Download fixed income: mitigating risk through active management

WhiteCapability
MFS
Paper Series
Focus
Month
April 2016
2012
®
Authors
Jed Koenigsberg
Institutional Portfolio Manager
FIXED INCOME: MITIGATING RISK
THROUGH ACTIVE MANAGEMENT
IN BRIEF
• Asset flows – Investors have shown strong interest in ETFs and other
passive, index-replicating bond strategies, as evidenced by asset flows.
• Benchmark inefficiencies – There are numerous complexities and
benchmark inefficiencies associated with passive holdings in fixed income
that have a bearing on the risk-return profile of these investments.
Michael Adams, CFA
Institutional Portfolio Manager
• Index composition and liquidity – Factors for consideration include the
nature of the over-the-counter (OTC) bond market and issuer-weighted
indices, which often means that investors seeking to replicate the index will
be investing most heavily in bonds issued by the most indebted companies
and countries.
• Interest rate sensitivity – Passive investors have been taking on more
interest rate risk than they were during the global financial crisis as a result
of the rise in the interest rate sensitivity (duration) that has followed the fall
in yields in the benchmark indices.
Robert M. Hall
Institutional Portfolio Manager
• Benchmark-aware approach – We advocate a “benchmark-aware”
active approach that allows a manager to incorporate the style discipline
benchmarks provide, while maintaining the flexibility to make investment
decisions that may help avoid the pitfalls of passively tracking the benchmark.
For some years now, investors have been seeking passive, indexreplicating bond investing strategies, including exchange-traded
funds (ETFs), in an effort to emulate the success of passive equity
investing. However, equity and bond indices are constructed quite
differently, which has important implications for investors. Investing
in fixed income indices poses a number of challenges, among them
the nature of the over-the-counter (OTC) bond market and the
inefficiency of fixed income benchmarks.
The structure of the fixed income market and the indices created to represent
the opportunity set in the asset class have particular characteristics that argue for
an active approach. In this paper we review these factors and make the case
for an active “benchmark-aware” approach to fixed income investing.
APRIL 2016 / FIXED INCOME: MITIGATING RISK THROUGH ACTIVE MANAGEMENT
Investors flocking to bond ETFs
OTC trading/liquidity issues
In the past few years, passive strategies, including ETFs, have
attracted assets and now make up 27% of the total assets in
US bond mutual funds and ETFs, up from 20% in 2011 (see
Exhibit 1). While ETFs are still a small segment of the market,
their weight has more than doubled, rising from 3.5% in 2011
to 8.4% by the end of 2015. Investors see these instruments as
offering quick, easy access to the markets, as well as liquidity
and low management fees.
The way fixed income is traded over the counter is a
complicating factor for benchmarks. The bond market is
almost exclusively a dealer market: An investor buys bonds
from a dealer and sells the bonds back to the dealer on
negotiated terms. There are no exchanges with posted prices.
As a result, many securities, especially corporate issues, are
difficult to trade and price effects can be material. Larger issue
size is usually a significant advantage in the execution of trades.
Exhibit 1: Passive and ETFs gain assets —
US intermediate term bond assets (2011–2015)
1,200
Active funds
Passive ETFs
Total passive
funds ex ETFs
(Billions $)
1,000
800
600
400
200
0
2011
2012
2013
2014
2015
Sources: Morningstar, Strategic Insight/MF.
Benchmark inefficiencies
There is a perception among some investors that bond
ETFs pose little risk; however, this is far from accurate.
Bond ETFs often track the Barclays indices, a family of broadbased fixed income benchmarks first published by Lehman
Brothers in 1973, when active bond investing was in its
infancy.1 Fixed income products have become much more
complex in the intervening years, and index providers have
responded with a proliferation of subindices, custom indices
and new weighting schemes.
Since an index defines the universe of securities in which a
manager may invest, which index is chosen has a direct
bearing on the portfolio’s risk exposures and relative
performance drivers. For these reasons, investors are well
served by understanding the makeup of the benchmark
index for any given investment strategy, including ETFs.
Essentially, investors need to know what the index actually
contains in order to have a reliable view of their holdings.
This is particularly important in fixed income because the
benchmark indices have particular structural inefficiencies
that impact the risk profile and returns of a portfolio.
The OTC nature of the bond market means that periods of
poor liquidity can have a meaningful impact on passive
strategies, which are forced to replicate an index and therefore
have to purchase bonds regardless of pricing. This effect is
amplified in a low-rate environment, where every quarter point
makes a difference. The reduction in dealer inventory in the
wake of regulatory changes following the global financial crisis
has led to reduced liquidity in some instances.
In addition to liquidity, the sheer size of broad market
indices is a consideration. Tracking the indices can be difficult
for portfolio managers, whether through sampling or full
replication. For instance, the Barclays U.S. Aggregate Index has
more than 1,000 unique issuers and more than 9,000 issues,
making it almost impossible to fully replicate. This means that
passive managers have to make “active” investment decisions
as they decide which securities to include in their representative
portfolio. For example, the iShares Core U.S. Aggregate Bond
ETF contains just under 5,000 issues as of 31 December 2015.
