When portfolio manager Michael Phelps looks at the global credit markets, he sees distinct diversions between the U.S. and Europe, both in terms of monetary policy and economic cycles, which means ample opportunity to take advantage of rising U.S. interest rates. And if all goes well, he'll be able to steer the fund to outperform its long-only peers.
The $5.8 billion BlackRock Global Long/Short Credit Fund (BGCAX), an alternative-strategy bond fund which Mr. Phelps co-manages from Europe
along with Josh Tarnow in New York, has effectively hedged out interest rate risk in a way that could prove most valuable in a rising rate cycle.
A portfolio duration of 0.2 gives the fund a negative correlation to both the Barclays Aggregate Bond Index and U.S. Treasury bonds.
“In this kind of yield environment, interest rate risk is 90% of the risk of the Barclays Aggregate,” Mr. Phelps explained.
Hedging out that risk gives the bottom-up stock pickers the flexibility to focus on credit-risk investing opportunities, especially as the
Federal Reserve moves closer to raising interest rates.
“There has been such divergent monetary and economic policy between the U.S. and the rest of the world,” he added. “We've been benefiting from the dislocations, and hopefully that will continue to drive our performance.”
With Europe in the early stages of a quantitative easing program, Mr. Phelps said part of the world is generally where the U.S. was three or four years ago, “while the U.S. recovery and credit cycle have matured.
“That brings up opportunities,” he added. “It's very hard to imagine that as the Fed moves away from historically easy monetary policy that that wouldn't throw off opportunities in the credit markets.”
This year through April 23, the fund has gained 1.7%, compared with a 1.3% gain for the Lipper Alternative Credit peer group. The Barclays Aggregate Index is also up 1.7% from the start of the year.
But the strategy's weakness in the run up to higher U.S. interest rates is evidenced when it is compared to long-only investment grade corporate credit funds.
Over the past 12 months, the BlackRock fund has gained just 0.9%, which is in line with the 0.7% peer group average. But the Barclays benchmark is up 5.2% over the same period, and the Lipper investment-grade corporate bond fund average is up 5.5%. The category is led by the $16.4 billion Vanguard Long-Term Investment Grade Fund (VWESX), which has gained 2.4% this year and 11.8% over the past 12 months.
“The point is, the BlackRock fund, which can and does go short, has underperformed the average of funds that only go long,” said Todd Rosenbluth, director mutual fund and ETF research at S&P Capital IQ.
“The BlackRock fund has greater flexibility to go long and short, but as of late, long-only has been more fruitful for investors,” he added. “However, if we see rates go higher, that flexibility in that fund will be helpful.”
Put another way, the BlackRock fund's 0.2 year duration compares to an average duration of six years for the Lipper investment grade corporate bond peer group, and a duration of 13 years for the Vanguard fund.
In a rising rate environment,
longer duration represents bigger downside risk.
“If somebody believes that rates are going to move higher, the theory is that the strategy being used by the BlackRock fund should do better than long-only bond funds,” Mr. Rosenbluth said.
