Recent events in the UK have again highlighted a new approach to investing in short-duration fixed income is needed. Mhammed Belfaida explains why the Aviva Investors Sterling Liquidity Plus Fund can be part of the solution.
Read this article to understand:
- The four desired outcomes for investing in short-duration fixed income
- Why new sources of diversification, including triple-A-rated asset-backed securities, are required in a more challenging market environment
- The types of investors who might consider an allocation to the Aviva Investors Sterling Liquidity Plus Fund
As we highlighted in a previous article, Hitting the yield sweet spot: Opportunities in short-duration credit, the new macroeconomic environment, the monetary policy response to it and changing views on a range of longer-term structural factors necessitate a new approach to fixed income investing.1
In summary, we consider four desired outcomes to investing in short-duration fixed income:
- Liquidity
- Diversification
- Security
- Stable returns above cash
To outperform cash, many investors have historically allocated to corporate and/or government bonds through the aggregate index. However, the index was never designed to be an investment portfolio.
While such an approach can provide potentially higher yields than money markets over the long term, it is less likely to provide investors with the desired outcomes. Delivering on these requires a much more diversified approach than a narrow duration/spread combination.
Targeting a stable return above cash is sometimes confused with maximising yield per unit of risk. While the latter can help optimise portfolios, it will not offer stability in periods of heightened volatility. By contrast, the Aviva Investors Sterling Liquidity Plus Fund has proved resilient throughout economic cycles, outperforming its target while delivering on the above characteristics.
The past decade has seen two rate-hiking cycles (2017/18 and the current cycle). This, however, has had a limited impact on the fund due to its limited reliance on duration as a performance driver.
More recently, we saw the unprecedented twin headwinds of higher sovereign yields and wider credit spreads. For the first time ever, risk-free rates and credit spreads both contributed negatively to full-year total returns. Again, the fund managed to largely limit downside risk thanks to limited duration and diversification across different types of liquid assets rather than solely relying on traditional credit markets.
Figure 1: Aviva Investors GBP Liquidity Plus Fund: An optimal solution to liquidity, security and stable returns above cash
Past performance is not a reliable guide to future performance. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.
Note: Daily data points, cumulative performance, net of fees.
Source: Aviva Investors, Bloomberg. Data as November 15, 2022
An alternative approach to diversification
In a stressed environment, normal correlations between asset classes break down, challenging the benefits of diversification.
This is exactly the scenario that unfolded in the UK in late September and early October after the negative market reaction to former chancellor Kwasi Kwarteng’s ‘mini-budget’. Short-duration funds faced a double whammy: rising rates and widening spreads at the same time.
Changing correlations will pose challenges for investors relying on traditional fixed income
Looking ahead, changing correlations will pose challenges for investors relying on traditional fixed income, suggesting they will need other options for portfolio diversification.
In our view, investors should look at ways to complement their allocations to traditional fixed short-duration funds to achieve greater diversification and lower correlation. We believe our Sterling Liquidity Plus Fund can fulfil such a role. Instead of simply allocating to gilts and credit, the fund screens a wider opportunity set. The fund invests in liquid secured and unsecured assets with a focus on areas traditional portfolios are unable to access.
To build the universe, our starting point is not a benchmark. Instead, we focus on asset classes most likely to achieve the four desired outcomes referenced at the start of the article.
Figure 2: Liquidity solutions: Broadening the investable universe
Source: Aviva Investors, Bloomberg. Data as of November 15, 2022
Triple A-rated asset backed securities (ABS) is one asset class that can help achieve these objectives, offering top-rated credit quality and ample secondary market liquidity.
As Figure 2 illustrates, the asset class also offers the highest spread per unit of risk due to:
- Competitive barriers to entry for managers. There is less market crowding due to it not being included in traditional passive benchmarks.
- Need for expertise in analysing the risks in ABS transactions. In-depth expertise and resources are required to perform the requisite analysis on the collateral, structure and servicer in any transaction. Reflecting the resources we have focused on this area, the fund has not experienced any downgrades on our ABS holdings since 2006.
We believe a benchmark-agnostic approach allows us to identify better opportunities. Active portfolio management gives us the flexibility to tactically manoeuvre when opportunities across various asset classes present themselves.
