Download Navigating the Fixed Income Universe

Navigating the Fixed
Income Universe
A Simplified Flight Plan Through
a Complex System
Written by Susanna Gibbons, CFA
Vice President, Senior Portfolio Manager
Navigating the Fixed Income Universe | 1
RBC GAM Institute
Executive Summary
“It is far better to
grasp the universe
as it really is than to
persist in delusion,
however satisfying
and reassuring.”
~ Carl Sagan
The universe of fixed income opportunities appears to be expanding at an
accelerating rate, with each opportunity bringing its own risks, rewards and
idiosyncrasies. Institutional investors have more choices, but need to find a
discipline for systematically evaluating them. Rather than being lost in space,
investors can navigate their way with a straightforward flight plan. To take
advantage of the opportunities available in the widening fixed income universe,
institutional investors and their investment managers should distill the investment
management decision into two separate components: a duration decision and
a spread decision. These two types of risk factors introduce unique potential
return streams, and investors need to carefully target their risk profiles in order
to optimize their portfolios’ return potential. In this way, investors can bring a
disciplined risk-managed approach to ensuring their fixed income allocation takes
full advantage of what the fixed income universe has to offer.
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2 | Navigating the Fixed Income Universe
Exhibit 1
Agg Sectors Have Fallen as % of Barclays USD Bond Universe
Formation of the Universe
110%
When the Lehman Aggregate Bond Index (“The Agg”) was
formally introduced in 1976, it represented nearly all of the
potential investments that a fixed income investor could
access.1 Markets have evolved well beyond this simple time
to encompass an increasingly broad range of securities.
A touchstone for 40 years, the Agg (now the Barclays US
Aggregate Bond Index), represents a diminishing component of
the fixed income universe.
100%
90%
80%
70%
60%
50%
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
Sources: Barclays and RBC GAM
As of 12.31.13
Exhibit 2
Agg Sectors Are Less Than 50% of Total Fixed Income
Opportunity Set
110%
90%
The market then evolved to introduce what might be considered
either the quarks or the dark matter (depending on one’s view)
of the fixed income universe: credit default swaps (CDS). The
expansion of CDS trading paved the way for a whole range of
new synthetic securities:
80%
70%
60%
50%
• Single name exposures
• Indexes of CDS
• Structured exposure to indexes of CDS
• Customized baskets of CDS
40%
30%
20%
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
Sources: Barclays, SIFMA and RBC GAM
As of 12.31.13
Municipal securities are excluded from this discussion, with apologies to those
focused on this unique discipline. Dealing with the cross-sector consequences of
taxes is well beyond the scope of this endeavor.
2
This was the first year in which non-agency mortgages appeared in the Securities
Industry and Financial Markets Association (SIFMA) database; they may not have
been accessible as an investment opportunity until somewhat later.
2
Convertibles existed long before 1993, but this is when Barclays launched its
convertible benchmark.
1
• Corporate high yield debt (1987)
• Non-agency mortgages (1990)2
• Emerging market bonds (1993)
• Non-U.S.-government related securities (1994)
• Convertible bonds (2003)3
• High yield loans (2006)
If these sectors are included in the opportunity set, the Agg
represents just about 75% of the fixed income universe, as
indicated in Exhibit 1.
100%
10%
The original sectors in the Agg were corporates, mortgages,
Treasuries and a smattering of other government-related
securities. The mortgage market was in its infancy, as were the
government sponsored enterprises (GSEs). Whether fueled by
the Greenspan-era easy monetary policies is hard to say, but the
universe of available fixed income securities began its dramatic
expansion in the 1980s, and has continued unabated through
the most recent financial crisis of 2008-2009. In addition to
the Agg sectors, and roughly in order of appearance in a major
index or database, the market now includes:
If these securities are included (and granted, they are hard to
count), the Agg shrinks further to a modest 40% of the full fixed
income opportunity set, as indicated in Exhibit 2.
This estimate of the universe includes only U.S. dollardenominated securities. The universe continues to expand once
currency is introduced – but let’s stop here just for argument’s
sake. Fixed income investing strategies, it seems, are limited
only by our collective imagination. As the traditional benchmark
for bond investors, the Agg does little to shed light on the risk
and opportunity associated with this increasingly complex asset
class.
