Political uncertainty changes the way bond portfolios are managing risk

Published on 28 December 2018

Political uncertainty changes the way bond portfolios are managing risk.

In December’s show Kay Swinburne MEP, Vice-Chair of the European Parliament’s Committee on Economic and Monetary Affairs and Luke Hickmore senior investment manager at Aberdeen Standard discuss how Europe’s political landscape might impact investment and trading decisions; Lee Bartholomew, head of Derivatives Product R&D in Fixed Income at Eurex outlines the way that derivatives might be used to manage event risks and provide possible solutions approaching for 2019 in fixed income.

Dan Barnes Welcome to Trader TV Fixed Income – your insight into the trading climate for professional bonds investors. I’m Dan Barnes. In December’s show we’re talking with Kay Swinburne, MEP, Luke Hickmore, senior investment manager at Aberdeen Standard, and Lee Bartholemew, head of Derivatives Product R&D in Fixed Income at Eurex, about some of the big potential shocks hitting markets in 2019 and how asset managers need to manage those risks. Luke, Kay, welcome to Trader TV.

Kay Swinburne Thank you.

Luke Hickmore Thank you.

Dan Barnes To start with, Kate, could you outline some of the potential scenarios that we’re looking at with Brexit in Europe going into next year?

Kay Swinburne So, there is a lot of attention being paid right now to what’s going on in Westminster, but, of course, given what’s going on at the moment, it’s unprecedented. I wouldn’t like to say that this would be done by the end of the year; everybody has fingers crossed and, hopefully, that is the result that comes out. But of course, as soon as you’ve got Westminster ratifying the transition deal, you then have to actually factor in that the European Parliament itself, 751 members, have a vote. There are lots of things that if you were trading these markets in terms of just the timeline for this Brexit deal, there are lots of things that could, I presume, trip you up if they go the wrong way.

Dan Barnes Luke, can I bring you in there? I mean, how can you model these risks within the portfolio, potentially?

Luke Hickmore Really what it does for us is, it reduces your time scales. So, as a fundamental investor, you want to be looking over three, five year kind of horizons. Right now, my horizons are coming down to almost daily, and that makes it very, very difficult about how you trade these events. The thing you do know is there’ll be higher volatility, so you start protecting yourself against that. That might be for us going longer duration, taking protection in credit markets. For others, they may look at option strategies, but that’s the biggest risk that we’re going to face, that you could do something about over the next four, five, six months when you’re using derivatives.

Dan Barnes Does that actually potentially increase the risk in the portfolio?

Luke Hickmore Well, it does increase risk if you’re not very aware of the impacts they can have. You can lose the correlation with the physical assets. If you’re using fx CDS indexes as a hedge against your credit fund, it works really well when there’s stress. Right at this moment this is a great example of that. It doesn’t work very well when the correlation breaks down and you have to be able to move quickly if that change happens on you.

Dan Barnes And Kay, can you give us an idea of how the regulatory framework stands, support investments at the moment and how it might change?

Kay Swinburne So a message that your investors are probably not wanting to hear is that I suspect the European legislation is about to change all over again. And they’re not major changes, so it’s not a MiFID III-type piece of work, but every single piece of legislation that’s currently open and due to close before the end of this mandate in May, one expects that they’re going to be small changes. There’s an investment firm review fx, which is looking at changes to definitions in MiFID, as to what is an investment firm? So fundamental changes in definition, which could change the scope of MiFID II. So, I’m not sure we’re out of the woods yet in terms of the legislative change. We’re seeing changes on CCP location policy where a client might be allowed to clear all of their product. So if you have a swap, which involves a euro denominated leg of it, what happens to the other half if you’re forced to clear one bit of it in the eurozone? There are all sorts of political motivated, legislative changes happening, which are maybe blurring and and concealing the underlying MiFID II objectives of how do you get fair and transparent market activity, to help the buy-side position for their investors.

Dan Barnes And so Luke, what’s your advice for end investors who are talking to their asset managers about event risk in 2019?

Luke Hickmore Make sure that they’ve got a full toolset and that they’ve got a lot of flexibility in the powers of their fund as well. This is going to be a market where we face a lot of change very quickly and you’ve got to be flexible and able to move your assets in a way that makes sense and protect your investors through some pretty volatile times over the next year or so.

Dan Barnes That’s great. Thank you. And Kay, finally, do you have a word for investors’ pension funds who are looking at the way that European legislation might change in the future? Is there anything they need to be doing in terms of trade bodies, trade associations, lobbying?

Kay Swinburne Well, I think they need to be aware that there is a move in Europe to try and put as much of the trading for European investors into the EU 27 when the UK leaves, and that is a genuine motivation. But one of the things I think probably dwarfs all of the changes that they might put in place, is the change of head at the ECB next year, which whilst you’ve got European elections going on, you’ve also got the new commission coming in. You’ve almost got a cover – the perfect cover – for the new head of the ECB, the new president. And for the fixed income markets: now that they have a three trillion plus euro balance sheet, which is very, very full of fixed income instruments, both corporate and government bonds, one actually has to wonder who the next president is going to be, and what that strategy might do to impact other investors’ portfolios over time.

