This page displays white papers, updates and blogs supporting the investment rationale behind (CDRI) Cedar Global Income Index. CDRI is a target-based multi-asset index for institutional investors and family offices seeking access to highly liquid, cost effective and high sharpe ratio investment solution.
Concentrated default rates during financial crises and the case for bullet bond ETFs
Author: Product Team / 31 May 2019
A major advantage of buying a bond ETF is diversification. Unsystematic risk is impactful in fixed income due to capital structures' pecking order and must be diversified away. Long duration and rolling maturities, however, are major disadvantages of bond ETFs, as they are affected by frequent movements in treasuries and inflation expectations. Volatility of price return exhibited by bond ETFs makes an investor susceptible to timing and execution error when chasing yields. One way to counter the negative price volatility effect is by imitating strategies conducted by special situations hedge funds in an ETF structure. Special sits strategies evolve around buying short-dated bonds that turned suddenly cheap and by controlling the price return effect as the bond move toward par at maturity. Nonetheless, such a strategy has to be executed under controlled limits in order not to backfire.
In an ETF structure, bullet bond ETFs grouped according to specific maturity dates allow money managers to guarantee return for a specific mandate whether for institutional investors or family offices. The only risk of such a strategy is a high default rate among the credit sphere. The 2001 and 2008 financial crisis showed however that default rates among IG corporate bonds ranged between 2% to 4%. As for high yield bonds, default rates were 10% and hit specific industries. As of February 2009, Moody's reported that around 80% of dollar volume defaults had been concentrated in two industries, banking and real estate. Many other industries like retail, technology, transportation and utilities only contributed 1.9% of dollar volume defaults and had at max up to 5% of total issuers per industry defaulting.
Default rates during financial crises by credit rating
Bullet bond ETFs did not exist during recent financial crises and thus it would be difficult to analyze how such products would trade in terms of liquidity and NAV discount/premium during a future crisis. Nonetheless, bullet bond ETFs present a solution for money managers when implementing a target return mandate based on the pillars of capital protection, performance guarantee and recurring income. Combining a bullet bond ETF with a multi-asset portfolio would reduce the overall risk and beta of the portfolio since at-par price recuperation is only correlated to the changes in risk of defaults and not to other asset classes.
Source of chart: Standard & Poors
Opportunity cost: Is the American Debt as Risky as the Greek One?
Author: Product Team / 29 July 2019
A shocking reality in this week's economic data is the parity between the yield on the US debt vs the yield on the Greek debt for a maturity of 10 years.
It is 2 %.
How is this number interpreted? Depending on the economic microscope, one might see this number differently. On one side, it is understood that interest rates are reflective of inflation in an economy or as a mean to control inflation in a given economy. On another side, yields on different government bonds could also reflect a premium an investor is receiving to hold an asset with higher probability of default compared to the ‘‘real risk-free rate’’. But from which case is this parity arising?
Inflation in Greece has been hanging in a range below 1% for the last few years. First, this trend has been reflective of a weak economic growth driven by lackluster households’ income growth, and reflective of the fact that emigration levels have been on the rise or better put ‘depopulation of Greece’. This is what we call the Greek intrinsic economic factor. Secondly, the Greek economy, as part of the European Union, should converge to other European Union economies as the adhesion to the union and to the Eurozone is defined by economic convergence factors. From this regard, even though the latest inflation numbers in Greece were in negative territory, the Greek 2% interest rate is reflective of the risk premium an investor should receive to invest in a troubled EUR denominated debt versus the safe "risk-free" German Bund.
On the other side of the pond, the US economy has been having the best run in recent memory. Inflation picked up momentarily to the Federal Reserve target of 2% and unemployment rate has been at a record low. As a standard monetary policy reaction, over the course of last year, the FED increased interest rates to maintain the longevity of the economic cycle. Consequently, yield on the short-term US government debt has been hanging around 2% just similar to yields on long-term maturities. Cautious about the long-term economic perspective, investors resorted to the purchase of long-term US government debt as a portfolio hedge. The latter action has caused the hump-shaped yield curve in the recent year which is reflected in the 2% yield on the US long-term "risk-free" rate.
