O’Connor Interest rate volatility guides O’Connor hedge fund portfolios

In this letter from O’Connor’s CIO Kevin Russell, he writes that interest rate volatility is their preferred risk indicator for economic uncertainty. 

18 Apr 2021

Now trending: interest rate volatility

This is an extract of Kevin Russell's Q1 2021 CIO letter

Our favourite indicator for risk is monitoring implied volatility … with higher implied vol often preceding risk aversion across strategies

Kevin Russell,

Chief Investment Officer,

O'Connor

We follow interest rate volatility very closely

To best follow the rotations and risk aversion associated with the recalibration in economic growth expectations and inflation concerns, we continue to follow interest rate volatility very closely. Investors know that we have long since shifted some of our focus from equity index volatility and skew toward interest rate volatility as our preferred indicator for risk appetite. In choosing to the follow the MOVE Index (Merrill Lynch Option Volatility Estimate) more closely than the VIX Index (CBOE Volatility Index), we are judging that interest rate volatility, on both a realized and implied volatility basis, is the best indicator for risk appetite and stability across the full range of relative value disciplines.

We view interest rate volatility as an indicator of economic uncertainty

As our focus on interest rate volatility is somewhat unique amongst our peers, the question often arises, why are we so focused on this relatively obscure market index and risk measure? The answer is two-fold. First, we believe that interest rates serve as the fulcrum point for the economy, providing a comprehensive view about growth, inflation, and policy all at once. Second, interest rates are the benchmark for risk-free returns and are central to the valuation of every asset in investor portfolios. Put simply, when interest rate volatility is high, certainty about economic conditions and confidence in asset valuations is low, often manifesting itself as risk aversion amongst relative value investors, especially those who operate on leverage.

Following the MOVE Index in the first quarter, we can clearly see the telltale spike in interest rate volatility that occurred, bringing with it both risk aversion and violent factor rotations within the equity markets. Encouragingly though, we started to see signs of stabilization in interest rate volatility at the end of the quarter, which we feel bodes well for our strategies for the coming months (Figure 1).

Figure 1: Rising interest rate volatility suggests reduced investor confidence

Source: Bloomberg LLC. Data as of 12 April 2021.

Rising interest rate volatility suggests reduced investor confidence, charts the Merrill Lynch Option Volatility Estimate (MOVE Index) from January 1, 2021 through April 12, 2021.

Figure 2: 2020 also experienced periods of high interest rate volatility

Source: Bloomberg LLC. Data as of 31 December 2020.

2020 also experienced periods of high interest rate volatility, charts the Merrill Lynch Option Volatility Estimate (MOVE Index) from January 1, 2020 through December 31, 2020.

It should not come as a surprise that we undertook some portfolio deleveraging in early March, just as we did in early October 2020, given the spike in interest rate volatility (Figure 2). However, just as we did in November 2020, we began to increase leverage again at the end of the first quarter in anticipation of interest rate volatility beginning to normalize.

We continue to be very focused on the macroeconomic landscape to provide the broadest possible lens for our investment process. Again, this is not to make first order directional risk allocations to different asset classes, but rather to help us understand which segments of the market are most likely to experience high levels of dispersion of securities performance.

Operating a multi-strategy, relative value approach to investing aligns our capital with structural alpha opportunities and insulates us significantly from risk aversion events emanating from macroeconomic developments. We subscribe to the idea that a healthy paranoia is useful in monitoring our portfolio and strategies. In fact, while some relative value investors experienced substantial performance challenges in the first quarter attributable to crowding, concentration, and leverage, it is undeniable that some of those challenges were catalyzed by the shifting macroeconomic landscape and risk outlook.

Aligning with six key mega trends

As we have repeatedly discussed in prior letters, in addition to our core relative value strategies, we are benefiting from the fact that we have a significant amount of our capital aligned with several structural alpha opportunities. These are driven by six mega trends occurring within the financial markets: the size of US credit markets, environmentally focused investing, Chinese equity markets, special purpose acquisition companies (SPACs), private credit, and supply chain finance. While we see each of these trends as long duration in nature likely lasting for several years and will have capital allocated to them consistently, the specific opportunity set and available returns will ebb and flow at different points in time, presenting unique opportunities and meriting more of our attention.

