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Flexible credit: the upside of downside protection

To successfully manage downside risk, dynamic and flexible allocation allows investors to handle market shifts with greater flexibility and security. You will need to be aware of the tools available to you to preserve capital and to take risk when the chances arise.
Flexible credit: the upside of downside protection

Flexibility always has a place, but now more than ever during this period of volatility as its capacity to provide a level of downside protection makes it particularly important. Here we explain why credit investors cannot afford to just rely on rates and diversification for protection. We also consider the robust suite of tools needed to preserve capital during market sell-offs and help protect our ability to take risk when opportunities are greatest.

Diversification: still on the menu?

Harry Markowitz, the Nobel Prize winning economist and godfather of modern portfolio theory, famously remarked that diversification is “the only free lunch in investing” – and although multi-asset credit benefits from decorrelation across sub-asset classes, the rise in correlations[1] have eroded the impact of diversification in recent years (see figure 1).

Fig 1. Don’t depend on diversification  

Fixed income asset class correlation (36m rolling v US government bond)

Sources: Federated Hermes, Bloomberg and Bank of America Merrill Lynch as at 31 July 2019. Note: The R coefficient is a numerical output used as a correlation measure tool between two variables.

Of course, there is value in adding diversifying sources of return by investing across different sub-asset classes but, given rising correlations, diversification alone should not be considered an adequate source of downside protection.

Dynamism is vital

To successfully manage downside risk, we believe dynamism is vital. Dynamic and flexible allocation allows us to respond to market changes with greater flexibility and security – that is, adjusting portfolios to seek optimal sources of value throughout the cycle.

Another way in which we aim to preserve capital is through our ability to access a broad spectrum of liquid credit. This allows us to leverage our credit view across all debt instruments, gives us the ability to diversify our sources of alpha generation, and respond to changes in the market. We exploit relative value through high-conviction name- and security-selection.  We also believe in active management predicated upon bottom-up, fundamental stock picking within a top-down framework. The discipline of assessing and pricing credit, environment, social and governance (ESG) and liquidity risks is deeply ingrained in our investment process. ESG integration is a valuable tool for both downside protection and alpha generation through engagement on key issues that can impact the enterprise value and cash flows.

Broadening the toolbox

We aim to protect capital and enhance convexity by using an expanded set of tools: these include single-name credit default swaps (CDS), index CDSs and options on the index.

Indeed, within our credit team, we express a myriad of different views, and our views of the market will inform whether we use just one or a combination of these products to both seek to preserve capital during broad, adverse market moves and exploit opportunities when they arise.

Effective risk management is also an integral part of the investment process and so, using a centralised hub to manage portfolio risk is essential. Every day, we review our portfolio hedges using a proprietary dynamic duration-management tool that calculates the suggested hedge by currency and part of the curve based on current positioning, market environment, shape of the interest rates curve and correlations. We subsequently review the results and adjust the hedge as appropriate.

Fighting risk with risk

Naturally investors will want to protect themselves from extreme scenarios. By simulating the performance of the global high-yield market (which is long-only by definition) compared to a global high-yield portfolio that uses options and index shorts as a hedge, it suggests that the latter will outperform the benchmark if spreads widen in the wake of a market correction thanks to the convexity provided by options (see figure 2). Such a simulation demonstrates the potential benefit of embedding options- and index-based strategies into our portfolios and highlights that options exposure can reduce the impact of market shock.

Fig 2. Scenario analysis: the appeal of downside protection.

Source: Federated Hermes as at January 2020. For illustrative purposes only.

Indeed, adopting such a flexible approach enables us to mitigate risk more effectively than solely relying on rates and diversification – and it may also enhance upside growth too.   

For more information on our flexible-credit capabilities, click here.

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

For professional investors only. This is a marketing communication. The views and opinions contained herein are those of the Credit Team at the international business of Federated Hermes, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”).


[1] A rise in correlations limit the ability of fixed-income instruments to preserve capital in periods of volatility.

¬ Haymarket Media Limited. All rights reserved.
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