Going back to the observed parity this week, what should an investor do? We believe in opportunity cost, and therefore we designed the Cedar Global Income Index (CDRI). The index by construction behaves like a bond being held to maturity. As long as the economic outlook is not crystal clear for an investor, and inflation expectations do not look promising, the index allows the investor at the day of investment to lock and secure the observed yield-to-maturity. By construction, the index intends to minimize duration risk and to reduce the effect of extreme long-term uncertainties on income mandates. The index's hold-to-maturity components are maturing in 2021, the date of a major index rebalancing. Furthermore as a model portfolio, Cedar Global Income Index additionally includes alternative income ETFs serving the goals of yield maximization, regular dividends stream and low volatility.
Last week we discussed in our blog post, how a foreign investor can invest in a CDRI tracker and hedge currency risk at portfolio level. Given the low duration, low volatility and regular distributions of CDRI in addition to the target rebalancing, currency hedging through natural hedges and long-term derivatives would not be an impediment to execute on a mandate of capital preservation and income generation.
The viability of a stable USD multi-asset wrapper for foreign investors and techniques for currency hedging at portfolio level
Author: Product Team / 22 July 2019
Family offices and trusts in Europe are finding it difficult to execute on a mandate of capital preservation and income generation. The persistent low yield environment coupled with subdued inflation expectations is distorting asset allocation models.
The persistent Low Yield Environment and limits to asset allocation strategies
ECB stopped its flagship EUR 2.5 trillion bond buying scheme in 2018. However, the European Central Bank’s easing policy is still far away from the exit gates. ECB chief indicated in June 2019 that a new round of quantitative easing could be in the offing with perhaps more private assets purchases. Even if QE 2.0 does not become a reality, negative deposit rates are becoming a legacy action for the European Central Bank in the low inflation environment. On the other hand, money managers at family offices and trusts are finding it difficult to commit more funds toward alternative assets for liquidity management and return concerns. Since the start of the low yield era in 2014, Institutional investors created an overcrowded and an intense demand environment for alternatives as they hurried to scoop quality real assets in the market. Another option for European managers seeking yield would be to increase exposure to the European High-Yield environment, nonetheless, such tactic would mean violating asset allocation limits of non-investment grade exposures.
A model portfolio multi-asset investable index as a solution
Cedar Global Income Index (CDRI), a Multi-Asset low volatility model portfolio index, presents a viable option for managers executing a mandate of capital preservation and income generation. The index generates income on a constant basis through exposure to bullet bonds and income-paying multi-asset ETFs. Most importantly, CDRI has an average investment grade rating and high liquidity eligibility criteria. The move to par of 2021 bullet bonds in the index produces a sustained yield coupled with low duration and a capital guarantee feature. Multi-asset ETF constituents in the index produce a constant cash yield and replicate a low volatility dividend-paying portfolio. With a 12-month distribution yield of 4.41% and an annual volatility of 2.75% as of July 2019, CDRI generates one of the highest sharpe ratios when compared to other Multi-Asset ETFs in the market.
FX hedging at portfolio level
As the index is quoted in US Dollars, a foreign investor seeking to invest in CDRI through direct indexing or a tracking certificate would need to manage currency risk at portfolio level. In the following paragraph, we will present ideas to support hedging techniques of FX exposure at a portfolio level. An investor in CDRI would need to know the index’s payment and rebalancing frequencies as well as the date of a major reallocation. CDRI’s constituents generate a monthly or quarterly cash income at a yield ranging usually between 0.05% and 0.30% per distribution. These recurring distributions affect the level of a total return tracker on a monthly basis. Moreover, Multi-Asset ETFs constituting 40% of the index are rebalanced on a quarterly basis; while bullet bonds which constitute 60% of the index are reallocated at their maturity date. Investors can use a range of FX hedging techniques depending on the availability of different factors such as access to capital, the tax environment and the investment objective. An investor with access to margin lending in US Dollars would lever-up the invested assets in the low volatility CDRI, increase net return on equity and partially protect the principal investment against FX fluctuations. An investor with access to options strategies and currency swaps would set settlement date at around the maturity date of the bullet bonds allocation. As of July, yield to maturity of bullet bonds had a move to par yield of 3.36%. While hedging techniques differ at each portfolio level, we recommend investors to increase the use of FX natural hedges and long-term derivatives, and to use hedges for what would be considered as tail risk.