The best way to explain our methodology is with the help of a hypothetical example. In the interest of numerical simplicity, we will be using round numbers.
Let’s begin with an ACME 3y Bond yielding 4.5%. A traditional bond manager would purchase this bond in hopes of earning the 4.5% a year. Our approach is to buy the bond and simultaneously short sell the 3y Government of Canada Bond.
In doing so, we have hedged the interest rate risk. When rates move higher or lower, the impact on the two positions offset each other. So, if interest rates were to rise 1% the loss on the corporate bond would be balanced with the gain on the short position.
By hedging the interest rate exposure, we have also taken out one of the main drivers of bond volatility. Around 80% of fixed income returns can be explained by fluctuations in rates.
With the rate risk hedged, what we are left with is the credit exposure.
The 1.5% is ACME’s 3y credit spread, the excess yield above the Government that they have to pay their bondholders. We believe this spread compensates investors well for the risks. Also relative to other asset classes, credit is less volatile.
Having isolated the risk where we see value, we apply modest leverage if and when appropriate.
With this methodology, we can build a diversified portfolio of credits with a yield of between 4 – 8%. The net effect of our approach is the ability to treat credit as a distinct asset class. One which we feel can generate strong returns relative to the risks and volatility.