Supply-chain trade finance getting our attention right now, as the operating difficulties of several important players in the ecosystem have created a significant supply/demand imbalance that favors investors. Recent negative press surrounding supply chain finance is a product of localized, firm-specific issues, not a blight on the asset class as whole. In fact, these difficulties at several important players in the ecosystem have created a significant supply/demand imbalance that is enhancing the attractiveness of the opportunity set for investors.

Against the backdrop of tight credit spreads in both the investment grade and high yield markets, we are seeing tremendous value in the trade finance space (Figure 3).

Figure 3: Spreads are tightening in corporate bond markets

Source: Bloomberg, as of 30 March 2021.

Spreads are tightening in corporate bond markets charts credit spreads for US Investment grade (all sectors) and US High Yield all sectors from December 2019 through March 30 2021.

In addition to the shorter duration, lower default probabilities, and higher recoveries available for corporate credit exposures taken via trade finance, we are also currently enjoying substantial yield pick-up ranging from 100 bps to as much as 2,000 bps in some cases, relative to observable benchmarks in the investment grade and high yield markets. While there is some additional complexity and operational intensiveness involved with supply chain finance compared to corporate bonds, the magnitude of the relative credit premium is undeniable and presents one of the most compelling opportunities that we see across all asset markets. We are fortunate to have been focused on supply chain finance for the past two years and find ourselves fully prepared to capitalize on this market dislocation for our investors.

We would be remiss to not discuss the SPAC strategy has delivered positive returns thus far in 2021 and volatility. Despite what has been a difficult four weeks for the strategy, having gotten caught up in the growth and secular winner risk unwind of the first quarter, we would note that the strategy has delivered positive returns thus far in 2021, and we see attractive valuations and compelling investment opportunities available. And, while we think that security selection is more important now than ever to derive returns from the SPAC market, we are heartened by the very modest level of embedded optionality being priced into the market right now, with the 411 SPACs looking for acquisitions as of quarter-end, trading at only a 1.1% and 1.7% discount, on a mean and median basis, as demonstrated by UBS Investment Bank data, to the cash in trust that offers downside support in SPAC securities (Figure 4).

Figure 4: Tightening spreads in SPAC market suggest downside support

Source: UBS Investment Bank, Special Situations group. Data as of 2 April 2021.

Tightening spreads in SPAC market suggest downside support, charts the mean premium/discount to NAV and the Median premium/discount to NAV, from July 1 2020 through April 9, 2021, for the SPAC market.

Merger arbitrage investing: A core focus

Longtime investors have likely observed that over the past few months we have increased the capital allocated to our merger arbitrage strategy, which has been one of O'Connor's core investment strengths throughout our history. An exciting dynamic emerging from the COVID-19 crisis is the fact that corporate confidence in the economy and commitment to strategic activity has dramatically improved over the past two quarters (Figure 5).

Figure 5: US M&A Volume and CEO Confidence

Source: Bloomberg, as of 31 March 2021.

US M&A Volume and CEO Confidence, charts US M&A volume and the CEO Confidence Index from December 1, 2015 through March 31, 2021.

With confidence and conviction now taking hold in corporate boardrooms, announced M&A monthly transaction volumes have increased over the first quarter (Figure 6). We expect higher M&A activity levels to sustain throughout 2021, creating the opportunity for us to scale up a diversified portfolio of investments.

Figure 6: Global M&A announced volume, 2020 – March 2021

Source:UBS, Bloomberg LLC. As of 2 April 2021.

Global M&A announced volume, 2020 – March 2021 charts the number of deals and total deal volume for global announced mergers and acquisitions from January 1, 2020 through April 2, 2021.

Building on a solid framework

After the hard work of repositioning the multi-strategy approach three years ago, we continue to be excited about our strategic competencies and the outlook for performance which carried through in the first quarter of 2021. While we know that returns and volatility will moderate from the levels experienced in 2020, we believe our approach is durable and can serve as a ballast in investor portfolios, by delivering attractive risk-adjusted and uncorrelated returns.

