Prologue Capital

Investing in fixed income markets

Originally published in the September/October 2012 issue

Prologue Capital’s mission is to provide low volatility returns in global fixed income markets. The firm has been able to achieve such returns since its inception in 2006 by trading actively in liquid markets and employing rigorous risk management techniques and sound market views. In order to assist with the latter, the firm has developed a thorough research process, carried out by an internal team of investment analysts.

Getting the macro right
Macro-economics is a key driver for fixed income prices. Thus, getting this part of the equation right is of paramount importance for any manager operating in this space.

Our macro analysis starts with identifying major secular trends inorder to determine the overall environment. During the first year and a half of Prologue’s existence, the firm operated in markets that employed ever-increasing amounts of leverage. One of our early successes was the ability to recognise the maturity of that secular trend and, more importantly, the deleveraging process which was precipitated by the 2008 crisis. Once we have identified which key secular forces are in play, we estimate how long they will materially influence the markets. This work draws heavily on historical comparisons and quantitative methods to determine likely time-frames for historical mean reversions and the probability of over or under-shoots. For example, using our time-frame analysis, we believe that the deleveraging process should continue to influence most large developed market economies for a number of years, but may come to an end considerably earlier in the United States compared to Europe.

Once the secular framework is established, we conduct a similar exercise for the regular business cycle, the profile and frequency of which differs depending on the secular backdrop. For example, business cycles were prolonged and relatively smooth during the secular credit expansion from 1990 to 2006 (to the degree that academia dubbed the period ‘The Great Moderation’) and currently show similar elongated shapes in China courtesy of secular labour and investment trends. Conversely, business cycles are usually truncated during deleveraging phases and balance of payment adjustments. With this in mind, we identify the current stage of the business cycle and its tangent, i.e., the speed of the cycle evolution. Only by knowing the current state of the economy do we have any realistic chance in determining where it is heading. This work draws heavily on careful observation and analysis of a wide range of coincident and leading indicators.

Getting the inflation picture and outlook right is important for all kinds of investors, and particularly so for those of us in the fixed income markets. Our approach to understanding the inflation picture and developing a view is in some parts similar to our general macro framework; we identify super cycles driven by secular trends and shorter inflation cycles. The latter are partly driven by the business cycle, particularly for those parts of the inflation basket that are heavily influenced by wages, but trends in commodity markets are often of greater near-term importance. We have found that using usual inflation forecasting techniques for inflation, for example Phillips’ curve-based models, are too imprecise for the time horizons relevant to our active money management style. Put differently, it is more important for us to understand where inflation is heading over the next few months than over the next few years. We have found that a detailed bottom-up framework is more efficient in understanding shorter-term inflation trends compared to more complex macro models. This process entails breaking down the inflation basket into sub-components with the aim to forecast those components either via various input models or trend variables. The process allows us to create a near-term inflation profile and, more importantly, identify which factors in the inflation basket are particularly influential at a specific point in time.

The policy reaction
Of all financial markets, fixed income markets are most heavily influenced by policy makers. The core product – government bonds – is issued by fiscal policy makers and their prices are directly and indirectly affected by monetary policy makers. Thus, it is essential for fixed income managers to have a good understanding of the world view and the reaction function of policy makers.

The evolution towards more transparent policy making has greatly aided our policy analysis. Central banks now publish regular updates of their findings,which often include detailed forecasts, while both monetary and fiscal officials express their viewpoints in speeches and testimonies. They also provide additional colour in consultations with market participants on a regular basis. The necessary information is thus often available – something that was not the case 10-15 years ago. That said, it requires significant time and effort to keep abreast of this information flow.

The opinion of others
Formulating our own macro views always takes place in the context of the marketplace. This enables us to constantly benchmark our views against the prevailing consensus and selected market participants we believe to be particularly influential. This exercise allows us to better understand the discrepancy between what we deem to be the correct price of securities and prevailing market rates, as well as helping us in determining the circumstance in which there will be a convergence of that discrepancy. In this way, we go beyond merely studying investor surveys; we try to fully understand the rationale behind alternate views. This exercise also functions as a good check on the soundness of the findings of our own analysis. Sometimes, after studying alternative view points, we find that our own reasons or facts are wanting.

Another important aspect is to determine the reaction function of other market participants. Owners of fixed income securities can be segmented into various buckets that have different drivers. Reserve managers, sovereign wealth funds, leveraged capital, long only real money, bank portfolios, and so on, have varying time-frames and objectives, which result in very different behaviour. We put a significant amount of effort into understanding which segments of market participants matter at a specific moment in time and how they respond to evolutions in key conditions. A leveraged fund will, for example, react very differently to a change in the supply schedule compared to a sovereign wealth fund. This can sometimes be modelled but anecdotal market intelligence also plays an important part in this process.

Where is the money?
When investing in fixed income markets, it is essential to determine what the de facto positioning is. An accurate insight into where money has, or has not, been put to work provides a true edge when combined with the rest of our analysis. We use a number of sources and quantitative tools to identify aggregate and segmented positioning. None of which provide a complete picture on their own, but taken together they typically give us a reasonable sense of where there are position overhangs, under-investments, and so forth.

The complete culmination
Each of the steps described here entails significant logistical and intellectual challenges, but the most difficult step is to synthesise the process into distinct and actionable conclusions. This includes weighing the importance of different factors, and sometimes excludes some of the steps described above. Given how dynamic the markets are, the process needs to be flexible yet incredibly robust, and always overlaid with sound judgement.

Tomas Jelf is Chief Economist at Prologue Capital, heading the firm’s macro research group, focusing on identifying key macro trends with a special focus on inflation in developed markets.