Point of View With Josh Tarnow and Michael Phelps

Overview:

  • The volatility in interest rates is threatening traditional bond returns. Investors should consider an alternative approach to fixed income that seeks to mitigate interest rate risk while offering attractive returns and diversification.
  • Add global markets to find more opportunities. Expanding the investment horizon to include global credit markets can offer more opportunities for attractive total return.
  • A long/short strategy seeks to minimize interest rate risk, offer more consistent results and take advantage of opportunities in both up- and down-markets.

For investors who were driven into cash by fears of equity or interest rate risk, a long/short credit strategy is a way to re-invest that can help reduce these risks.

With interest rates volatile and near historic lows, fixed income investors can no longer rely on declining interest rates to generate total returns going forward, and we believe they need to consider alternative solutions. BlackRock fixed income credit experts Josh Tarnow and Michael Phelps discuss the opportunities in global credit and potential benefits of an allocation to fixed income through a long/short strategy.

  • The volatility in interest rates is threatening traditional bond returns. Investors should consider an alternative approach to fixed income that seeks to mitigate interest rate risk while offering the potential for attractive returns and diversification.
  • Add global markets to find more opportunities. Expanding the investment horizon to include global credit markets can offer more opportunities for attractive total return.
  • A long/short strategy seeks to minimize interest rate risk, offer more consistent results and take advantage of opportunities in both up and down markets.

Markets have been volatile—how can I protect my bond portfolio?

It's been a tough ride for many investors over the last year. Up and down, but still historically low, interest rates are at the center of that volatility. Concerns in the interest rate market have resulted in losses and uncertainty for many bond investors. As you probably remember, from May to July of 2013, spikes in interest rates seemed especially painful for those invested in traditional fixed income strategies. That volatility bled over into credit and equities, resulting in losses there too. Because interest-rate-sensitive bond funds can be hammered by a rise in interest rates, investors should consider looking for potential solutions that can provide consistent returns independent of the interest rate environment.

What do you suggest?

Amid some of the short-term hiccups that credit and equity markets have seen recently, a long/short approach makes sense because it allows you to take advantage of both sides of the market. Such an approach can provide diversification of risk, and while that does not ensure a profit or protect against losses, it can provide more consistent results over time.

A Long/Short Credit Strategy Offers Diversification


Long/short investing does entail special risks. Short sales in securities that increase in value can cause a loss of principal. Any loss on short positions may or may not be offset by investing short sale proceeds in other investments.

Where do you see opportunities?

In traditional markets, we believe that investment grade and high yield bonds, as well as bank loans, continue to offer attractive opportunities. We feel strongly that investing in non-US bond markets benefits a portfolio, as it essentially double the opportunity set (see the chart below). Specifically, European high yield bonds continue to be a rapidly growing segment of the global credit market, and we expect to see European bank loan issuance pick up in 2014 alongside the growth in the bond market. Also, we believe European sovereign bonds are attractive vehicles for relative value trades or hedges as the changing dynamics in Europe with European Central Bank policy, merger-and-acquisition (M&A) activity and regulatory changes are presenting opportunities for long/short trades. While Asian markets can represent good value, our focus to date in exercising the strategy has been primarily in US and European markets. That's not to say we can't or won't invest in Asian credit—we absolutely have that flexibility.

Adding International Credits Doubles the Opportunity Set


Investors should note that international investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments.

Finally, it's important to look at opportunities up and down the capital structure, including equity-related securities. While we have been limited in our exposure, equities can be used for hedging purposes, or to express a tactical view, either outright or versus credit. Along that theme, we have seen a recent increase in opportunities related to convertible bonds, which have both bond and stock characteristics. A caveat: Anytime we use equities, it's very important to focus on the most liquid portions of the market so that we can effectively manage our risks.

Do you consider other types of investments?

Outside of bonds, we have mentioned equities, but we haven't talked about the importance of derivatives. Derivative markets play a vital role for hedging, expressing a positive or negative view on a security or sector, and most generally, optimizing overall credit exposures. While investing in derivatives comes with its own set of challenges and risks, it brings increased flexibility and efficiency to the investment process. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility.

Credit derivatives, such as credit default swaps, can allow us to take unfunded credit positions, which provide flexibility in expressing credit risk with what we believe is very deep liquidity. Shorting bonds can be an inefficient way of expressing a negative view, because the less-liquid nature of fixed income markets along with potentially costly borrowing can be unattractive. Depending on many factors (including liquidity, pricing, and the general market environment), derivatives overall can actually offer a better, more flexible, or more liquid—and, therefore, more efficient for our investors—way to express a view on credit than by using bonds.

How do factors such as currency risk and interest rate risk impact a long/short strategy?

