June, 2012 Print
Mark Johnson, Head of Strategic Client Group, BlackRock.
In the current market environment bond investors face a particularly chilling headwind. Nominal and real interest rates are low or even negative in many countries, while government bonds, traditionally regarded as the ultimate “safe” investment, are now subject to credit concerns. So much so in fact, that some people now joke that government bonds no longer provide risk-free returns but returnfree risk. Achieving the two main traditional objectives associated with bonds – risk reduction and return generation – has undoubtedly become much more challenging. So how can bond investors inject some energy into their portfolios while maintaining their risk reduction objectives?
The answer to this question will depend largely on whether the investor is focused on relative or absolute returns. Relative return investors typically have long-duration liabilities. For them, risk reduction means holding a portfolio of matching assets that mitigates the duration gap (i.e. the risk due to changes in the interest rate). An optimal portfolio for relative return investors will usually comprise a strategic allocation to government bonds, with additional returns generated by deviating opportunistically from this strategic weight.
Absolute return investors, by contrast, might not require a strategic weight in bonds at all. For them, cash or even gold may be the safe haven asset class. Positions in fixed income assets are taken opportunistically, when valuations are attractive. Their portfolios might be much more diversified across various sub-categories of fixed income investments and less concentrated in long-duration government bonds. While local authorities are clearly in the former camp given their longduration liabilities, their funding position and/or longer-term recovery plan may allow them to take some extra risk and add value opportunistically.
Boosting a relative return portfolio Government bonds, as a rule, entail only two major risk factors: term risk (the compensation for postponing consumption by lending one’s capital), and inflation risk (the compensation for bearing the risk that the purchasing power of one’s capital will have declined when returned at maturity). The shape (i.e. risk and return characteristics) of a bond portfolio might be enhanced by adding a number of “vitamins”. These could include: vitamin C (corporate bonds, which adds credit risk to the portfolio), vitamin H (high yield bonds, which adds a dose of illiquidity risk), and vitamin E (emerging market debt, which provides some exposure to political or macro risk). For bearing these risk factors, investors usually ask for compensation via higher yields. Although diversifying a bond portfolio might provide higher returns, in exchange investors must give up some of the safe-haven attributes typically associated with Gilts or Treasuries.
Where investors are in a position to incorporate absolute return strategies, there are also various facets of active management (which we may call vitamin A), which could be employed to enhance the risk reduction and return generation attributed to a bond portfolio as outlined in Table 1 (previous page).
As a first step, opportunistically taking advantage of attractively priced sub-asset classes and individual securities in the fixed income universe can help to enhance returns. However, translating opportunities into returns requires skill, experience and insight. In particular, the manager will need to be able to: Assess the appropriate risk premium for different risk assets. This involves in-depth research into the aggregate financial health of corporate borrowers, the macroeconomic outlook, the demand for products at different phases of the cycle, and the availability and cost of funding in markets: Taken together, they allow the manager to take an informed view of the right time to be invested in specific sectors in a tactical asset allocation context. Choose the issuers and securities to best express those asset class views based on a combination of factors. These include: deep examination of individual company fundamentals, an analysis of the specific covenants or investor protections in a particular bond, quantitative assessment of valuation or market sentiment regarding an issuer, or some combination of these.
The appropriate techniques for going active for the earmarked part of the portfolio will depend on schemes’ individual risk objectives and investment constraints. A traditional active approach, for example, would have an active opportunity set that is largely defined by the benchmark. For instance, an active high yield portfolio would generate the large majority of its alpha over its benchmark from high yield bond selection aiming to identify attractive sectors and issuers.
Thinking laterally. Today’s low yield environment is also characterised by high volatility and dislocations in the global fixed income markets. Although this is generally bad news for a long-only investor, it creates opportunities for investors who are willing to think and invest outside their traditional fixed income instrument set. The ability to select the best issuers and securities across the corporate and sovereign universe is a very useful skill, but it still leaves traditional investors vulnerable to shocks due to the directional nature of long-only investing.
However, if the skill of choosing and buying attractively priced assets is combined with the skill of identifying and selling unattractively priced assets, fixed income investors can create less directional, marketneutral returns. As a result, they can achieve a superior position on the risk/return spectrum. This effect is amplified if the investor is able to screen the rates and credit markets for opportunities globally.
Clearly, not all fixed income investors have the skills or experience to enhance their risk/return position in this way. For those investors, allocating to hedge fund managers who do have these attributes is often a preferred option. The highly challenging market environment in the last few years provided the toughest of tests for hedge fund managers, and those who successfully weathered the storm can be seen as efficient “all-season” additions to a fixed income portfolio.
Adding active management, credit, high yield and emerging market debt as well as fixed income hedge funds can help to diversify a portfolio in a way that enables it to weather the current cold headwinds of bond markets more effectively. However, these are just a few of the options. In addition to boosting a bond portfolio with vitamins, investors could also consider more “exotic” bond exposures, such as insurance-linked securities or mezzanine real estate debt. Finally, schemes can complement their portfolios with nonbond assets that offer regular cashflows, such as high quality equity income strategies or infrastructure assets so as to strengthen a bond portfolio’s resistance against weather conditions even worse than those we experience at present. Nevertheless, the relatively illiquid nature of these assets needs to be considered carefully before investing, given their impact on present and future cash flow requirements.
Despite facing greater pressure on the liability side, local authorities in the main still have a long-term investment horizon. As a result they are well-placed to benefit from the higher return potential associated with a vitamin-enhanced bond portfolio.