Derivatives don’t appear in many local authority portfolios. Used properly, they are excellent risk management tools, but they can be unfamiliar and a little more complicated.
Nonetheless, some local authorities are taking advantage of derivatives indirectly through investments in certain pooled funds. For example, funds that invest in foreign currency denominated instruments, such as US corporate bonds, provide UK investors with a GBP share class.
Of course, once your funds are converted to dollars you as the investor are exposed to exchange rate risk. If the dollar were to suddenly drop against the pound, your investment would suddenly be worth a lot less if you were to sell your shares and convert those dollars back to pounds. To help minimise this risk, the fund manager would usually open a currency hedge.
While currency hedging can be used for speculative purposes, in the context of pooled funds it is used to alleviate some of your exchange rate risk by agreeing to convert a set amount of the dollar denominated portion of the fund back to pounds on a set date, at a set price. By fixing out this element, the funds are protected from unexpected drops in the exchange rate. On the other hand, if the dollar were to appreciate, then the standard dollar share class portion of the fund appreciates in value.
The currency hedge is then monitored and moved on a regular basis to ensure that it keeps up with any changes in portfolio valuations. The constant movement of this hedge is what smooths out volatility in exchange rates over the life of your investment and while this doesn’t eliminate all risk, it certainly helps to minimise any losses (especially over a long investment horizon). Many of the funds in the Arlingclose fund suite make use of currency hedging in their GBP share classes.
Some fund managers will also use derivatives to enhance the income generated on their investments through a covered call strategy. A call option is a derivative product which gives an investor the right (but not the obligation) to buy a stock at a predetermined price. So an investor who thinks the price of a stock will rise in the future may enter into a call option whereby they agree to buy that stock at a later date at a price agreed today. If the value of the stock has risen at the expiration date, the investor can buy the underlying stock at a discount. If the stock fell in value, then the investor could simply not exercise the option and just lose the premium they paid to open the option.
Pooled funds that employ a covered call option strategy play the role of the option writer in this scenario. Writing call options is a high-risk investment as if the stock price were to rise, the fund manager would incur a large loss. This risk is mitigated by “covering” the option which means buying the underlying stock that you write the option for – this way if the stock price rises, the losses are netted off. This strategy is utilised successfully in a couple of the higher income payers in the Arlingclose fund suite – including one regularly paying 7% a year.
While derivatives are not the most commonly used financial instrument for local authority treasurers, they certainly are a useful tool when the right situation arises. Some local authorities have made substantial savings by utilising interest rate swaps, a derivative that has found its way back into the local authority toolkit recently. With some swap rates a full 1% below PWLB rates its not surprising they are attracting attention. And for local authorities who do not want to engage directly with derivative products, investments in pooled funds which do employ these strategies can yield some similar benefits for income as well as risk mitigation.
For more information on pooled funds or the use of derivatives in your portfolio, please contact your usual Arlingclose representative or email firstname.lastname@example.org.