Consider alternative bond strategies

It’s a challenging environment for fixed-income investors. Traditional bond strategies don’t generate the robust yields they once did. But this doesn’t mean you should flee fixed income and load up on stocks. Instead, consider alternative fixed-income strategies.

Once such strategy involves using long and short positions to capitalize on good buys and hedge the risks that stymie typical strategies, notes Philip Mesman, a portfolio manager at Picton Mahoney Asset Management in Toronto.

Long position: You’re betting the security’s price will go up.

Short position: You’re betting the security’s price will go down.

Mesman’s long positions focus on the middle of the North American corporate bond market—firms rated B to BBB. Such companies are often worth more than they’re priced.

The short side of his portfolio hedges three key risks:

• Interest rate risk – the bond’s price falls when rates rise
• Price risk – the bond costs too much
• Credit risk – the issuer may default or go bankrupt

The severity of these risks varies depending on where we are in the investment cycle. To hedge interest rate risk, Mesman may short government bonds.

Many wonder how you can short bonds, since their face values don’t change. That’s true, but it doesn’t mean the selling price of a bond can’t drop below its face value.

Say you hold 10-year government bonds with $100 face values, issued at a rate of 1.5%. If the interest rate jumps to 2%, newly issued bonds are clearly more attractive.

Now assume you wanted to sell your bonds instead of holding them to maturity. To match that 2% coupon offered on the newly issued bonds, your price would have to dip below $100.

To hedge price risk, Mesman shorts over-priced bonds with weak credit profiles.

As with senior secured debt, you must be an accredited investor to participate.

Mesman notes that when rates move up from their current record lows, traditional bond strategies will again be effective.

Updated July 20, 2016.