They form a stable base and offer diversification from equities and other investments, which is good for the portfolio’s risk/return profile. It is more important than ever to be innovative and to offer fixed income constructions which can provide an attractive return in all market circumstances. An example of this is the Robeco Hattrick strategy. This strategy has been launched in the form of a capital-protection structure, Robeco Hattrick Bond Apr 05/15 (EUR).

Leeuwen

Historically low rates?

First we would first like to address the generally accepted view that interest rates are at historical lows. Are interest rates historically low? This depends on which period of history being looked at. Figure 1 shows Dutch interest rates since 1841 and reveals that long-term interest rates of just below 4 per cent cannot be considered to be extremely low from a historical perspective. What is also apparent is that interest rates in the last 30 years were higher than in every other 30-year period which precedes it. So strictly speaking interest rates are not at historically low levels. It is rather the case that they have been high in recent years.

This does not mean that we are proclaiming that interest rates will fall further this year but it is good to keep things in perspective. It is important that investors can achieve attractive returns on their bond portfolios irrespective of the direction in which interest rates move. In response to this Robeco developed the Hattrick strategy.

The Hattrick strategy

The Hattrick strategy is able to achieve positive returns in fixed-income markets irrespective of the direction in which interest rates move, so even when long-term rates rise, or credit spreads widen. In sport the word ‘hattrick’ means that the same player scores three times in one match and the Robeco Hattrick strategy follows the same principle with its combination of three strategies:

• adjustment of the portfolio’s interest-rate sensitivity (duration policy);

• selection of corporate bonds (credits);

• currency policy.

Both long and short positions are taken using derivatives in order to benefit from decreasing and increasing interest rates and credit spreads. The strategy strives to generate an absolute return and has, in contrast to the traditional fixed-income products, no benchmark. The three strategies are quantitative: they are managed exclusively using Robeco’s proprietary quantitative models, models which have also been used for some time in Robeco’s traditional products. Using historical back testing of the models, we have researched how the Hattrick strategy would have performed in the past. The results, the pro forma track record1, are given in table 1. The table shows that the strategy’s risk is slightly higher than that of a global fixed income product and that the return is clearly higher. Over the same period, the volatility of the JPMorgan Global Bond Index amounted to just over 3 per cent with a return of more than 6 per cent. The Lehman Global Aggregate Index recorded a volatility of more than 2 per cent over the period and a return of around 7 per cent. Even in an annus horribilis for fixed-income investors like 1994 and also 1999 (interest rates rose in both years) the Hattrick strategy generated excellent returns. The correlation between the Hattrick strategy and traditional bond products is, in fact, almost 0. Figure 2 shows the three individual strategies contribute to the pro forma returns of the Hattrick strategy. The figure shows that in 2002 and 2003 very high returns were generated. This was the result of the volatility of the credit markets during this period. By taking long and short positions, the Hattrick strategy was able to benefit significantly from both upward and downward movements in the market.

In addition, the figure clearly shows that there is almost no period of decline. This is the result of the very low underlying correlation between the three strategies, which provides the diversification advantages. If there are limited opportunities in one market, there are always two other markets where returns can be generated. Table 2 not only shows that the correlations between the underlying strategies are very limited, but that the correlation with other asset classes such as global bonds, global equities and various hedge-fund indices amounts to zero or less as well. The risk/return profile of a diversified portfolio can be clearly improved by the addition of the Hattrick strategy.

It should, however, be noted that because of the long and short positions in the Hattrick strategy, the correlations can sometimes vary considerably.

As indicated earlier, the Hattrick strategy is made up of three underlying strategies, each of which is driven by a quantitative model.

The duration strategy

The duration strategy is used to actively control the portfolio’s sensitivity to interest-rate movements. This strategy is based on the duration model. This model was developed by Robeco quantitative researchers and fixed-income investors and has already been used for 10 years as an important decision-support instrument in the management of fixed-income products. Robeco’s Lux-O-Rente product is managed solely on the basis of this model. The model performed better than the market in nine out of the 10 years and generated an information ratio of 0.9 per cent. What makes this model so suitable for the Hattrick strategy is the fact that it performs well in both bull and bear markets. This is illustrated in Figure 3. In the circle you can see that the models’ performance continues to show an upward trend whether interest rates are rising or falling.