The issue-weighted problem
The foundation of an index is its weighting scheme. The
overwhelming majority of indices — both equity and fixed
income — are market-capitalization weighted. This weighting
scheme was originally developed for equity indices as a way to
reflect the broad equity market.2 In equity indices, the market
determines the weights; in bond indices, however, weightings
are largely determined by issue size and debt outstanding.
Bond indices are driven by how much debt a company or
sovereign decides to issue and the size of the individual security
issued. Consequently, investors seeking to replicate the index
Passive managers have to make “active” investment
decisions as they decide which securities to include in
their representative portfolio.
—2—
APRIL 2016 / FIXED INCOME: MITIGATING RISK THROUGH ACTIVE MANAGEMENT
Investors are now taking more interest rate risk than
they were during the global financial crisis in 2008.
Exhibit 3: US yield per unit of duration down more than
half since crisis
1.4%
1.2%
Yield per unit of duration
will be investing most heavily in bonds issued by the companies
and countries that are most dependent on external financing.
Many may still have strong balance sheets, but there is a risk
that passive bond investors could be buying the “biggest
losers.” In contrast, in a market-capitalization-weighted equity
index, investors typically own the “winners,” i.e., the
companies that have grown in market capitalization due to
their success. The issuer-capitalization methodology inherent in
bond indices is counterintuitive in many respects. Investing in a
bond index can result in holding the debt of the most highly
leveraged issuers, with the attendant risks this poses.
Interest rate sensitivity rises
A further complication is that as yields have fallen, duration
(interest-rate sensitivity) has increased for the indices, with
the effect that investors are now taking more interest rate
risk than they were during the global financial crisis in 2008.
Exhibit 2 charts the trajectory of duration relative to yield for
the Barclays U.S. Aggregate Index, revealing a notable
divergence, the effect of which is a fall in the yield per
unit of duration shown in Exhibit 3. The decline in yield per
unit of duration indicates that investors are receiving lower
compensation per unit of interest rate risk for their investments
in fixed income indices.
6
5%
5
4%
4
3%
3
2%
2
0.8%
0.6%
0.4%
0.2%
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Barclays Point, Jan. 2016.
A similar fall in yield per unit of duration has occurred in
the European and global indices. Exhibit 4 depicts the
decline in the United Kingdom, Germany and France, while
Exhibit 5 shows the same trajectory for the Barclays Global
Aggregate Index.
Exhibit 2: Duration of Barclays U.S. Aggregate Index
increased as yields declined sharply
6%
1.0%
Exhibit 4: Yield per unit of duration down sharply in
Europe since crisis
0%
Yield to worst
Duration
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
0.8%
0.7%
Yield per unit of duration
1%
0.9%
Duration
Yield to worst
1.0%
1
0.6%
0.5%
0.4%
0.3%
UK
0.2%
Germany
0.1%
0
0.0%
Source: Barclays Point, Jan. 2016.
France
2006
2007
2008
2009
Source: Barclays Point, Jan. 2016.
Bond indices are driven by how much debt a company
or sovereign decides to issue and the size of the
individual security issued. Investing in a bond index
can result in holding the debt of the most highly
leveraged issuers, with the attendant risks this poses.
—3—
2010
2011
2012
2013
2014
2015
APRIL 2016 / FIXED INCOME: MITIGATING RISK THROUGH ACTIVE MANAGEMENT
Exhibit 6: Treasuries as a share of US Aggregate Index
increased significantly
1.0%
40%
0.9%
35%
US Treasuries outstanding as a
percentage of US Aggregate
Yield per unit of duration
Exhibit 5: Global Aggregate yield per unit of duration
also declined
0.8%
0.7%
0.6%
0.5%
0.4%
30%
25%
20%
15%
0.3%
0.2%
2006
2007
2008
2009
2010
2011
2012
2013
2014
10%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
2015
Source: Barclays Point, Jan. 2016.
Source: Barclays Point, Jan. 2016.
Another consideration is that the duration of a benchmark
comes from issuer preferences regarding the term structure
of issuance and is not necessarily the duration that a given
investor should hold. The optimal portfolio duration for an
investor should be a function of his or her time horizon and
risk profile, rather than that of the index. Said another way,
duration can be thought of as exposure to the interest rate
factor. In this context, choosing an appropriate bond portfolio
duration is essentially an asset allocation decision, which
investors should make based on their particular circumstances.3
Composition and new issue market size
The composition of the indices is also an important factor that
potential passive ETF investors should consider. The increase
in bonds issued by the US Treasury in the wake of the global
financial crisis has led to a rise in the proportion of Treasuries
in the Barclays U.S. Aggregate index (see Exhibit 6). This is one
of the reasons yields per unit of duration have fallen in the
benchmark indices.
The decline in yield per unit of duration indicates
that investors are receiving lower compensation per
unit of interest rate risk for their investments in fixed
income indices.