While our investment teams continue to work effectively from a mixture of our offices around the world and their home offices, we are looking forward to connecting with each other and with many of you in person as soon as vaccine distributions accelerate around the world.

Subscribe now

Perspectives matter. Tune in to our insights.

More insights

Singapore Retail Investors

PLEASE READ THESE TERMS AND CONDITIONS CAREFULLY BEFORE PROCEEDING. BY UTILIZING THE WEBSITE AND PAGES THEREOF LOCATED AT WWW.UBS.COM/AM-SG ("WEBSITE"), YOU ACKNOWLEDGE THAT YOU HAVE READ THESE TERMS AS WELL AS THE GLOBAL TERMS OF USE(collectively "TERMS") AND THAT YOU AGREE TO BE BOUND BY THEM. IF YOU DO NOT AGREE TO ALL OF THE TERMS OF THIS AGREEMENT, YOU ARE NOT AN AUTHORIZED USER OF THESE SERVICES AND YOU SHOULD NOT USE THIS WEBSITE.

This website is not intended for and should not be accessed by persons located or resident in any jurisdiction where (by reason of that person's nationality, domicile, residence or otherwise) the publication or availability of this website is prohibited or contrary to local law or regulation or would subject any UBS entity to any registration or licensing requirements in such jurisdictions. It is your responsibility to be aware of, to obtain all relevant regulatory approvals, licenses, verifications and/or registrations under, and to observe all applicable laws and regulations of any relevant jurisdiction in connection with your entrance to this website. Each investment product and service referred to on this website is intended to be made available only to residents in Singapore.

UBS reserves the right to change, modify, add or remove content on the website as well as these terms at any time for any reason without notice. Such changes shall be effective immediately upon posting. You acknowledge that by accessing our website after we have posted changes to these terms, you are agreeing to these terms as modified.

The materials on this Website are distributed by UBS Asset Management (Singapore) Ltd (company registration number: 199308367C), which is licensed by Monetary Authority of Singapore ("MAS") in Singapore pursuant to the Securities and Futures Act (Chapter 289 of Singapore). UBS Asset Management (Singapore) Ltd is part of the Asset Management business division of UBS Group AG. UBS Asset Management (Singapore) Ltd together with UBS Group AG and its group companies shall collectively be referred to as "UBS".

The information contained in this Website has been prepared and is intended for general circulation. The information does not constitute advice and does not take into account the specific investment objectives, financial situation, or particular needs of any particular person. The investment services or products referred to in this Website may not be suitable for all investors. UBS recommends that you independently evaluate particular investments and strategies and seek independent advice from a financial adviser regarding the suitability of such investment products, taking into account your specific investment objectives, financial situation and particular needs, before making a commitment to purchase any investment products. Investment involves risks. You should be aware that investments may increase or decrease in value and that past performance is not indicative of future performance.

The information contained in this Website is not an offer to buy or sell or the solicitation of an offer to buy or sell any investment product or to participate in any particular trading strategy. UBS, its officers and/or employees may have interests in any of the investment products referred to on this Website by acting in various roles. UBS, its officers and/or employees may receive fees, commissions or other benefits for acting in those capacities. In addition, UBS, its officers and/or employees may buy or sell investment products as principal or agent and may effect transactions which are not consistent with the information set out in this Website.

You fully understand and agree that, by making available this Website, UBS should not be construed as making: (a) any endorsement of any investment product referred to in this Website; (b) any representation that UBS has performed any due diligence on any investment product referred to in this Website; or (c) any representation that the information in this Website is complete, accurate, clear, fair and not misleading. The use or reliance on any such information contained in this Website is at your own risk and any losses which may be suffered as a result of you entering into any investment are for your account and UBS shall not be liable for any losses arising from or incurred by you in connection therewith. UBS is not responsible or liable for the accuracy and completeness of any such information or the performance or outcome of any investment made by you after receipt of such information, irrespective of whether such information was provided at your request.

Using, copying, redistributing or republishing any part of this Website without prior written permission from UBS is prohibited. Any statements made regarding investment performance objectives, risk and/or return targets shall not constitute a representation or warranty that such objectives or expectations will be achieved or risks are fully disclosed. The information and opinions contained in this Website is based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any misrepresentation, errors or omissions. All such information and opinions are subject to change without notice. A number of comments in this Website are based on current expectations and are considered “forward-looking statements”. Actual future results may prove to be different from expectations and any unforeseen risk or event may arise in the future. The opinions expressed are a reflection of UBS’s judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed.

