Alternative Investments: Part 4 — Duration-Oriented Unconstrained Bond Strategy

Preface: See part 1, 2, and 3, first, as this article relies on definitions & discussions from those articles.

Alternative Investments: Part 1 — Overview

Alternative Investments: Part 2 — Absolute Return Currencies

Alternative Investments: Part 3 — Managed Future


file-nov-19-2-33-06-pm

An obscure investment style and — to the average investor — an investment strategy with an even more obscure name, a Duration-Oriented Unconstrained Bond Strategy isn’t nearly as complex as it sounds; put simply, it relies on economist Irving Fisher’s eponymous equation — namely, the Fisher equation — and typically has two possible investment-paths:

  1. If inflation is expected to fall over time, the fund invests in long-duration bonds — for example, 30-year Treasury bonds.  (Treasury bonds are a loan to the government for a specified time-frame but can also be sold to a buyer for a profit or loss — the price moves up and down over time based on desirability.)
  2. If inflation is expected to rise over time, the fund invests in short-duration/no-duration investments (Treasury-bills/T-bills, cash-like investments), and/or Treasury Inflation-Protected Securities (known as “TIPS”).  (Treasury bills are similar to Treasury bonds but the timeframe for the loan is less than one year. TIPS aren’t significantly affected by rising inflation, as the original loan amount adjusts based on inflation.)

The Fisher Equation

Defined simply as i=r+E* (where “i” is nominal risk-free bond yield, “r” is real yield, and “E*” is expected inflation), the Fisher equation states that long-term Treasury bond yields and inflation expectations are linked — long-term Treasury bond yields rise or fall over time in relation to changes in inflation/disinflation/deflation.  More specifically, long-term Treasury bond yields follow inflation over time: if inflation rises, long-term Treasury bond yields eventually rise, meaning long-term Treasury bond prices fall; if inflation falls, bond yields eventually fall, meaning long-term Treasury bond prices rise.  This action can be seen in a chart of Long Term U.S. Treasury rates and Inflation — see Chart 1 here, where Lacy Hunt has observed that “Treasury bond yields and the inflation rate have moved in the same direction in 80% of the years since 1954.”

However, it is worth noting that the yield/expected-inflation interaction can be a slow process; Lacy Hunt has written that “Expected inflation may be slow to adjust to reality, but the historical record indicates that the adjustment inevitably occurs.”  As such, there are, of course, temporary periods where the link does not hold, as there are many factors that can cause bond yields to gyrate wildly over the near term, but the Fisher equation’s significance is due to its effectiveness over time — over longer stretches of time the connection does exist, and it is validated as one of the most tested and documented fundamentals in economic study.

Duration-Oriented Unconstrained Bond Strategy

It’s very important to note that a typical Unconstrained Bond Strategy is very different than a Duration-Oriented Unconstrained Bond Strategy.  The typical Unconstrained Bond Strategy mutual fund has often been heavily weighted with low-credit(“junk”) bonds and foreign bonds — and managers in the category have rarely made significant adjustments to their portfolios based on the investment/economic environment — essentially creating a portfolio that is highly correlated with credit-sensitive bonds (and even equities!); this is a portfolio that is more akin to a diversified bond strategy than an alternative investment.

However, a Duration-Oriented Unconstrained Bond Strategy fund is one that may adjust its portfolio significantly over time; its investments and returns are the result of economic interpretation.  Based on that economic interpretation (more specifically, the interpretation of long term inflation expectations) the strategy may at times be highly correlated with long-term Treasury bonds (subject to high volatility), while at other times it may be correlated with cash-like investments (subject to low volatility, not correlated with long-term Treasury bonds); however, its flexibility — its ability to change — is what makes the strategy an alternative investment.

A Duration-Oriented Unconstrained Bond Strategy is a different kind of Unconstrained Bond Strategy; it can be a volatile and aggressive strategy, but it’s one that is on a different volatility-time path from traditional risk-oriented asset classes, such as stocks — and it may at times even provide a low correlation to traditional bonds.

 




 

Advertisements