The large size of the new issue market in fixed income relative
to equities is a further consideration. The annual turnover in
the corporate bond market is approximately 20%, versus a
little over 1% for the equity market. This makes sense, as a
common equity is usually a long-term perpetual security,
whereas bonds have finite maturities. This adds an additional
level of complexity and increased trading cost when a manager
is seeking to track the benchmark. The impact of new issuance
can have a significant impact on the composition of an index.
For example, the US energy sector increased its issuance of
new high-yield debt such that the weight of energy in the
Barclays High Yield Index has increased from 3.9% in 2004 to
11.1% currently (2 March 2016).
The benchmark-aware approach
As we have highlighted, there are numerous inefficiencies
and complexities related to investing in fixed income indices
that passive ETFs take on when they track a bond index. We
do not support jettisoning benchmarks, as some managers of
unconstrained fixed income strategies have done.
Rather, we advocate a benchmark-aware approach to active
investing that allows a portfolio manager to incorporate the
style discipline benchmarks provide along with an appropriate
level of flexibility to make suitable investment decisions.
—4—
APRIL 2016 / FIXED INCOME: MITIGATING RISK THROUGH ACTIVE MANAGEMENT
In our view, the adoption of a benchmark-aware approach can
provide the appropriate structure — the guardrails, if you will
— to enable fixed income investments to behave as they are
usually intended, i.e., as ballast in a well-diversified portfolio,
while avoiding the pitfalls of an approach that hugs the
benchmark. In this case, a benchmark becomes a risk
barometer to evaluate a manager’s risk profile, rather than
an investment blueprint, and allows for active management
of the risk budget.
Active strategies within fixed income allow managers to
broaden the opportunity set and allocate across sectors to find
better credits — and also avoid poor credits. The asymmetrical
nature of bond returns — also referred to as negative skew —
means that in bond management one wins by playing strong
defense, that is, by avoiding the problematic credits that
default on payments.4
Conclusion
While interest in bond ETFs that track the benchmark indices
continues to show strength, investors should be aware that
fixed income indices have certain characteristics that may make
them less efficient — and potentially more risky — investments.
In the current lower growth economic environment, allocating
capital to indices that invest most heavily in bonds issued by
the companies and countries most dependent on the capital
markets for financing may give some pause — appropriately
so, in our view.
It is notable too that passive investors are now taking on more
interest rate risk than they were during the global financial
crisis in 2008 as a result of the rise in duration (interest rate
sensitivity) that has accompanied the fall in yields.
Active managers can work to mitigate credit risk, interest rate
risk, debt concentration, liquidity and duration-matching risk
in ways that passive managers cannot, while maintaining
a benchmark-aware approach that allows investors to
understand the risk profile the strategy is likely to demonstrate.
We are proponents of a benchmark-aware approach to fixed
income investing that provides important risk management
discipline while addressing some of the issues associated with
passively tracking an index.
We advocate a benchmark-aware approach to
active investing that allows a portfolio manager
to incorporate the style discipline benchmarks
provide along with an appropriate level of flexibility
to make suitable investment decisions.
—5—
Endnotes
All legacy Lehman Brothers benchmark indices were rebranded as Barclays Capital indices in November 2008.
Siegel, Laurence B., Benchmarks and Investment Management. Charlottesville, VA, The Research Foundation of the Association of Investment
Management and Research, 2003, 89–103.
3Ibid, p. 90.
4An asymmetrical or skewed distribution occurs when one side of the distribution does not mirror the other. Applied to investment returns, asymmetrical
distributions are generally described as being either positively skewed (meaning frequent small losses and a few extreme gains) or negatively skewed
(meaning frequent small gains and a few extreme losses).
1
2
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be
relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.
Issued in the United States by MFS Institutional Advisors, Inc. (“MFSI”) and MFS Investment Management. Issued in Canada by MFS Investment Management
Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS
International (U.K.) Limited (“MIL UK”), a private limited company registered in England and Wales with the company number 03062718, and authorized and
regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered office at
One Carter Lane, London, EC4V 5ER UK and provides products and investment services to institutional investors globally. This material shall not be circulated
or distributed to any person other than to professional investors (as permitted by local regulations) and should not be relied upon or distributed to persons
where such reliance or distribution would be contrary to local regulation. Issued in Hong Kong by MFS International (Hong Kong) Limited (“MIL HK”),
a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the “SFC”). MIL HK is a wholly-owned, indirect
subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and fund sponsor registered with the U.S. Securities and Exchange
Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services
to “professional investors” as defined in the Securities and Futures Ordinance (“SFO”). Issued in Singapore by MFS International Singapore Pte. Ltd., a private
limited company registered in Singapore with the company number 201228809M, and further licensed and regulated by the Monetary Authority of Singapore.
Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian financial
services license under the Corporations Act 2001 in respect of the financial services they provide. In Australia and New Zealand: MFSI is regulated by the U.S.
Securities and Exchange Commission under U.S. laws, and MIL UK is regulated by the U.K. Financial Conduct Authority under U.K. laws, which differ from
Australian and New Zealand laws.
MFSE-WHYACTV-WP-4/16
35250.1