Puts Protect the Downside for Government Bonds
By Daniel P. Arsenault, FRM, CFA Investment Director – Equities
Daniel P. Arsenault
Investment Director – Equities
Over the past 20 years, balanced funds – funds which invest in a mix of bonds and equities, managed to some strategic mix – have enjoyed relatively consistent positive returns. Canadian government bond yields have fallen precipitously since hitting a peak in April, 1990, and equity growth has been strong despite trudging through several severe recessions. In today’s environment, however, equity returns are expected to be lower than in previous years, and bond yields have little room to fall further. We believe professional money managers need to focus now more than ever on structural downside protection to maintain growth potential. It is the safeguarding of capital during periods of market stress – preserving capital to invest later – that is fundamental to achieving long-term financial goals. For this reason, as of November 4, 2016, the Mackenzie Ivy Team has implemented a put option strategy on the bond exposure in the balanced funds managed under the Ivy banner. This Team’s equity strategies have always been synonymous with downside protection, and now similar protection has been brought to the fixed-income portion of their balanced portfolios.
The Mackenzie Ivy Team believes that this combination of downside-protection strategies makes the Makenzie Ivy Balanced funds unique in the Balanced peer group, and offers clients significant protection in both equity and bond spaces.
Global government bond yields have declined consistently over the past 25 years. Yet predicting rates is just plain hard (impossible?) to do. Rates are currently near historic lows, yet economic growth is not nearly high enough to entice those investors into riskier assets. And despite periods over the past several years when the consensus has been rates will rise, we have seen global evidence that “low” can turn into lower, or even negative (!).
Going Short Duration
One traditional strategy for dealing with the expectation of rising yields is invest in similar bonds with shorter terms, so the price impact of the higher yields is lessened –going short duration. While these bonds may go down in value as a result of the yield move, the move will be muted. Everything else being equal, shorter-dated bonds lose less when yields rise.
However, in this strategy the reverse is also true; if yields fall then the shorter-dated bonds will rise less. In a balanced fund, where the fixed income portfolio often functions as a ballast against equity market volatility, shortening duration beyond a certain point may not be desirable for the overall volatility of the fund’s returns. In addition, shorter-dated bonds generally pay lower yield, all else equal, so the manager being early (or, indeed wrong) on their rates prediction for higher rates would result in a lower portfolio return as a function of lower coupon payments.
Ivy’s Put Option Strategy
The fixed income portfolio managers will continue to actively manage the duration and yield curve positioning of the Mackenzie Ivy Balanced funds. In addition, structural steps were taken to perpetually limit the downside associated with interest rate risk in the balanced funds managed by Mackenzie Ivy. In November 2016, the Team initiated positions in out-of-the-money put options on government bonds in its two balanced funds:
The purpose of the put options is to shield the funds from the interest rate risk of the bonds. This was not a tactical call on interest rates. Rates may indeed go lower long before going higher. The put options, which rise in value as the price of bonds fall, provide protection for the bonds in the portfolio, and will act as a structural brake on losses should rates rise. Simply, the put strategy is designed to mitigate losses should interest rates rise significantly and the bonds fall in value. This strategy also gives this protection without sacrificing upside participation if bond yields stay low, or indeed fall further. The two balanced funds have, in effect, purchased insurance for the bonds in the portfolios.
If rates go down further or stay where they are, then the funds will lose the cost of the puts. However, if rates rise then the puts should increase in value and the gains on the put positions would offset losses in the bond portfolio.
To illustrate, below we show a hypothetical example of one-year returns in a portfolio with five years duration and a yield of 2% per annum, for successive increases across the yield curve. Though the cost of the put options will change over time, this picture should give investors a better idea of the effects the puts have in the bond portion of the portfolio. At the time of implementation in the two funds, the cost of the puts was about 40 basis points (bps) per annum on the fixed income portfolio, or about 10 bps per annum for the entire fund.
Balanced funds diversify the sources of portfolio risk across bonds and equities in an attempt to achieve a more consistent investor experience over time. The Mackenzie Ivy Team has long embedded downside protection in equity portfolio management – high-quality companies with defensible competitive advantages are purchased at reasonable valuations. The funds’ stocks are chosen, in part, for their ability to withstand market and economic downturns.
But bonds in Mackenzie Ivy Balanced funds have been without such direct intentional downside protection, although risk management has always been a top priority. With this enhancement to the two Mackenzie Ivy Balanced funds, we believe that downside protecting equities, diversifying bonds and fixed-income put protection now offered give investors peace of mind and downside protection unmatched elsewhere in the market.
Please contact your financial advisor for more information about Mackenzie Ivy Balanced funds.