**Fund Manager's Investment Notes** - Asset Allocation Series

Peeling Back the Layers of Major Asset Allocation

When it comes to stability, many might first think of fixed-income assets represented by bonds, which are considered representatives of "stable" assets due to their lower volatility and more reliable returns. However, in recent years, with the frequent occurrence of bond defaults, the fluctuations in the bond market have also been affecting investors' hearts. On one hand, the experience of "stepping on a mine, and all efforts going to waste" is something that every fixed-income investor wants to avoid at all costs; on the other hand, strategies such as credit downgrading that bring potential excess returns are like a delicious sandwich tempting the thirsty hearts of investors in the current environment of declining interest rates. So, how to make a good fixed-income "sandwich"? We believe that its stable recipe has the following aspects:

1. The Basic Bread Layer - Liquidity Management

Investing is inseparable from buying and selling, and the timing of entry and exit is a question that investors must think about in advance. Generally speaking, in bond investment management, holding to maturity is relatively rare, as investment managers always hope to enhance investment returns through certain trades. With buying and selling, liquidity management becomes very important. To put it simply, liquidity management means freedom in buying and selling, with unrestricted capital flow. In China's bond market, which is generally long-oriented, buying is relatively straightforward, while selling is more complex because when investors want to cash out and exit, they may not necessarily be able to do so at a reasonable price and quantity. Therefore, when investing in bonds, one must first know where the exit is, how wide it is, and whether it is possible to escape in an emergency.

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In terms of liquidity management, there are three main points worth considering:1. Trading Volume and Turnover Rate. Trading volume represents the absolute liquidity, while the turnover rate is a relative measure of liquidity. When investing, all other conditions being equal, we should prioritize securities with high trading volume and turnover rates. This ensures the full effectiveness of the price and increases the freedom of buying and selling without being troubled by volume constraints.

2. Early Withdrawal for Risk Prevention. For credit bonds, it is imperative to manage credit risk and assess market liquidity. If adverse conditions arise, one must withdraw early without lingering, as credit bonds are difficult to sell when they decline. An example is provided below.

Before the bond default event, the overall situation was uneventful, and the credit spread gradually increased the yield of the portfolio. However, once the default occurred, we can observe a significant price drop (from the original 99.570 to a low of 34.500, a decline of 65.35%) and a contraction in trading volume (the maximum daily trading volume from the start of the decline to the lowest point was 16,000, which translates to a transaction amount of less than 14 million RMB. This is too small a proportion relative to the bond's overall scale of about 2 billion RMB. Although the bond's trading was not active under normal circumstances, the trading situation further deteriorated after the default event). At this point, not only are interest losses faced, but more critically, there is the risk of a total loss, as the inability to sell results in being stuck. Any previous unrealized gains have become a thing of the past.

3. Liability Management. For most funds, liability management is very important, as it involves managing clients' funds and naturally requires understanding their risk preferences and the nature of their capital. The worst-case scenario of improper liability management is facing large temporary redemptions from clients. At this time, the fund manager either has to liquidate assets proportionally or sell assets with good liquidity first. The former is also acceptable if it can be completed smoothly, as it ensures that the investment allocation is not disrupted. However, not all bonds can be liquidated quickly, and a large-scale sale may lead to unfair pricing. In this case, only assets with good liquidity, such as interest rate bonds, are passively sold to alleviate the redemption crisis. Just as a company may face bankruptcy due to high debt pressure and the bank's decision to cut off or withdraw loans, bond investment is similar; improper liability management can very likely cause significant damage to the fund.

Therefore, liquidity management is like the bread layer of a sandwich, the outermost and first layer seen, and as the provider of energy from carbohydrates, it maintains the vitality of bond investment.

II.

