Risk USA: Buy-side prepares for fixed-income storm

Artificially low volatility leaves firms nervous about the future – and looking for fixed-income alternatives

Mutual funds and other retail investment vehicles are trying to insulate themselves against fixed-income market volatility that could be unleashed as the US Federal Reserve winds down its bond-buying programme – or tapers, in the language of Fed chairman, Ben Bernanke.

Suggestions that the central bank could end its programme of quantitative easing first came in May, when Bernanke said improving economic conditions could see the Fed rein in its bond purchases, currently running at $85 billion a month. Although the Fed did not start to taper in September, as was widely expected, Bernanke has said he anticipates tapering to start towards the end of 2013 and for the programme to end entirely in 2014.

"The prospect of volatility associated with tapering as it plays out will clearly be a huge challenge for fixed income in general," said Geoffrey Craddock, chief risk officer at Oppenheimer Funds, speaking during a roundtable at today's Risk USA conference in New York. "Part of my concern is that our fixed-income products perform appropriately in that environment. But, second, given our predominantly retail base, fixed income has been a traditional part of the 60-40 allocation portfolio and the 40 isn't going to work anymore."

Those concerns were shared by other panellists. Sanjay Sharma, chief risk officer for global arbitrage and trading at RBC Capital Markets, said quantitative easing by the Fed, the European Central Bank (ECB) and others has artificially depressed volatility.

"The Fed and the ECB and the other places fixed-income assets have gone are net sellers of volatility," he said. "But they are not hedging their books, so there is an artificial volatility environment... Where we end up in two or five years from now, to my mind, is very uncertain."

The prospect of volatility associated with tapering as it plays out will clearly be a huge challenge for fixed income in general

For the buy side, this means reassessing portfolio construction. Because of the uncertainty over fixed-income performance, some firms may look to alternative products. Oppenheimer's Craddock says this is exactly what he has been doing. "We and many others are pursuing a lot of other products that fit into a fixed-income alternatives space," he said.

But this in turn presents fresh issues with regards to managing these new products. In particular, there need to be appropriate risk controls and disclosure for those instruments to ensure they do what investors expect, Craddock said.

The aim is to avoid the uncertainty surrounding the market impact of tapering. "There is a 60% probability it will be gradual and we will wake up with 5% growth and the 10-year rate at a normal level," said RBC's Sharma. "But I think the remaining 40% leads to an incredible amount of volatility that we should brace for."