate forecast. An alternative measure that uses nominal 10-year yields minus trailing 12-month core CPI shows that real US 10-year rates are currently near 30-year lows of -0.5% per annum.
 

An interesting historical precedent is the 1985-1988 period when oil prices collapsed from above $30/barrel in late 1985 to below $10/barrel in 1986 pushing inflation lower. However, starting in 1987 (see black line below) a gradual rebound in oil prices drove a spike in CPI. This led to several Fed rate hikes and a significant selloff in US treasuries, with bond yields rising from 7% to above 9% within six months. 

“Although we are unlikely to see a bond selloff quite as severe as 1987 given sluggish world growth and low yields globally, fixed income markets appear to be ruling out even a modest spike in rates.  We should also not underestimate the highly stimulatory effects of cheap energy on importing nations where offsetting shale oil industries do not overwhelm them – eg. the Eurozone and Japan.  Remarkably, Fed funds futures are only pricing in one rate hike this year, while US 10-year yields have fallen about 30bps in the last five months despite a concurrent 40bps rise in core CPI. Stronger inflation data and consequently a rise in bond yields appear to be an underappreciated risk,” they conclude.

Source: Bloomberg, as at 30 March for all data, unless otherwise stated.
 

The Reserve Bank of India is Focusing on Liquidity and Transmission

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Las nuevas medidas del banco central de la India juegan a favor de su renta variable
CC-BY-SA-2.0, FlickrPhoto: Koshy Koshy. The Reserve Bank of India is Focusing on Liquidity and Transmission

In his latest white paper, Paul Milon, Investment Specialist, Indian Equities, Hong Kong at BNP Paribas Investment Partners talks about the Reserve Bank of India’s decition to  cut its key policy repo rate by 25bp to 6.50% on 5 April 2016. in what he believes was a widely expected move.

“The 25bp repo rate cut was widely expected by financial markets. By January 2016, Consumer Price Index (CPI) had met the central bank’s target of 6% and now seems on track to be at 5% by March 2017. Moreover, the budget announced on 29 February supported the government’s commitment to fiscal consolidation. Despite the pressure on expenditure from the implementation of the 7th central pay commission, the budget maintained the government’s fiscal reduction targets aiming for a deficit of 3.5% of GDP for FY2017, down from 3.9% for FY2016.”

He mentions that as well as the rate cut, the RBI has also taken several steps to improve liquidity and transmission. “While the cash reserve ratio (CRR) was unchanged, the minimum daily CRR was reduced from 95% to 90%. Additionally, the Marginal Standing Facility (MSF) rate was reduced by 75bp to 7% and the reverse repo rate was increased by 25bp to 6%, leading to a narrowing of the policy rate corridor from +/-1% to +/-50bp around the repo rate.

These measures to improve liquidity, combined with the recent introduction of the marginal cost of funds-based lending rate (MCLR) on 1 April 2016, are likely to lead to better monetary transmission. Since the implementation of the MCLR, fresh lending rates have already declined by around 25bp and are expected to decline further following April 11th’s measures.

Following this rate cut, the RBI is likely to remain cautiously accommodative. In assessing further moves, the RBI will monitor a) the CPI inflation trajectory along with the 5% target by March 2017; b) monsoon development as deficient rainfalls could lead to higher food inflation; c) the inflationary impact of the roll-out of the 7th pay commission; and d) evidence of transmission of prior policy rate cuts into lower lending and deposit rates.

In light of the inflation dynamics and RBI’s targeting of 1.5%-2% positive real rates, there may be room for another 25bp rate cut later this year, pending sufficient monsoons occurring.

Following the rate cut, banks are expected to lower their deposit rates, which may lead to more domestic investors shifting part of their assets from deposits to equities, providing some support to the Indian equity market.

He concludes that “More broadly, the accommodative monetary policy stance – with a focus on improving liquidity and policy transmission – is expected to help India’s economic recovery, especially as lower lending rates should lead to a pick-up in credit growth. The RBI continues to expect India to grow at 7.6% as measured by Gross Value Added (GVA) for the financial year ending in March 2017 (FY 2017), the fastest growth rate among large economies.”

Fannie Wurtz appointed Managing Director, Amundi ETF, Indexing & Smart Beta

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Fannie Wurtz, nombrada managing director de Amundi ETF, Indexing & Smart Beta
Photo: Fannie Wurtz. Fannie Wurtz appointed Managing Director, Amundi ETF, Indexing & Smart Beta

Amundi continues to develop its ETF, Indexing and Smart Beta, which are major components of the Group’s strategy. In this context, Fannie Wurtz is appointed Managing Director of the ETF, Indexing and Smart Beta business line under the supervision of Valérie Baudson, member of Amundi’s Executive Committee.

Fannie Wurtz is Managing Director of ETF & Indexing Sales at Amundi. Prior to joining Amundi in February 2012, she was responsible for ETF Institutional Sales and Amundi ETF business development with French & Swiss institutional clients at CA Cheuvreux from 2008.

In addition, the Board of Directors of CPR Asset Management has appointed Amundi’s Valerie Baudson as CEO of the company. CPR Asset Management is a subsidiary of Amundi which manages, in particular, thematic equities with close to €38bn in assets under management.

The CPR Asset Management Board of Directors has also promoted Emmanuelle Court and Arnaud Faller, respectively, to Deputy CEO heading business development and Deputy CEO heading investments. Nadine Lamotte has been confirmed as Chief Operating Officer responsible for Administration and Finance. The above named make up the Management Committee which also includes Gilles Cutaya, Head of Marketing and Communication.