Example: TIPS + Selling Credit Exposure

Combining a long TIPS position with selling credit protection results in a strategy closely resembling an inflation- linked corporate bond. As shown in the hypothetical example below, adding credit exposure to an inflation-linked government bond can bring the asset’s expected return closer to the liability growth rate.

Adding credit exposure can be achieved in either an active (single-name CDS) or passive (index CDX) manner. An active approach will involve the manager selling CDS on multiple individual bonds and allows them to express a view on sectors or individual companies. A passive approach of selling CDX gives the investor credit exposure to a basket of 125 individual Credit Default Swaps and will typically exhibit a higher level of liquidity compared to individual Credit Default Swaps. Both approaches provide fixed coupons in compensation for taking on credit risk.

Considerations

Single-name CDS contracts trade Over the Counter (OTC), which requires posting collateral and introduces counterparty risk. SLC Management has extensive experience trading OTC and cleared OTC derivatives, including Credit Default Swaps. TIPS are generally accepted collateral since they are issued directly by the US Treasury and are classified as government bonds. CDX are cleared OTC, so the counterparty risk of an OTC transaction is mitigated as contracts are settled through a clearinghouse. Portfolios with cleared OTC instruments may also require an allocation to highly liquid assets to meet Initial Margin and Variation Margin requirements.

¹ Source: Bloomberg

This document is intended for institutional investors only. The information in this document is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this presentation.

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.

The use of derivatives may expose the portfolio to risks that differ, and may be possibly greater than, the risks that would be generally associated with investing in fixed income assets. These risks include, but are not limited to: i) the lack of availability of a liquid market at the time that the portfolio may want to unwind a derivative contract; ii) the possibility that the portfolio may not be able to realize value from any derivatives contract if the contract counterparty cannot fulfill its obligations under the contract; and iii) the possibility that the portfolio could experience a loss of all or part of any margin, cash or securities, on deposit with that counterparty if that counterparty goes bankrupt. There is the possibility of deterioration in the functioning or liquidity of the market for derivative instruments which may decrease the value of the derivatives instruments, thereby decreasing the value of the portfolio. Under certain circumstances, the portfolio may be unable to close out derivative contracts in a timely manner or realize values that reflect the fair market values of those investments. The posting of derivative collateral and margin could result in liquidity demands for the portfolio. The portfolio will need to hold ample eligible collateral and margin to satisfy collateral requirements. Derivative contracts may include the use of leverage. Derivative collateral may not be sufficient to close out the portfolio’s obligations under its derivative contracts.

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