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Navigating the Fixed Income Universe | 3
Fixed Income Investment
Strategies: A New Approach
The Need for Duration
When institutional investors have used a benchmark as the
basis for an investment strategy, they have also used it to
manage the principal/agency risk of delegating their investment
decisions to investment managers. A benchmark is a way to
define the opportunity set, evaluate investment performance
and assess managers. The more complex the investment
sectors, the more important the benchmark is. Within fixed
income, institutional investors have used the Agg for decades
as the gold standard for comparing managers. But the Agg was
not introduced as an investment strategy. It was introduced to
provide a benchmark which reflected the relevant fixed income
universe.
The Agg as presently constituted probably does not represent
the relevant universe for most institutional fixed income
investors. It has a preponderance of risks which are unattractive
for active investors (such as duration targets ill-suited to
investor needs), with less exposure to risks (such as credit) that
can add value over time. The one-size-fits-all approach to fixed
income investing blurs the distinctions that should be made
among the different risk elements in the investing universe,
and narrows the universe in a way that may not suit investors’
needs.
In using the Agg as a basis, traditional core fixed income
strategies combine what should be two separate risk decisions:
duration and spread. The primary purpose of disaggregating the
Agg is to disaggregate those two distinct risk decisions so that a
more precise portfolio risk profile can be formulated to address
each investor’s objectives.
It is likely that many of the institutional investors who are
leaving Agg-oriented strategies intend to shorten the duration
of their portfolios. While it may be unwise to challenge the
prevailing sentiment that interest rates are likely to rise in the
coming years, interest rate forecasting (whether for the short
term or the long term) is one of the least reliable ways to deliver
consistent alpha. For much of the modern era of fixed income
investing, various investment managers, economists and
market pundits have, when interest rates are rising, forecasted
further increases, and at least so far, the dire warnings have
been overtaken by subsequent market events. During each
of the periods circled in Exhibit 3, a rise in interest rates led
forecasters to call for an end to the bull market, but rates did
not continue to rise as expected. In fact, the long-term trend of
lower rates remains intact.
According to research provided by BARRA (now part of MSCI),
active duration managers are not prevalent, as their strategies
tend to produce very low information ratios:
While a top quartile manager in general has an information
ratio of 0.5 before expenses, a top quartile active duration
manager may have a significantly lower information ratio—
perhaps on the order of 0.1. It is easy to generate significant
amounts of active risk with interest rates bets, however, and
so active duration managers can occasionally, just through
luck, significantly outperform.4
Although this argument was made in the mid 1990s, it remains
relevant today – investment managers have shown no data
that indicates they have developed greater skill in consistently
forecasting interest rate movements.
Exhibit 3
Periods When Interest Rates Rose Were Not Followed by the Continued Rises Forecasted by Pundits
18
10-Year Treasury Interest Rates (%)
16
14
12
10
8
6
4
2
0
Dec-80
Jan-84
Jan-87
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Jan-05
Jan-08
Jan-11
Jan-14
Fixed Income Active Strategies”, by Ronald N. Kahn, BARRA Newsletter (http://www.barra.com/newsletter/nl162/FIAcStratNL162.asp)
4”
Sources: Bloomberg and RBC GAM
As of 3.31.14
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4 | Navigating the Fixed Income Universe
Exhibit 4
Instead of choosing a duration profile based on interest rate
forecasts, institutional investors should select a duration profile
that aligns with their overall portfolio objectives.
Balancing Current Income Requirements with Tolerance for
Principal Volatility
Given the contractual nature of bond coupon payments, fixed
income instruments are uniquely suited to hedge a variety of
risks, and most fixed income strategies take advantage of this.
In this vein, there are two primary purposes for investing in
fixed income:
Fixed Income Securities
Income Stability/
Longer Duration
Principal Stability/
Shorter Duration
1)To provide stability of principal
2)To provide stability of income
To address the need for duration, investors need to balance
current income requirements with tolerance for principal
volatility, as shown in Exhibit 4. An insurance company may
have a greater need for a steady stream of income, while a
manufacturing company may have a need for stable principal
to fund a capital expenditure program. Even in a flat yield curve
environment, income stability will be sacrificed by moving to a
shorter duration.
Investment Objectives
It is important to note that principal stability needs to be
considered on the basis of net asset value, which takes into
account the particular liability that the investor might be
hedging. This framework can then be applied for investors with
liability profiles ranging from less than one year to more than
20 years, across multiple asset classes. The optimal duration
profile for any investor will minimize the risk-related impact
of duration decisions while maximizing income generation
potential.
