Download Bonds Are Different

VIEWPOINT
February 2017
AUTHOR
James Moore, Ph.D.
Managing Director
Bonds Are Different
In the active-versus-passive debate, investment flows
suggest passive has been winning. And many, if not
most, investors seem to believe the rationale for passive
applies equally well to fixed income as equities. But
bonds are different. And we believe the case for active
fixed income management has only been strengthened
by the uncertainty and volatility that President Donald
Trump’s policies may engender.
The active-versus-passive debate is an old one, of course, with reasoned arguments on both
sides. On a visceral level, in recent years many investors paid active equity management fees
only to get below-benchmark returns.
Basic math lies at the core of the logical argument for passive: In sum, the performance of
all investors aggregates to the performance of the markets. For every winner, there must be a
loser subsidizing a winner’s gains. Throw in fees, and the average net return above the market
for active investors is negative.
The logic may be compelling. But when it comes to bonds, we believe the logical argument
falls short.
Bonds are different for multiple reasons. Bond investors have varying objectives, which is
seldom the case for equities. Trading dynamics differ. New issues, and their magnitude within
benchmarks, are more significant factors. And the return profile of individual bonds is far more
skewed than it is for equities.
For these and other reasons, we believe the case for active fixed income management is
persuasive. Let’s take a closer look:
1)A significant fraction of investors in fixed income markets have primary objectives that
differ from maximizing mark-to-market total returns.
Central banks, for instance, buy and sell foreign bonds to stabilize exchange rates and trade
domestic-currency sovereign bonds to manage the money supply. Commercial banks and
insurance companies often invest based on returns on risk capital, agency credit ratings and
accounting conventions. They seek predictable, steady income – mainly from coupon
payments; they generally shun capital gains and losses, earnings that equity analysts often
regard as lower quality. The majority of these investors also treat the investment grade
threshold (triple-B-minus/double-B-plus) as a perilous cliff best avoided.
2
February 2017 Viewpoint
Figure 1 summarizes the fixed income balances held by these
investors. Note that of total global fixed income assets of about
$102 trillion as of 30 June 2016, as reported by the Bank for
International Settlements, nearly half is held by non-mark-tomarket investors.
Figure 1: Bond holdings by non-mark-to-market investors
Bond holdings
($ trillion)
Investment objective
– Foreign exchange
– Reserves
10.8
Stabilize exchange rates
– Domestic holdings
4.5
Manage money supply
U.S. insurance
4.3
Book yield, predictable income,
regulatory-driven capital charges
U.S. banks
2.8
European insurers
5.3
European banks
4.7
Asian banks and insurers
12.6
Other banks and insurers
2.0-3.0
Investor group
Central banks
Total
47.0-48.0
Source: Company filings, European Federation, EIOPA, EBA, SNL Financial, Bloomberg
and PIMCO as of 31 December 2016
when a company issues more debt, its weight in a bond index
increases. Why should a company’s decisions on capital
structure drive an investor’s decision to hold its bonds? Why
should an investor boost holdings in a company’s liabilities
because the company increases financial leverage?
Imagine triple-B-rated Acme Enterprises decides to issue $1
billion to fund a new factory for roadrunner traps. Given its
cash flow forecasts and advice from its bankers, the company
issues $500 million in five-year, $300 million in 10-year and
$200 million in 30-year bonds. Bloomberg Barclays Credit and
Aggregate indexes would increase Acme’s representation by
$800 million – not $1 billion – because inclusion in the index
requires a minimum amount outstanding of $250 million
(rising to $300 million in April). This disqualifies the 30-year
bonds, whose pricing is therefore affected because index buyers
will not hold them.
Across the corporate universe, there are companies with a single
equity share class that is included in one or more equity indexes
and with dozens, if not hundreds, of individual debt issues.
However, the fraction of their debt included in indexes may
vary widely.
3)The new issuance market is much more important for
bonds than equities.
With the exception of the Dow Jones Industrial Average, most
commonly referenced equity benchmarks are capitalization
weighted, with weights determined solely by the market
capitalization of the companies. Most companies have a single
publicly traded share class, or two at most.
In the year ended 30 September 2016, total U.S. corporate bond
issuance was approximately $1.55 trillion against an outstanding
balance of $8.55 trillion, according to the Securities Industry and
Financial Markets Association and Bloomberg, while U.S. equity
issuance was $190 billion against a total market value of over $24
trillion (much less if secondary equity offerings are excluded).
Thus, new securities make up about 18% of bond market
capitalization; in the equity markets, new issues are less than 1%.
This stands to reason as common equity is generally a perpetually
lived security whereas bonds have finite maturities. Thus, an
active presence in the issuance market can materially affect
performance for fixed income investors, whereas its contribution
to equity performance is rarely more than a rounding error.
Bond indexes are different. Weightings chiefly reflect how much
debt a company or government issues and the size of an
individual security issued. Yet if a company issues more debt,
the aggregate value of the enterprise is not fundamentally
affected: Cash coming in is an asset; debt added is a liability.
