When Up is Down

Interest Rates and Investment Strategy

Investors expected that the Fed would not only end its bond-buying program, but many believed it would also raise interest rates. While the Fed did agree to taper its bond-buying, essentially decreasing its $150 billion monthly bond-buying program by $15 billion per month, ending the program in 2022. However, the Fed kept interest rates the same and clearly signaled that it would not raise interest rates anytime soon, and almost definitely not until the taper of its bond-buying was completed — in other words, not for at least one more year.

Investors who had been betting on the Fed raising interest rates wagered on the yield curve flattening for Treasuries. Therefore, they invested in short-term Treasuries believing those would outperform longer-term Treasuries, as well as 10-year and 30-year bonds. Instead, we are seeing the opposite happen. Short-term bonds are dropping in price and yields are approaching their highest levels since March 2020. Meanwhile, prices for long-term bonds have climbed. This same phenomenon is happening for government bonds that only in the United States, but also in the UK, Canada, and elsewhere.

When Small Become Enormous and Safe Isn’t

To be clear, this is not the wild volatility we have seen in crypto and meme stocks, but while these swings may be small, investment funds leverage these bond bets highly, and, therefore, losses are amplified. Misguided trades are producing painful losses. A couple of examples include Rokos Capital losing 27% in 2021 as of the end of October (and this is for a bond fund that focuses on government and investment-grade bonds!). Several other bond funds are down in 2021 along with multi-strategy hedge funds, all of whom lost money from recent government-bond moves. So much for “safe investments.”

An obvious (and likely to be ignored) lesson is that risk management should be an obsession for any firm that wants to be sustainable. An investment strategy is only as good as its risk-adjusted return. Which is another way of saying, it’s sustainable competitive advantage. All of these bond funds claim to generate high risk-adjusted returns because they leverage “safe” bond investments — government securities and investment-grade bonds. But when the market moves a little bit against them, they generate substantial paper losses.

A Little Goes a Long Way

This is the essence of Bridgewater’s message (Bridgewater is the largest hedge fund in the world with over $200 billion under management). They claim to generate superior risk-adjusted returns by simply using prudent leverage (they typically borrow 30% and purchase investment grade or government bonds), and claim that, while their returns are similar to unleveraged riskier investments, the Bridgewater portfolio of less risky fixed-income securities with leverage generates superior risk-adjusted return. This may sound simpleminded, but they have raised $200 billion and generated enormous profits based on this. Their message simply comes down to prudent choices among less risky investments, leveraging those investments, and then implementing better risk management.

A successful investment strategy has superior risk management combined with a proprietary investment strategy targeting superior risk-adjusted returns. On top of that, exceptional market conditions dictate that an essential component to that investment strategy should focus on profiting from more frequent and intense market volatility.