Exhibit 5
Negative Correlations Are Most Powerful When Bonds Have
Extended Maturities
Growth of $100
$250
For investors whose primary purpose for owning fixed income
is to hedge risky assets, longer duration exposures will be the
most effective. Negative correlations between fixed income
and equities are most powerful when bonds have extended
maturities. In Exhibit 5, a portfolio with a 50% allocation
to equities (represented by the S&P 500 Index) and a 50%
allocation to long duration Treasuries generates the highest
total return over time, with a significantly lower standard
deviation of returns, compared to an all equity portfolio and
a portfolio that is half equities and half intermediate duration
bonds.
$200
$150
$100
$50
Stocks
50/50 Stocks/Long‐Term Bonds
Mar‐14
50/50 Stocks/Intermediate Bonds
Sources: Barclays and RBC GAM
As of 3.31.14
Long-Term Bonds = Barclays U.S. Long Treasury Index
Intermediate Bonds = Barclays U.S. Intermediate Treasury Index
Fixed Income Active Strategies, by Ronald N. Kahn, BARRA Newsletter
(http://www.barra.com/newsletter/nl162/FIAcStratNL162.asp)
4
Mar‐13
Mar‐12
Mar‐11
Mar‐10
Mar‐09
Mar‐08
Mar‐07
Mar‐06
Mar‐05
Mar‐04
Mar‐03
Mar‐02
Mar‐01
Mar‐00
$0
By reducing the risk associated with duration, investors can free
up a significant risk budget for allocation to spread strategies,
which can be expected to carry both higher absolute returns
and greater alpha opportunity. The decision-making process
regarding spread has three steps:
1)Choose to buy spread
2)Choose which spread to buy
3)Choose how much spread to buy
RBC GAM Institute
Exhibit 6
Information Ratios (%) of Top Quartile of Managers
Strategy
Investors usually benefit from taking risk in credit, mortgages
and other “spread sectors,” so named because they trade at
a yield spread above Treasuries of comparable duration. The
opportunity to add alpha from investing in the spread sectors
is significantly greater than focusing on duration management
strategies. Compared to the 0.1 information ratio noted in the
BARRA research and the 0.2-0.7 information ratios for U.S.
Government-only mandates, top managers in the spread sectors
have provided significantly higher information ratios, as shown
in Exhibit 6.
Spread Decision: Beta
Once the decision to purchase spread product has been made,
the next step pertains to beta, i.e., which types of spread
product deliver a return and volatility stream that is consistent
with investor objectives and risk tolerance? In the simplified
schema presented in Exhibit 7, spread sectors have been
plotted purely on the basis of risk as measured by optionadjusted spread (OAS) volatility.5 Investors can select the
sectors which achieve those objectives.
An investor could opt for a more conservative risk profile by
confining the opportunity set to the sectors on the left or add
incrementally greater risk by allowing sectors on the right.
By allowing additional spread sectors, an investor gives the
investment manager more opportunities to add value to a
portfolio either through relative value strategies or bottom-up
security selection.
The more volatility investors are willing to tolerate, the more
they can expand the investment universe for their fixed income
allocation. It is important to think about this in terms of
increased risk tolerance driving higher return potential, rather
than the other way around. Sectors do not always present return
opportunities commensurate with their risks, and an investment
manager has a critical role in evaluating the expected return
potential for a given level of risk.
Optimal Portfolio Construction
In an ideal world, an investment benchmark functions as a
proxy for both sector exposures and risk tolerance. In practice,
however, given the evolving complexity of fixed income
markets, the standard benchmarks do not always serve those
functions. Unfortunately, the world of customized benchmarks
is cumbersome and difficult to manage. By breaking the
investment decision down to two targeted decisions on duration
and spread, investors can reverse engineer the appropriate
benchmark.
5 Years
10 Years
U.S. Government
0.20
0.66
0.22
Core Fixed Income
1.18
1.28
0.54
Core Plus
1.10
1.40
0.55
Corporate
1.07
1.32
0.67
U.S. Mortgage
1.41
1.62
0.55
High Yield
0.42
-0.20
0.14
Source: eVestment Alliance
As of 12.31.13
Exhibit 7
The More Volatility Investors Are Willing to Tolerate, the More
Sectors They Should Allow
3.5
3
2.5
Volatility Tolerance
On a standalone basis, high yield strategies have relatively low
information ratios that suggest less alpha opportunity. However,
the beta opportunity is significant. For an investor with higher
tolerance for volatility, an optimized fixed income allocation
should allow this sector. The more tolerance an investor has
for volatility, the more sectors the investor should allow in the
fixed income allocation. Sector flexibility allows a fixed income
manager to search for the best opportunities available in the
current market environment.
