COMMODITY INCOME
market beta and default risk. At this time, default rates are low in HYB’s by historical standards, but if yields start to rise, we may see the ‘worst case scenario’ in which credit risk takes over. In such an event, the most risky government
and corporate bonds would be dumped and prices would plummet. (Incidentally, it is entirely reasonable to assume that equity prices would follow suit.) We can all easily envisage more horror stories
from the bond markets. The most recent idea that we have noted in the financial press is “Risk Parity”,6
a posh term for a silly but far
from risk-free strategy, whereby bonds are leveraged in order to behave like stocks, and then combined with stocks in a portfolio in order to take advantage of the negative correlation between the two classes. Magically, by increasing the leverage of the bond portfolio, investors are lowering the risk of the portfolio? We think this unlikely. The last time we checked, bonds were a “debt”
security (by definition, a leverage on assets) and we are unaware of many investable stocks that do not already carry debt at vertigo inducing levels. We have back-tested the behaviour of this strategy by using the S&P500 Index for stocks and the Dow Jones Corporate Bond Index for bonds. We leveraged the bond index to reach the standard deviation of the stock index – as the Risk-Parity strategy maintains. The findings are nothing short of ghastly:
Source: Bloomberg for US0001M Index
is to combine the certainty of a weak income with the strong likelihood of a capital loss.” Sad but true. History shows that the “capital loss” to which Authers
refers would, to all intents and purposes, be impossible to recoup in bond markets for very many years. Despite all this, bonds remain in great favour with investors and global assets in bond funds continue to rise. Why is that? Is it because investors think they can
ride the bubble before it bursts or is it that they (or their advisors) are bereft of any other ideas?
HYB’s in particular present a substantial threat to investors. Despite the risks, their yields have fallen below 6%, for the first time in history
drawdowns of 63%, average 5%-tail losses of 17% and a value at risk of 11% – all three being worse than those of a portfolio made exclusively of stocks. As the much respected John Authers recently wrote in his Financial Times column: “So to buy [bonds] now
Drilling Down For Secure Yield
THE PREVIOUS TWO sections present a conundrum: how to combine the high return of oil with the low volatility of fixed income without being exposed to the high standard deviation of the former and the downside potential of the latter? It has been shown that exposure to oil is an excellent
hedge for bond holdings, as its returns are negatively correlated with bond index returns at all maturities. It follows that at the very least, it would be sensible
for investors to consider collateralized bonds or their equivalents in which the value of the collateral protects not only against default, but also against the interest rate sensitivity in plain vanilla bonds. More specifically, bonds secured by proven oil assets. Surely, it seems obvious that, if the structure is right, oil (and perhaps other commodities) can reduce the
risk and enhance the return of bond portfolios. As an example of a new and innovative type of
‘alternative bond’ income investment, we describe the Insch Insight Ltd – Black Gold7
(BG), a secured income
investment derived from oil revenues. We see this type of investment as an excellent source of yield and a hedge for bond portfolios against rising interest rates and inflation. Of course, BG is not suitable for, or available, to many
categories of investors or within certain jurisdictions but, by merely making some simple comparisons, deficiencies of bonds are starkly revealed. Basically, BG allocates the capital to loan notes
secured by licenses on fully proven oil resources from producing properties, predominantly located in Canada. Protection rights over the licenses and
March 2013 61 Perhaps they hope to ‘time’ the market? The fact is
‘market timers’ get trampled in the stampede for the exits. No matter what representation is made and no matter who is making it, market timing is the most difficult (impossible?) investment strategy.
Figure 8: US 1 Month LIBOR
-2 -1 0 1 2 3 4 5 6 7 8
US 1M LIBOR forecast
US 1M LIBOR
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
%
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