By the Numbers
Benchmark portfolio positioning for elevated volatility
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Recent spikes in rate and equity volatility have likely left investors managing benchmarked portfolios thinking about how to protect fund performance . Paring back spread duration, rate duration or both should allow indexed portfolios to deliver more consistent returns against the backdrop of higher volatility with the caveat that shorter rate duration would leave portfolios exposed to underperforming into a rate rally.
Recent comments by a range of investors about taking defensive positions likely resonate among those trying to navigate uncertainty around tariffs and any knock-on effects to the broader economy. Short-term bond ETFs have taken in upwards of $16 billion, according to Bloomberg, as investors look to insulate themselves from growing uncertainty about the future path of both interest rates and credit spreads.
Bond investors benchmarked against the Bloomberg US Aggregate index may look to outperform by adding shorter spread duration assets that offer an OAS or total return advantage against the index or one of its constituents. From there, portfolios can choose to run a shorter rate duration than the benchmark, pair assets with Treasuries to rebalance duration or extend duration through Treasury futures or receiver swaptions. Adding duration through derivatives may be difficult for certain portfolios as they can be viewed as a form of financial leverage, which may not be permissible in certain mutual fund structures.
Strategies for MBS benchmarks
Recent outperformance of up-in-coupon MBS likely reflects outsized demand for shorter duration exposures. But an outright overweight in higher coupon MBS leaves indexed portfolios underweight versus their target duration. One strategy that asset managers could employ to reduce spread duration is to pair up-in-coupon MBS with Treasuries to create a duration-neutral proxy for lower coupon MBS. For example, pairing UMBS 6.0% with longer duration Treasuries on a duration-neutral basis versus UMBS 2.5% offers a slight pickup in Treasury OAS, a total return advantage into a 100 bp rally or sell-off while shortening spread duration by 5.5 years (Exhibit 1).
Exhibit 1: Up-in-coupon + UST sheds spread duration versus down-in-coupon
Source: Santander US Capital Markets, YieldBook
Additionally, indexed MBS investors may look to add out-of-index exposures that offer low beta to the MBS index. Looking over a 3-year horizon, the universe of non-QM ‘AAA’ bonds have a beta of 0.31 to the MBS portion of the index, a beta of 0.28 to the broad investment grade component of the index and a beta of slightly greater than one to the 1- to 3-year cohort with the corporate index. Non-QM ‘AAA’s have also offered the best risk-adjusted return across the universe of senior non-agency exposures and a substantial pick up in OAS versus the MBS index, generally offering treasury OAS of 90 bp to 100 bp with index OAS currently sitting at 35 bp. Similar to up-in-coupon, benchmarked investors should recognize any differences in duration as they migrate out of index into low beta exposures.
Strategies for corporate benchmarks
Investors looking to shed spread duration relative to the corporate portion of the index may look to short CLO refinances as they trade to substantially shorter spread durations and wider spreads than the broader index. Since the beginning of the month, the basis between corporate index OAS and ‘AAA’ CLO nominal spreads has widened by 20 bp, providing investors with an attractive entry point to add CLOs versus the index (Exhibit 2). Investors looking to add pools that are still in their reinvestment period could shed upwards of 4.5 years of spread duration while investors in even shorter CLOs backed by static pools could shed as much as 5.5 years admittedly while also shedding a roughly equivalent amount of interest rate duration which they would have to buy back in either the cash or futures market. CLO managers that have delivered the greatest amount of alpha include Fortress, RBC and Medalist Partners. Santander’s proprietary rankings of CLO manager performance can be found here.
Exhibit 2: CLOs offer significant OAS pickup versus corporate index OAS
Source: Santander US Capital Markets, Bloomberg LP
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