As global credit managers, we believe returns should come primarily from management of our views on credit. In order to isolate returns from credit, we aim to hedge out the other risks associated with investing in global fixed income, such as currency risk and interest rate risk. That means implementing interest rate hedges on each and every trade we do in the portfolio. For non-U.S. investments, not only will we seek to hedge out duration, but we also look to eliminate foreign currency risk by hedging back to the U.S. dollar. The mechanics of such a trade are illustrated below. Part of the importance of derivatives can be seen here—we can use futures and interest rate derivatives to mitigate duration risk for bond investments. We can also use foreign exchange forward transactions to seek to hedge out our non-U.S. dollar currency risk, as demonstrated. While different bonds and investments will have different hedges, the concept remains the same—we believe it is important to hedge positions individually and refresh them daily to ensure we're properly hedging. We're also always looking at places where duration could creep into the portfolio. For example, in May and June 2013, when interest rates spiked higher, some of the crossover (closer to investment grade) names in high yield began to trade with higher correlation to interest rates than they historically have. When we see that, we re-assess our strategies to determine how we can most efficiently hedge our investments.

Using Derivatives to Isolate Credit Risk

What catalysts are creating opportunities in global credit markets right now?

With the absolute level of yields and spreads being low right now, we think the opportunity set in 2014 could be more absolute return-like in nature, versus the last two years in which investors have benefited from a more traditional buy-and-hold strategy. Over the next year, we expect corporate activity broadly to increase, mainly in the form of M&A and corporate restructurings. It will be important to be flexible and nimble to capitalize on that, and we think a long/short approach is best poised to do so.

We're particularly excited about the opportunity set in Europe given some of the macro factors at play in the region. As inflation continues to decline, the European Central Bank could move into a round of non-traditional monetary policy. While the market will constantly be wary of such a change, we think supportive policy—along with a lack of yielding products—will be a positive for European credit.

On a related note, we also see the European Central Bank moving toward a regulatory role for European banks. They have been implementing a "Comprehensive Assessment" of banks in the region, consisting of an asset quality review and risk assessment of each bank's balance sheet. Additionally, new and rigorous stress tests are taking place, which we believe will identify stronger and weaker banks. Ultimately, we believe there will be winners and losers out of this process, with winners and losers up and down each bank's capital structure, presenting tremendous opportunities for a long/short manager.

What should investors be concerned about in credit?

A major concern in global credit markets is the current level of yields, which are not particularly compelling from a return perspective. For instance, European high yield, which was fairly cheap relative to U.S. high yield this time last year, is now trading at less attractive levels overall. This is just one example. So we're seeing it become much more of a security selection story. From a fundamental perspective, eventually companies are going to start taking advantage of this low interest rate environment and put more leverage on their balance sheets. That will be negative for credit but positive for equity and could create long/short opportunities within the capital structure. While supply and demand technical factors are supportive now, we could see them loosen over the next year, with dislocation becoming more apparent as volatility picks up. These potential shifts in fundamentals and technicals could disrupt long-only managers and could prove beneficial for long/short managers who are able to capitalize on the opportunities. This underscores the need for flexibility in managing a long/short credit strategy and highlights the importance of looking broadly at asset classes, including bonds, stocks and derivatives.

How do you identify and implement areas of risk and return in credit?

Following the incredible rally in credit over the last two years, security selection is becoming increasingly more important, as is the experience of a long/short manager. So having a team with expertise and a track record in identifying long AND short opportunities is critical. Three components make up our approach: our allocation toward traditional risk, then our allocation to alternative and absolute return strategies, and finally, how we hedge our overall risk. It's that second bucket we believe will drive returns going forward, where we employ alternative approaches to traditional asset classes. In terms of hedging, we may look to hedge all of or a portion of the market risk in our traditional strategies, and sometimes our absolute return strategies, to the extent there is residual market risk coming from there.

How should an investor incorporate a credit strategy into their portfolio?

Investors can utilize a long/short credit strategy in several ways. For those who wish to reduce interest rate risk, a zero duration credit strategy offers diversification potential. Additionally, employing a long/short strategy offers a way to pare back risk from a long-only credit allocation. Finally, for investors who were driven into cash by fears of equity or interest rate risk, a long/short credit strategy is a way to re-invest that can help reduce these risks (though it's important to remember that in a long/short credit strategy, you're still taking on credit risk). Given the challenges of managing market, credit, interest rate and other risks, we recommend that investors rely on a proven professional manager to oversee their investments across the fixed income universe.

Adding the Global Long/Short Credit Fund Can Help Decrease Volatility and Duration

Absolute return investment techniques include using short selling, futures, options, derivatives and arbitrage.

Investing involves risk, including possible loss of principal.

Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets. Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility and in general, are not suitable for all investors.

Keep in mind that a long/short investment strategy may not perform as expected and the value of securities purchased long could decrease and/or the value of securities sold short could increase, thereby multiplying the potential for losses.

There is also the possibility that long and short strategies could both fail, thereby increasing volatility and potential losses.

Asset allocation strategies do not assure profit and do not protect against loss.

Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses which may be obtained visiting the iShares ETF and BlackRock Mutual Fund prospectus pages. Read the prospectus carefully before investing.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio managers profiled as of July 25, 2014, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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