Be ready to move amid ‘unreliable’ liquidity

Rachel Alembakis

By

08/10/2018

Investors can prepare to rebalance in a quickly repricing market by using convertible bonds and credit default swaps, Cheyne Capital Management president and director of research Stuart Fiertz said.

Given the fragility exposed in both equity and credit markets, surging geopolitical risk and concerns over economic expansion, Fiertz supports the strategy.

There are “many visible fault lines”, Fiertz told the audience at the Investment Magazine Absolute Returns Conference in September.

“We could each choose our favourites, but certainly we’re extended on the equities side, there’s evidence we’re extended on the credit side, interest rates, inflation seems low, how long will it remain, and the economic expansion is breaking new records in terms of time,” he said.

At the same time, idiosyncratic risk is increasing, driven by business model changes like the Internet of Things, and increased geopolitical risk with the rise “of a harder right and a more radical left” in countries like the US, the UK and Germany. Given all that, Fiertz said, “liquidity is unreliable”.

“It’s all good having trading strategies – these indicators that tell you where to move to – but will you be able to move in time?” he asked. “I think that is a fundamental building block. Given all these fault lines and the speed at which markets will reprice in today’s environment, especially at this time of unreliable liquidity, in our view, you need to be pre-positioned.”

Fiertz suggested that investors “embrace convexity” – meaning measuring and managing the amount of market risk to which a bond portfolio is exposed. This means investing in floating instruments; Fiertz specifically mentioned convertible bonds and credit default swaps.

“We think that what you should do in this case is embrace convexity at the instrument level, and build that up within each of the asset classes. That convexity will translate to convexity at the portfolio level, so that if you are indeed long and wrong, the portfolio will automatically reposition itself,” he said. “And you won’t have to be prescient…or have to rely on the market liquidity that I don’t think will be there the next time around.”

Convertible bonds may have “fallen out of favour” in the market, Fiertz said, but they “get more long in the market as equities go up, and get out of the market when the equities come down”.

Fiertz said Cheyne Capital uses credit default swaps to manage credit risk spread and raised concern about the state of the private debt market. He said evidence suggested that private debt was in the “late stages” of the credit cycle, raising further risks for investors.

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