Ignoring issuance fees, new cash – new debt = 0. However,
As new bonds typically come to market at a slight discount to
outstanding issues, a strong presence in the new-issue market
can add incremental value for two reasons. First, although size
matters, investment banks do not treat all comers equally –
allocations are not made pro-rata or based solely on an investor’s
size. A host of other factors contribute to a successful
To the extent these objectives differ from those of pure mark-tomarket investors or these constraints come with some
embedded cost, some value must be transferred to those not
similarly constrained.
2)Unlike equity indexes, where the market determines the
weights, in bond indexes issuers principally determine
the weights.
February 2017 Viewpoint
3
syndication. Second, after issuance not all new issues will
tighten, or increase in price, equally. Knowing when to
participate aggressively in a new issue or to pass requires strong
credit analysis and an understanding of trading technicals.
There are many other ways active managers can add value –
including by the prudent use of derivatives as substitutes for
cash bonds and by understanding misvalued embedded options
and risk premia due to policy or regulatory factors.
4)Most bond trading occurs via over-the-counter
transactions and not on exchanges.
These and other characteristics help explain why the median
active manager of intermediate-term U.S. bonds in the U.S.
outperformed its passive counterpart over the 10 years ended last
December, according to Morningstar.2
Exchanges work when the number of listed securities is
manageable and a high degree of standardization exists. At the
end of 2016, MSCI’s All Country World Index listed 14,447
equities, covering 99% of the global equity opportunity set.
Bonds are different: PIMCO’s databases track more than
344,000 fixed income securities in all currencies, and we are
constantly adding new ones. Bonds from a single issuer may
vary in terms of covenants or indentures. Two current 10-year
bonds from a single issuer may not be perfect substitutes
depending on when they were issued, if they were from a
merged predecessor company, or due to other reasons!
Therefore, the majority of bond purchases and sales are not
simple orders, but negotiations. The outcome is determined not
only by the object of interest, but also by factors affecting the
two parties negotiating. Research by Edwards et al.1 (2007)
documents a host of factors affecting bid-ask spreads and clearly
suggests that size is a significant advantage in execution.
5)Individual bond returns are highly skewed versus stock
returns, which are more symmetric.
In the short run, the expected path of any given stock conforms
roughly to a random walk with a long-term upward trend.
Consequently, when aggregating individual holdings in
portfolios, the rate of convergence under the law of large
numbers (LLN) is fairly rapid.
Bond returns are quite different. In most cases, the most a bond
can return is principal and interest earned until reaching
maturity. But some return far less due to default, (forced)
premature sales due to a credit rating downgrade, and other
reasons. Aggregating across holdings, convergence under the
LLN can be slow. The higher the quality of the index, the slower
convergence will be.
In active management, a manager can potentially add alpha to a
fixed income portfolio by playing offense when the time and
circumstances warrant, but a significant amount of value, if not
the majority, is typically added by strong defense.
FINAL THOUGHTS
Importantly, active managers can seek to mitigate volatility,
which is likely to remain high. The Federal Reserve’s hiking
cycle has begun, and the evolution and impact of Trump’s
policies remain uncertain. As noted in our recent Cyclical
Outlook, we believe the probability of both left-tail (downside)
and right-tail (upside) macro outcomes has increased.
In the end, the key question for investors is, “Do I have strong
reason to believe my active managers will add value in excess of
fees?” I would not argue that all do or even that a majority do,
but those managers who understand and exploit the five reasons
above, plus a host of others, stand a very good chance.
So much for common wisdom.
Biography
Dr. Moore is a managing director in the Newport Beach
office. He is head of the investment solutions group and
leads our global team of pension solutions strategists. Prior
to joining PIMCO in 2003, he was in the corporate
derivative and asset-liability strategy groups at Morgan
Stanley and responsible for asset-liability, strategic risk
management and capital structure advisory work for key
clients in the Americas and Pacific Rim. Dr. Moore also
taught courses in investments and employee benefit plan
design and finance while at the Wharton School of the
University of Pennsylvania, where he earned his Ph.D. with
concentrations in finance, insurance and risk management.
He has 22 years of investment experience and holds
undergraduate degrees from Brown University.
my Edwards, Lawrence E. Harris and Michael S. Piwowar, “Corporate Bond Market
A
Transaction Costs and Transparency,” Journal of Finance, v 62 (3) June 2007, 1421-51.
1
B ased on Morningstar U.S. Intermediate-Term Bond Category for the Institutional share class,
after fees. The median active manager returned 4.70% and the median passive manager
returned 4.19% for the period.
2
Past performance is not a guarantee or a reliable indicator of future results.
Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the
desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in
connection with managing the strategy. All investments contain risk and may lose value. Investing in the bond market is
subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and
bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more
sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low
interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased
market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when
redeemed. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and
the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the
amount invested. Investors should consult their investment professional prior to making an investment decision.
Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio
vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. The credit
quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The
quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally
range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively. A derivative, such as
a futures contract, forward contract, option or swap, is a security whose price is dependent upon or derived from one or
more underlying assets; the derivative itself is merely a contract between two or more parties.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material
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