CHICAGO - Money managers say they are taking a more defensive stance and streamlining their exposures in the Treasury market as the U.S. economy picks up speed.
"Players on the buy-side of the market are not looking to increase returns these days as much as they're trying to hold on to them," said James Somers, president of Somers Asset Management.
After a year of impressive returns from their fixed-income investments, money managers are reducing the duration of their overall portfolios while arming their holdings with a number of hedging tools.
Faster growth in the U.S. economy and persistent fears that inflation will soon follow have prompted portfolio managers to enlist somewhat of a back-to-basics approach to reducing the risk of losses.
"Bond investors are referring to their old finance textbooks and looking at the traditional ways of protecting their portfolios," said Frank K. Reilly, professor of business administration at the University of Notre Dame, a former bond trader, and author of three books on portfolio risk management. "The key is to immunize your portfolio from the risk of losses."
Reilly and other academics and portfolio managers made their comments here during interviews at a bond analysis and portfolio management seminar hosted by Notre Dame and the University of Illinois at Urbana-Champaign.
Given current economic conditions in the U.S. and the belief that interest rates are poised to move higher, Reilly recommends that investors employ a technique he calls "classical immunization." This is a strategy whereby a bond portfolio is protected for a holding period so that its value at the end of the holding period, regardless of the course of interest rates during the period, is at least what it would have been had interest rates been constant throughout the holding period.
"Classic immunization is not a passive policy and requires frequent rebalancing," Reilly said. "You may not make stellar returns, but you will avoid losing money."
This strategy is in sharp contrast With the way in which investors have participated in the markets in the last 12 months, when they relied on a riskier strategy known as contingent immunization, Reilly said.
Contingent immunization investment procedures give a bond portfolio manager the opportunity to attain higher rates of return through active speculative investment. Reilly conceded that contingent immunization of investments has paid off handsomely for retail accounts in recent months. But that was when the economy maintained a slower growth rate and when Treasury market analysts were forecasting lower inflation, he said.
"Changes in the economy and in the makets have necessitated changes in investment strategies," Reilly said. "People want to be ready for when rates go up."
Thus, a return to more conservative tactics, such as classical immunization, is warranted, he said. As long as money managers rebalance their positions to stay in line with the intended duration of their portfolios, losses can be avoided.
Managers should frequently rebalance their holdings because the duration of a bond portfolio declines more slowly than its maturity, Reilly said, assuming there are no changes in market rates. This allows investors to gradually reduce duration over time.
Moreover, managers should consider movements in the Treasury yield curve. When yields change, Reilly noted, the yield curve may not experience a parallel shift. As a result, price shifts may be influenced by rates at one sector of the yield curve and an investment may be influenced by rates at another segment. For example, long-term rates could increase while short-term rates hold steady or move lower.
Trading the exchanges is another strategy retail investors are increasingly using to reduce exposure to risk. Managers are becoming more savvy about betting on positions at the Chicago Board of Trade and the Chicago Mercantile Exchange.
"If rates remain volatile in the future, options in futures provide money managers with an opportunity to reduce risks and increase overall returns," said James A. Gentry, professor of finance at the University of Illinois at Urbana-Champaign.
One of the best ways for money managers to hedge against risk is to use options and futures to offset the effects of volatility in the market.
David P. Lerman, director of financial futures and options marketing and teacher of investment courses at the Chicago Mercantile Exchange, said one of the most common strategies is to "straddle" positions, whereby investors simultaneously place buy and sell orders in the markets. The idea is for a loss on one position in the options or futures to be offset by a gain made on another.
"People have woken up for options and futures and realized that they are a viable means of reducing risk," Lerman said.