3 Years
Standard Deviation of OAS
The Need for Spread
Navigating the Fixed Income Universe | 5
2
1.5
1
0.5
0
U.S. Securitized
Corporates
Emerging Market
Sovereign (USD)
High Yield High
Quality
Emerging Market
Corporate
High Yield
Sector Inclusion
Sources: Barclays and RBC GAM
As of 2.28.14
OAS is a way to measure and compare the spreads of securities with different
cash flow optionality.
5
RBC GAM Institute
6 | Navigating the Fixed Income Universe
The chart below establishes beta targets, i.e., benchmarks or categories of benchmarks,
that should be met (over an investment cycle) in order to achieve an institutional
investor’s desired risk level. In addition, each strategy will also have an alpha target;
the alpha target generally increases along with sector flexibility.
About the Author
Exhibit 8
Intersection of Spread and Duration is Beta Target
Short
(0-2 yrs)
Intermediate
(2-4 yrs)
Long
(4-7 yrs)
Very Long
(7+ yrs)
LIBOR
Barclays
Intermediate
Gov’t/Credit
Barclays
Aggregate
U.S. Gov’t
Medium Volatility Sectors:
Above Sectors, Plus Certain Structured
Product, Emerging Market Sovereign
LIBOR +100
Swaps +100
High Volatility Sectors:
All Above, Plus Emerging Market Corporate,
High Yield, Synthetic Credit
LIBOR +300
Spread
Low Volatility Sectors:
Securitized, Investment-Grade Corporate
Credit, Investment-Grade Sovereign
Swaps +300
Barclays
Investment Grade Swaps +100
Corporate Index
Swaps +300
Swaps +300
Spread Decision: Alpha
Finally, an investor needs to have an alpha target. Within the construct of a duration
decision driven by an investor’s overall portfolio objectives and a sector decision driven
by an investor’s risk tolerance, how much incremental return does the investor expect
or require? The duration and sector decisions define the beta selection, or benchmark.
The incremental return required is the alpha target, which can be defined through
the use of ex-ante tracking error (TE).6 An investment manager can use TE to assess
types of risk (such as interest rate risk or credit risk) in a portfolio and based on the
expected interactions of those risks, forecast the extent to which portfolio returns will
vary from the benchmark’s returns. Every portfolio will have an embedded level of value
at risk (VaR) defined by the duration and sector decisions already made. The amount
of incremental risk that an investor is willing to take can be defined by the amount
of portfolio TE expected over an investment cycle. Higher TE implies a higher level of
portfolio risk; higher risk implies greater potential for incremental return.7
Ex-post tracking error is a useful tool for evaluating portfolio performance relative to a benchmark, while exante tracking error is a risk management tool.
7
Traditionally, institutional investors have used investment policies or guidelines stipulating allowable
sectors, minimum credit quality and other parameters in an effort to control risk and oversee their investment
managers. A viable substitute for these kinds of parameters can be a robust risk-budgeting process made
possible through the use of TE estimates. This process will help investors manage risk and benefit from
increased flexibility in terms of sectors and credit ratings. Investors may select managers based on their
demonstrated skills in particular sectors.
6
The Next Generation
In many ways investors have already gone boldly into the new world of fixed income
investing. The adventurous spirit is laudable, but runs the risk of placing investors at the
creative whim of actors outside their control. These masters of the universe are largely
responsible for the expansion of the fixed income opportunity set in the first place. At this
point, investors should step back, take control of the process and start constructing their
own flight plans. The steps proposed here – the simple distillation of the decision-making
framework into the two discrete components of duration and spread – start to determine
what that plan will look like. Instead of reflexively selecting the traditional benchmark for
managing fixed income exposures, investors can more accurately target a portfolio which
incorporates the risks they want to take, avoids the risks they don’t want, and provides
managers with clear guidance on where in the universe they actually want to go.
Susanna Gibbons, CFA
Vice President,
Senior Portfolio Manager
Susanna Gibbons leads the credit
research team in our fixed income
group. She researches the banking
sector of the corporate market and is
a portfolio manager for several of our
core fixed income solutions. Susanna
joined RBC GAM-US in 2007 from
Jeffrey Slocum & Associates, where
she was director of fixed income
research. Before that, she held
several senior positions, including
director of fixed income research and
senior portfolio manager, at The St.
Paul Companies (now The Travelers
Companies). Susanna’s experience
also includes research analyst roles
at several other U.S. insurance
and investment firms, including
MetLife and J.P. Morgan Investment
Management. She earned a BA from
Bryn Mawr College and an MBA
from the New York University Stern
School of Business. Susanna is a CFA
charterholder.
RBC GAM Institute
Navigating the Fixed Income Universe | 7
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any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. The
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