The duration model provides forecasts for bond markets in the three main regions, the dollar bloc, Europe and Japan, using the following six variables:

• the valuation of a bond market, measured by the slope of its yield curve;

• trends in the performance of global bond markets;

• mean reversion, based on the theory that if a market has outperformed other bond markets over a certain period, it will underperform those markets in the period to come;

•  the performance of the stock market as contra-indicator for the outlook for bond markets;

•  commodity prices, as a measure of inflation

• a seasonal effect, according to which bonds perform better in the period September through January than in the rest of the year.

The Hattrick duration strategy takes long positions in the bond markets where the model predicts bond prices to rise (or yields to fall) and short positions where the model expects bond prices to fall. All the positions are taken using futures. The duration for the Hattrick fund duration can vary from -7.5 years to +7.5 years.


The credit strategy

Bonds issued by all companies in the investment universe are arranged in order of attractiveness using the credit-selection model. Robeco has been using this model since 2002 to support buy and sell decisions for both its investment-grade and high-yield credit products. Just like the duration model, the credit-selection model performs well in both rising and falling credit markets. This is shown in Figure 4 .

The credit-selection model contains three variables:

• the spread over government bonds (the wider the better);

• stock momentum, a variable which selects bonds of companies whose stocks have performed well;

• balance-sheet data, or financial ratios which select bonds of companies which do not want to grow too fast and are economical in their use of capital.

Spread, stock momentum and balance-sheet data each determine one third of the total model score for a company. In this way the model selects companies for which there is positive stock-market sentiment and which have a healthy balance sheet and attractively priced bonds. These corporate bonds outperform the market in both good and bad times for the corporate-bond market as a whole. In Hattrick, the credit strategy dictates that long positions are taken in the credits at the top of the list, leveraged to a total of four times the fund’s net assets. At the same time the fund takes short positions, which add up to the same total, in credits which appear at the bottom of the list. As a result, the Hattrick portfolio is not sensitive to movements in the credit market as a whole.


The currency strategy

The currency model predicts the direction in which the major currencies will move in the near future. Robeco has used the model since 1996 to support the currency policy pursued by its global equity and fixed-income funds. The model performs well in all market circumstances, also when bonds are not performing well. Table 2 shows the monthly excess return of global bonds versus cash, and the model’s performance. The table also shows that if bonds perform worse than cash (and the excess return is lower than 0%), the model performs well. At times when bonds perform moderately (excess return between 0% and 0.75%) and well (excess return above 0.75%), the model also performs well.

The currency model is made up of a trend model and a non-trend model. It gives signals depending on the volatility of the currencies. If the volatility is high, the combination of these two models does not seem to work well. So in this case the model gives a neutral signal, except for euro/yen, where it does work (with slightly adjusted parameters). The model contains the following variables:

• Trend variables, which compare short and long-term exchange-rate averages with each other in order to determine whether there is a trend and whether that trend is an upward or downward one.

• Non-trend variables, which look at the interest-rate differential between currencies, mean reversion (the return of a price to its average level) and investors’ risk appetite.

In the Hattrick strategy forward exchange contracts are used to take a long position in those currencies about which the model is positive and a short position is taken in the currencies about which the model is negative. The sum of the long and short currency positions will range from 25 per cent to 125 per cent depending on the number of signals the models gives at any given moment. In the current market circumstances innovative strategies are more desirable than ever to enable investors to achieve attractive returns on fixed income securities. The Robeco Hattrick strategy responds to this by offering a combination of strategies which, through their low correlation with each other and the fact that they take both long and short positions, can perform well irrespective of what is happening in the market. Because of the strategy’s low correlation with other asset classes, such as equities, bonds and hedge funds, it offers interesting opportunities for diversification within a diversified portfolio.


Erik van Leeuwen is a Fixed Income portfolio manager and
Petra Sagel is an investment specialist at Robeco.