UBS does not hold out any of its officers and/or employees as having any authority to advise you, and UBS does not purport to advise you on any investment product. Any investment will be made at your sole risk and UBS is not and shall not, in any manner, be liable or responsible for the consequences of any investment.

This Website and its contents are provided on an “as is” and “as available” basis. UBS does not warrant: (a) the accuracy, timeliness, adequacy commercial value or completeness of this Website or its contents, and expressly disclaims any liability for errors, delays or omissions in the contents, or for any action taken in reliance on the contents; (b) that your use of and/or access to this Website or its contents, will be uninterrupted, timely, secure or free from errors or that any identified defect will be corrected; (c) that this Website or any content will meet your requirements or are free from any virus or other malicious, destructive or corrupting code, agent, program or macros; (d) that any information, instructions or communications posted or transmitted by you through this Website is secure and cannot be accessed by unauthorised third parties; and (e) that use of the contents in this Website by you will not infringe the rights of any third parties. No warranty of any kind, implied, express or statutory, including but not limited to the warranties of non-infringement of third party rights, title, merchantability, satisfactory quality or fitness for a particular purpose and freedom from computer virus or other malicious, destructive or corrupting code, agent, program or macros, is given in conjunction with this Website.

You hereby agree to indemnify UBS and any of its officers, employees or agents against, and to keep UBS and any of its officers, employees or agents harmless from, any claims (actual and threatened), settlement sums, liability, loss, damages, costs (including solicitor and client costs and expenses (legal or otherwise)), charges, expenses, actions, proceedings, whether foreseeable or not which we may sustain, suffer or incur, directly or indirectly out of or in the course of or in connection with any the following: (a) any use of this Website or the contents by you, or any part thereof; (b) UBS having made available the Website; (c) any breach of these Terms by you, however arising; or (d) any negligence, act or omission, wilful default, unlawful act, fraud and/or misconduct on your part or violation of any rights of another person or entity by you.

The funds referred to in this Website have been authorised or recognised by the MAS for sale to the public in Singapore (the “Funds”). Copies of the registered Singapore prospectuses ("Prospectuses") referred to in this Website have been lodged with and registered by the MAS. The MAS assumes no responsibility for the contents of the Prospectuses. The registration of the Prospectuses by the MAS does not imply that the SFA or any other legal or regulatory requirements have been complied with.

MAS registration is not a recommendation or endorsement of a Fund nor does it guarantee the commercial merits or performance of such Fund. It does not mean that a Fund is suitable for all investors nor is it an endorsement of its suitability for any particular investor or class of investors. UBS Asset Management (Singapore) Ltd has been appointed as the representative for the Funds in Singapore for the purposes of performing administrative and other related functions relating to the offer of Shares under Section 287 of the Securities and Futures Act, Chapter 289 of Singapore (the "SFA") and such other functions as the MAS may prescribe.

You may not assign your rights under the Terms without our prior written consent. UBS Asset Management (Singapore) Ltd may assign our rights under the Terms to any third party.

No person or entity who is not a party to the Terms shall have any right under the Contracts (Rights of Third Parties) Act, Chapter 53B of Singapore or other similar laws to enforce any term of the Terms regardless of whether such person or entity has been identified by name, as a member of a class or as answering a particular description. For the avoidance of doubt, this shall not affect the rights of any permitted assignee or transferee of the Terms.

These Terms shall be governed by, and shall be construed in accordance with, the laws of Singapore. The courts of Singapore shall have exclusive jurisdiction to hear and determine any suit, action or proceeding, and to settle any disputes, which may arise out of or in connection with these Terms and, for such purposes, you agree to submit  to the jurisdiction of the courts of Singapore. Each party hereby waives any objection which it might at any time have to the courts of Singapore being nominated as the forum to hear and determine any proceedings and to settle any disputes and agrees not to claim that the courts of Singapore are not a convenient or appropriate forum.

© UBS 2021 - the key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Reset