Key Patty Layer - Duration Management

Duration is a concept that transcends maturity, widely applied in individual bond investment and bond portfolio investment. The core of duration management is mainly due to three points:

1. Duration is related to potential coupon income, affecting the safety margin of the portfolio. First, the concept of duration is quite specialized; simply put, it is the interest rate fluctuation brought about by the length of the term. For example, bank fixed deposits have one-year and three-year terms, and under normal circumstances, the one-year fixed deposit rate will be lower than the three-year fixed deposit rate. This is because lending the same amount of money to the bank for three years sacrifices more liquidity compared to one year, and the bank should pay extra for the loss of liquidity. Therefore, under the same conditions, the longer the term, the higher the interest rate. Bond investment is similar; if the expectation is for ample funds or a downward trend, choosing a longer duration will better increase investment returns.

2. Switching durations in response to interest rate market changes can capture excess returns in stages and control risks. If the previous coupon factor is a static dimension, then switching durations to capture excess returns is a dynamic dimension. Duration can be used to measure the impact of interest rate changes on bond prices; the longer the duration, the greater the impact of interest rate changes on bond prices. When it is judged that the interest rate environment is favorable and the future funding situation will further relax, interest rates will decline, and bonds will have opportunities for a phased bull market. As mentioned earlier, under the same conditions, the longer the duration, the greater the increase in bond prices caused by the decline in yields, and the more capital gains the investment portfolio will obtain. Therefore, in theory, we should extend the duration, that is, increase the position of long-duration bonds, in order to obtain greater excess returns. Conversely, during the interest rate hike cycle, shortening the portfolio duration can enhance the defensiveness of the portfolio and reduce the volatility of portfolio returns.3. Tracking the term structure can help select better bond types. If the dynamic dimension mentioned in the second point above provides a direction for duration management, then tracking the term structure offers a dialectical dimension to refine bond selection. Let's take the recent yield curve of government development bonds as an example. In the chart, we can see that the yield curve on February 18, 2020, has shifted downward compared to the curve two months prior, clearly reflecting the marginal easing of the interest rate environment and the resulting decline in interest rates. In theory, we should have lengthened our duration two months ago to capture the phased benefits. But how long should we extend the duration? At this point, we should track the term structure. We can observe that the lower half of the chart is a bar chart of the spread, which depicts the extent of the interest rate decline over the past two months. A careful examination reveals that the spread for the 1-year term is the largest, followed by the 5-year term, then the 15-year term, the 7-year term, and the 10-year term has the smallest spread. This result indicates that during the past two months of interest rate decline, it is not the case that the longer the duration, the better. In fact, the 10-year term variety has the thinnest relative profit. Why does this result occur? As shown in the chart above, the reason is that the starting points of each variety are different, in other words, the historical percentile values of the yields of each variety at that time were different. The historical percentile value of the yield for terms of 1 year or less (38.14%) two months ago was much higher compared to the 10-year term yield (25.77%), and the spread of the 1-year term or less variety from the minimum value is 47.84 basis points higher than the 10-year data (105.94bp - 58.10bp). This means that the original yield for terms of 1 year or less was relatively high, and theoretically, there was room for decline even without this round of interest rate decline. Therefore, this round of interest rate decline actually acted as a force and catalyst, enabling the interest rate level of government development bonds with terms of 1 year or less to reach the desired level in one step, thereby contributing to relatively more phased spread benefits.

Considering the above three points, duration management ostensibly manages the term, but in reality, it manages the yield to maturity and its marginal changes. Duration can be as short as a few months or as long as 30-50 years. The large span it covers determines the potential for excess returns in duration management, which is why it is said that duration management is like the meat layer in a sandwich, as this part indeed needs to be well-prepared to be "juicy and rich."

III.

Auxiliary Vegetable Layer - Credit Management

With the increasing frequency of bond default events in recent years, credit risk management has become particularly important. Taking the default bonds in the previous liquidity management as an example, we can see that when bonds default, the market is prone to a cliff-like decline. This not only may consume the safety cushion that has been painstakingly accumulated but also poses the risk of capital loss. Credit risk management is akin to picking ginseng on the edge of a cliff because as credit sinks, the credit rating of the bonds held decreases, but the coupon rate increases, thickening the returns, which is as delightful as picking the "precious ginseng" on the edge of the cliff. However, on the other hand, a misstep could lead to a fall into the abyss, resulting in misfortune.