Dan Barnes That’s great. Thank you. Luke, I see you nodding there, what’s your view on that concern?

Luke Hickmore So, I think it’s quite interesting. In the sterling market we’ve been used to five big investors in this market, which changes the liquidity pattern pretty dramatically. In Europe we’re now getting used to one big, 14-percent owner and pretty much everything in the credit market in Europe. That’s going to change the liquidity situation pretty dramatically as well. And I think we’re just starting to see the response to that, the feel of it in the market right now, during the stressful times when liquidity just dries up very, very quickly, when you’ve got one big hold or a few big holders in the market. And it’s going to take a while for the market to get used to that. And I suggest we’re going to get a lot more use of derivatives and ETFs as ways of laying off risk or putting risk into portfolios because of that change, which brings its own risks as well. Knowing where things are clear, it is going to be so important over the next six months to a year, and yet at the moment, it’s still pretty obscure.

Dan Barnes Kay, Luke, thank you for coming on.

Kay Swinburne Pleasure.

Dan Barnes Now we’re going to speak with Lee Bartholemew, head of Derivatives Products R&D for Fixed Income at Eurex, about the way derivatives can be used to handle event risk in fixed income markets. Lee, welcome back to Trader TV.

Lee Bartholomew Dan, thank you very much for having me back.

Dan Barnes So can you tell us how are derivatives used to take risk on and off in a portfolio when there’s a very known event coming up?

Lee Bartholomew I think there’s two things. One, it doesn’t matter whether the risk event is known or not known. And then it’s purely down to how you construct your portfolio. So, I think if you’re a total return type investor, but you’ve got short duration portfolio, you’re going to position differently from a long term fundamental investor who may be long duration in terms of your outlook. So, I think the type of instruments that you use differ for both, but also in terms of the thought process, I think if you look at what an asset manager has now done, I think with the investment time horizon is less Why? Because margins are under pressure, because we don’t have volatility around for any sustained period, but when we do have it, it’s volatile. One thing that you’ve seen in 2018, and this will help us kind of understand what goes on in to 2019, is you’ve had electronification and the growth of more platforms, which means in an OTC perspective, some of that liquidity has been split across two or three, maybe four platforms. I think in Europe, within certain segments, I would say definitely in the Italian BTP segment, we’ve seen that volume because we have that listed market, and what you’ve seen there is the markets have held up pretty well in the most volatile times. And I think that is testament to some of the products that we have on board, but also giving the end clients an access to the market where you can go in and out quickly.

Dan Barnes And where portfolios are using derivatives, how does the risk profile of the portfolio change?

Lee Bartholomew I think, again, it depends upon what type of asset manager you are. So, if you’re looking at tactical, then you tend to keep your duration shorter, you tend to keep the portfolio more constricted to a listed space or to short term instruments, i.e. out to three year swaps. You’re looking at different futures, you’re looking at the basis between listed and the OTC space. You know, if you are an LDI manager, then you’re looking for longer duration, you’re looking at kind of a balanced portfolio in terms of your remit of generating alpha, while maintaining your beta management. The other point which I would make is you need now to take into account, a lot more so if you’re an asset manager, you’ve got to look at the cost of putting the transaction on, the liquidity, the depth, so thinking for a new product; can it replicate your portfolio? And I think a lot more products now are being used within that toolkit for an asset manager, in order to generate returns as well as keep ahead of the benchmarks.

Dan Barnes How have derivative instruments better evolved to help firms manage risk?

Lee Bartholomew I think it’s not just about the products evolving, it is about the number of tools at the traders’ disposal or the portfolio managers’ disposal now. With the advent of technology the world has gone data obsessed and I think asset managers have gone margin obsessed. Looking forward to 2019, it’s all about, ‘what instruments can I put within my portfolio to reduce my margin, but which can give me a better chance of making a return?’ So I think what people now look at is the amount of analysis that gets done before a position gets executed, on what avenue and venue do we execute it, so, ‘do we do all listed? Do we go all OTC? Do we do cash? Do we do bonds?’ And I think it’s looking at that complete, holistic portfolio, and then looking at the size of the position for the liquidity. I think a lot within Europe gets done between what’s in the order book vs what’s done in the off book, and for an asset manager, it’s important to know that you can get the risk done at the price that you want to do. As you evolve more and more, it’s about deploying the different tools at your disposal, so; ‘which part of your portfolio do you auto-execute? When do you use your algorithms? When do you use voice?  Which counterparty do you use?’  All of it is in what I call the TCA,  and I think that’s really the drive going forward for 2019, which is more margin efficiencies.

Dan Barnes That’s great. Lee, thank you very much.

Lee Bartholomew Thank you very much for having me.

Dan Barnes I’d like to thank Kay Swinburne, MEP, Luke Hickmore of Aberdeen Standard, and Lee Bartholemew from Eurex, for their insights into 2019, and of course, are you for watching. To catch our monthly reports on other markets or to subscribe to our newsletter, go to TraderTV.NET.