Investment process | CFSGAM

Duration strategies are based on comparing ten year bond yields with fair value (long run inflation plus a real yield hurdle). When yields exceed/are below fair value, duration will be longer/shorter than index. However, valuation alone results in excessive tracking error, by resulting in positions that are too large, too early in the cycle. Thus, short term risk management tools (economic momentum and trend analysis) are used to influence the size and timing of strategy changes to optimise value for risk.

Positioning along the yield curve is based on the relative value of different maturities rather than the absolute level of yields. Factors considered include the slope of the curve relative to long run levels; cost of carry; the bias of monetary policy; economic cycle risk, measured by leading economic indicators; and the strength of the trend. The goal is not to enter positions too aggressively too early in the curve cycle, but to be well placed to benefit from significant moves back to normal curve levels.

The sectors covered are: government, semi-government, swap, corporate bonds and high yield. When a sector’s average spread is wide/narrow compared with fair value the bias is to over/underweight that sector. Fair value is a spread level that compensates for credit and liquidity risk. The size and timing of allocation changes takes short term risks into account, including macro fundamentals (such as default expectations), relevant policy factors (eg state government budgets) and trend analysis.

Within inflation-linked bond (ILB) portfolios, several other processes are applied, nuanced for the nature of ILBs. In particular, duration strategies compare traded real yields with real fair value, while sector allocations are based on the relative value of real spreads between government and other issuers, in both cases taking account of shorter term market risks. In addition, the relationship between ILB and nominal bonds enables Break-even Inflation (BEI) strategies to be applied – effectively switching between the two markets when their pricing becomes misaligned.

Our credit process aims to capture and keep the yield and return premium that corporate bonds pay to investors. We measure and manage both expected and unexpected potential losses, through research and quantitatively driven portfolio construction. In-house credit analysis keeps us abreast of changes in credit quality of our holdings, while our risk tools measure VAR and tail risk at the portfolio level, enabling us to construct portfolios which are highly diversified both by industry and (where applicable) country.

Our credit research marries a thorough assessment of fundamental and quantitative factors. Fundamental analysis covers industry, business and financial risk, as well as Environmental, Social and Governance issues. The result is an internal credit rating and an estimate of loss given default. All exposures are reviewed daily to monitor changes in risk. Key events such as a material change in fundamental or quantitative factors, trigger a full review of the relevant issuer.