In actual bond investment, setting the threshold for credit risk is very important. Generally, regular asset management institutions set a unified threshold for bonds with low credit ratings, allowing only bonds with a credit rating above a certain level to be included in the inventory. Bonds not in the inventory are not allowed to be invested. This is equivalent to drawing a prohibition line on the inner side of the cliff, protecting the relative safety of the investment. As for how far this line should be from the cliff, it depends on the investor's risk preference.

Vegetables are beneficial to human health, just as credit sinking is beneficial to investment returns: an appropriate proportion of vegetables optimizes the overall taste of the sandwich, just as an appropriate level of credit sinking enhances investment returns; an excessive proportion of vegetables is not only detrimental to the overall taste of the sandwich but also不利于 maintaining good health, as vegetables provide limited energy, just as relentlessly pursuing excess returns through credit sinking is not conducive to the long-term stability of the investment portfolio. Moreover, investing too much effort in pursuing ultra-high returns may ultimately lead to a loss of the overall situation, which is not worth the loss. Excessive exposure to credit risk may enhance floating profits in the short term, but once a pit is encountered in the long term, all previous efforts will be in vain. Therefore, one should not lose sight of the bigger picture for the sake of small gains, always remembering that stability comes first.

IV.

Garnish Sauce Layer - Leverage ManagementLeveraging is a familiar concept to many. It is a technique that enhances investment returns through financing. On the surface, it appears to be the act of borrowing money, but fundamentally, it is predicated on whether the potential returns on the asset side can cover the financing costs. If they cannot or barely cover, the significance is minimal.

The reason for comparing leverage management to the sauce layer in a sandwich is that it serves an auxiliary function. What does it assist? It aids the three layers mentioned earlier, with the most critical being the selection of appropriate sauce to complement the meat and vegetable layers, such as beef with cheese or chicken with Orleans sauce. A suitable match can elevate the taste experience. Similarly, in bond investment, if the macro interest rate environment is abundant, leveraging a certain degree of leverage with an extended duration can, on one hand, lower the financing costs, and on the other hand, achieve higher excess returns on the investment side. Such a combination can fully utilize the activated funds to capture the excess returns of a bond bull market. If the overall funding situation is good but the short-term marginal changes are minimal, one should measure based on the return rate of the asset side. If the combined returns of credit bonds and interest rate bonds can cover the financing costs and have a good surplus, then leverage operations can be conducted under the premise of controlling liquidity. When the external environment's marginal improvement is not obvious, it is not advisable to use too much leverage to avoid passive position reduction and transaction friction due to marginal funding tension.

Some readers may ask, can we avoid using leverage? Of course, just as some people prefer sandwiches without sauce. However, in today's era, people's taste requirements for gourmet food are increasingly high, and investors' demands for returns are also growing. Therefore, generally speaking, if leverage can enhance the investment returns of a portfolio, it is recommended to consider it, especially since public funds face relative rankings, and being overly conservative can also lead to passivity. Leverage, as a magnifying glass and catalyst on the asset side, can also exacerbate the situation if the investment direction is misjudged or if there is a "mine" situation. Therefore, leverage, as a decorative sauce, is not the main ingredient; eating only sauce will not bring the experience of gourmet food. In other words, relying solely on leverage cannot make money; it must be combined with operations such as duration management and credit risk management to enhance returns.

In summary, fixed-income investment, as an important part of asset allocation, becomes even more significant under the risks of global economic downturn, geopolitical uncertainties, and international trade disputes. Fixed-income professionals often say that fixed income is not fixed, referring to the floating maturity yield, which reflects the existence of potential excess returns. Capturing excess returns is one of the joys of fixed-income investment and is also the delicacy of the fixed-income "sandwich." With liquidity management as the bread, duration management as the meat, credit risk management as the vegetables, and leverage as the suitable sauce, the organic combination of these four elements, along with the maturation of time, will enable everyone to create a fixed-income "sandwich" that meets customer tastes and has its own characteristics.

The content above is the property of the respective owners and does not constitute any investment advice. Investment carries risks, and investors should be cautious.