An ability to invest in covered bonds, ABS and unsecured floating-rate notes gives the fund the flexibility to respond to changing market dynamics by shifting asset allocation between these asset classes (see Figure 3).
Figure 3: Historical asset allocation of the Aviva Investors Sterling Liquidity Plus Fund (per cent)
Past performance is not a reliable guide to future performance. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.
Source: Aviva Investors, Aladdin Blackrock. Data as of November 15, 2022
As a result, the fund has exhibited a relatively low correlation to gilts and corporate bonds (see Figure 4). This year has painfully reminded investors that correlation relationships can change, emphasising the need for strategies capable of adapting quickly to changes in the market environment.
Figure 4: Aviva Investors Liquidity Plus correlation to traditional fixed income (past five years, as of 30 October 2022)
Note: Correlation calculated based on weekly data over the past five years.
Source: Aviva Investors, Bloomberg. Data as of November 15, 2022
Is this fund liquid?
The sharp rise in UK swaps in late September 2022 placed a significant liquidity strain on many investors, notably pension schemes and insurers, as they sought to raise cash to meet margin calls.
As we explain in Collateral cash: Time for a rethink, this episode raises important questions about the size of collateral cash pools and the liquidity of assets in those pools in stressed market conditions.2
Recent UK events proved many stress tests wrong, with some assets perceived liquid proving not to be after all. The gilt market needed the Bank of England to intervene to stop the brutal sell-off. During the same week, a reported £4 billion of ABS traded – with large selling of AAA and AA-rated paper by pension schemes to meet their short-term liquidity requirements.
Recent UK events proved many stress tests wrong, with some assets perceived liquid proving not to be after all
This happened without any noticeable hiccups. The asset class did what it is supposed to do and provided liquidity to UK pensions and insurers with limited price impact given its floating-rate nature. We saw better liquidity in STS (simple, transparent and standardised) AAA-rated ABS paper, as bank treasuries stepped in to purchase higher-yielding defensive assets without incurring excessive risks or capital costs.
The Association for Financial Markets in Europe (AFME) recently published a research paper, Comparing CB, ABS and Corporate Bond Liquidity.3 The key findings are that up until 2016, AAA-rated covered bonds appeared more liquid than ABS. Since then, however, ABS transactions have been more liquid. Another takeaway is that transactions costs are very similar for AAA-rated ABS and covered bonds, while costs for corporate bonds with equivalent ratings are higher.
This year has reminded investors that liquidity is fluid. As such, a carefully considered allocation to cash optimisation funds can provide investors with more optimal liquidity in all conditions.
Looking ahead
Surging inflation and the subsequent rise in interest rate expectations and volatility comes with greater dispersion and relative-value ideas. Accessing return drivers outside gilts and corporate bonds can enhance returns above cash as well as provide portfolio diversification. No longer can fixed income portfolios rely on duration to ballast overall risk.
We see an attractive opportunity in senior triple-A owner-occupied ABS
We see an attractive opportunity in senior triple-A owner-occupied ABS, which currently offer a premium to covered bonds for a lower weighted average life (WAL).
Currently, STS ABS offers a 50-60 basis point pick-up over Sonia for a one-year WAL, while auto ABS offers 100 to 120 bps for a similar duration. Higher front-end rates and a flatter yield curve mean we do not need to take substantial spread duration risk and we prefer the sub-one-year bucket.
Who can use the Aviva Investors Sterling Liquidity Plus Fund
- An attractive cash step-out strategy: the fund predominantly allocates to floating-rate bonds, meaning interest rate risk is somewhat negligible. This enables investors to enjoy a credit spread-based excess return. Since launch, the fund has delivered a performance of 40 bps above cash with an annualised volatility of 0.27 per cent. This equates to a Sharpe ratio of 1.48.
- For an LDI strategy, the fund can be used as an effective return-seeking component that seeks to deliver excess returns above the funding cost of the strategy or as an additional cash buffer to support collateral requirements.
- The introduction of the EU’s simple, transparent and standardised (STS) framework provides the opportunity for insurers to invest in a robust, high-quality asset class that benefits from favourable capital treatment. Partnering with an asset manager with the requisite ABS expertise can help navigate regulatory requirements and capture attractive opportunities.
