17.04.2019  reading time: 5min

Dynamic Barbell Strategy

When we are dealing with the last period of the economic cycle, investors are confronted with the conviction that in the context of generated income they take on too much risk by investing. The strategy of combining high-yield corporate bonds and other credit assets with high-quality government debt is the dynamic Barbell strategy. This strategy is a good way to generate income while limiting the risk of loss.
This is mainly because the payment streams are often correlated negatively, and the manager can change the weight of shares of particular types of debt in the portfolio as market prices and economic environment change. A Barbell strategy can work in every moment of the market cycle, but today’s economic environment is a good opportunity to implement this strategy, especially for investors who want to reduce the level of bottom losses without
resignation from income. Here are the reasons why you should try this strategy:

Most credit assets are expensive today. Let’s look at the US high yield debt market. Spread above the yields offered by the similar characteristics of government debt instruments is around 3.8%. The long-term average for this market is a spread of 5.1%. Interesting, especially for investors shortening the duration of the portfolio of debt instruments, thus wanting to avoid fluctuations in the value of portfolios caused by changes in interest rates. It was a widely used strategy in 2018, when the US Federal Reserve raised interest rates four times in the face of high economic growth.
Both actions, shortening the portfolio duration and overweighting the portfolio funds to the benefit of debt, reduce the defensive nature of the bond portfolio in a risk-free environment. Investors learned about it at the end of last year, when markets began to fear that the Fed would tighten the monetary policy too much.The 10 year credit cycle in the US is one of the longest in history. At some point, the period of expansion will end and the phase of recession will begin. We are not quite yet, but we think that we are very close to the beginning of the risk-off period. In March 2019, the FED lowered the GDP growth forecast from 2.3-2.5% to 1.9-2.2%, signaling at the same time that another increase in interest rates this year is unlikely. The observations may include the following: investors who outnumbered the share of credit instruments in the portfolio are not sufficiently remunerated and the tactics of shortening the duration of the portfolio of debt instruments is not necessary.
The FED’s “let’s wait and see” mode of action suggests that the risk of raising interest rates in the short term is small, and the possibility of slower growth means that exposure to interest rates should help to mitigate portfolio volatility.

Yield curves in the US are flat. This happens when long-term profitability is not as high as it would be under normal circumstances, given short-term and mid-term profitability.
When the curve is flat, the rates of return are usually higher for securities with higher credit quality and lower for the most risky segments of the bond market.
Thanks to Barbell’s strategy, the manager can, in the flattening of the curve, dominate in the wallet
securities sensitive to interest rates of higher quality at the expense of the most risky credit market sectors.
In March 2019, the difference between three-month and 10-year yields turned out negative for the first time since August 2007, Moving to minus 1 basis point, after information from the Federal Reserve regarding its expectations regarding further interest rate increases. Other measurements have also dropped. The difference between the two- and ten-year margins dropped below 10 basis points for the first time this year. This is the main indicator observed by investors who turned back – short-term profitability increased above long-term profitability – which occurred before each recession since the Second World War. In March, the yield curve in the US reversed.
In this situation, investors can sell their better US government bonds and other high-quality assets and balance higher-risk assets at more attractive prices.
As far as the credit side of the strategy is concerned, the break-even curve results in bonds with an average 3-5-year maturity being more attractive than longer ones because they provide higher profitability per unit of their duration, with an escalation in profitability over three to five years.

How to reduce portfolio volatility without having to give up a part of the rate of return.

To understand the mechanism, let’s look at the two strategies of Barbell: the first is a combination of 65% of assets in US Treasury bonds and 35% of high yield papers; the other is a 50/50 construction, which excludes junk bonds with the CCC rating – the most risky segment of US high-yield debt securities.
The first type of strategy is risk-weighted, since the loan is usually twice as volatile as interest rate sensitive assets, so investors would have to maintain higher interest rate exposure to compensate for the risk weight on both sides. The second type of strategy is risk management.
Over the past 20 years, both strategies have offered a higher rate of return than US Treasury bonds, offering 75-80% of the return generated by high-yield debt securities. Both strategies also offer a higher rate of return in the face of the risk unit than government securities and high-yield debt securities separately.

An example of loan management is combining exposures with high yield bond sectors – European banks, US energy companies – with positions in selected debts of emerging markets and securitized US assets. This is a good mix of loans that can generate a high level of income.

After a decade of expansion, financial markets can finally reach a turning point. For investors in bonds, this means the need to find a way to secure income while protecting the portfolio from the full effect of greater volatility and slower growth.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.