An awkward customer
In a world of increasing demand for investment solutions based around liability driven benchmarks, how do global bond portfolios fit in?
Historically, as Paul Abberley, head of fixed income at ABN AMRO Asset Management points out, “global bonds have always been problematic as an asset class in an optimisation framework. Normally an asset class will have some role to play, it adds some marginal improvement. But often in the 1980s, you could drop in global bonds and they would add no value. So they had no role and domestic investors saw no role for it.”
He goes on to add “for any of the benchmarks, there is no relationship to liabilities. Fixed income as an asset class is very good to match liabilities in a domestic context, but once you move to global fixed income, there is no link to liabilities”. The net result may be that, as Payden & Rygel’s Robin Creswell warns, “regulation in the form of minimum funding requirements, and a new awareness amongst institutions of what their liability is to the pension funds they sponsor, may force plan sponsors to take the ‘safe’ route, and immunise or substantially match their funds to the liabilities accruing. This would see a decline in global mandates. It would also most likely see a material increase in the cost to the employer in meeting funding costs, potentially increasing their contributions by between 10% and 20%.”
The only way to get excess returns in this environment is to widen the universe of opportunities as much as possible. The dilemma is how to reconcile this with a liability driven approach to investment. Anecdotal evidence suggests that whilst demand for dedicated global bond mandates in Europe may generally be declining, this is not necessarily the case elsewhere.
Pimco’s Suhail Dada says: “In 2005, we witnessed more subdued demand for dedicated global fixed income assignments from European clients, especially from pension clients. This was likely the result of strong returns posted by the European bond markets in 2004, which may have diminished the appeal of non-European bonds. But it could also be as a result of a focus on more liability driven investment.” However, he adds that “overall, we continue to see strong demand for global fixed income mandates from clients based in Japan, Asia Pacific and the Mideast region”.
Creswell sees that “demand appears to be linked to the performance of local markets with Icelandic and Norwegian institutions recently accelerating the pace at which they diversify away from domestic markets that have performed especially well. This was especially true of UK institutions that benefited from more than 15 years of declining bond yields, but which over the last five years have ‘discovered’ the value and diversification benefits of owning global bonds. Euro-based institutions have until now had little incentive to allocate away from one of the best performing markets, 10-year Bunds having hit yields of 3% during 2005. However once there is a perception that this particular party is over or near its end, it is likely these investors will attempt to realise some domestic profits and diversify into global mandates”.
What is very pronounced is that, as Creswell finds, “there has been wholesale conversion of domestic mandates to mandates with broad guidelines, permitting global bonds, a wide range of credit instruments, small amounts of outright currency exposure, usually no more than 5%, and in some cases allocations to emerging market debt and high yield, the two combined not usually exceeding 20%”.
Managers such as PIMCO are also encouraging clients “to structure investment guidelines to permit tactically investment in non-domestic bonds on a risk controlled basis when valuations are compelling”.
A key component of accessing a global investment universe is the use of derivatives, which Bruno Crastes of Credit Agricole Asset Management (CAAM) sees as “something that is still not deeply understood by institutions”. While institutions can focus on the dangers of leverage, Crastes sees the ability to sell futures when holding bonds or buying futures combined with cash as something that does not result in leverage and something that should be explicitly permitted in client agreements.
Bond indices always suffer from the fact that credit spreads account only for a small proportion of the valuation of a bond, so that any capitalisation weighted index has the danger that the more debt an entity issues, the greater its weighting despite the fact that its credit quality may be inversely related.
Despite the fundamental flaws that exist, as Abberley points out, “clients need to have an index to compare you with. They need a rough benchmark and you need to outperform that” but adds that “as a portfolio manager, you should not get too hung up on weightings in the benchmarks. You need to have a loose approach to that”.
Global bond indices include both government bond indices from providers such as the JP Morgan with 600-700 bonds and also global aggregate indices, most notably the Lehman Brothers Global Aggregate index with 10,000 or so bonds. Fund managers can also tailor their own variations which may be seen as more accurately reflecting their own approach. BlackRock for example, has the approach for European investors particularly German investors, of using the Lehman global aggregate excluding Treasury products, according to Andrew Gordon. “The concept here is that the investor wants exposure to global credit spreads so you take the Lehman global aggregate and take out Treasuries leaving the corporate bond market credit sector as well as the securitised sector such as US mortgages, Pfandbrief, etc. The US proportion has roughly 8% in pure agency securities, 25% in the mortgages sector with roughly 2% commercial MBS, and pure credit is roughly 22% in US corporate bonds.
“In Europe the big sectors are corporates with 11% in European credit, whilst German Pfandbrief and other regional governments are around 5% or so. Then you get into Japan, one of the reasons some people like this index is that the weight of Japan goes down, if you think about it, in Japan the biggest sector is JGB sector. When you take out the JGBs because the other sectors are relatively small, it brings the overall weight of Japan down to 7%.”
He adds that the advantage of this approach is that it is “a combination of US mortgages, US credit, European credit and various swap products”.
When it comes to valuations, the problem for European pension funds is that, as Pimco’s Suhail Dada points out, “they are facing the same issues that US pension funds have faced for the last 18 months or so. They look at long-term yields and on a historical perspective they are very low. Our view is that these yields are likely to remain low in the US and Europe due to relatively benign global inflation within the context of cheap factors of production in Asia and China, and the glut of global savings relative to investment opportunities which will sustain demand for financial assets going forward. Our sense is that yields are probably as high as they are going to get.”
Given that, obtaining extra returns through identifying relative undervaluations in the global markets becomes more important for pension funds. According to Dada, in 2005 “there was a value rotation away from Europe. At the start of the year the European bond market was a much more attractive place to take interest rate risk given that weak economic growth on a relative basis would prevent the ECB from following the Fed. Thus, in the first part of 2005, European bonds handily outperformed Treasuries. Later on in the year we shifted away from Europe and began to build our interest rate risk positions in the US, particularly at the front end of the US yield curve. The other market that we focused on early in 2005 was the UK, where we believed that slowing growth and benign inflationary pressures in 2006 would enable the MPC to lower rates.
“Here again our positioning is at the front and intermediate segments of the curve which we think offer much better valuations relative to the Europe. So given these valuation shifts, for European investors, 2006 may well be a year in which the benefits of diversification become clearer as global bond returns outperform relative to their local markets.”
With corporate bond spreads so low, it is not surprising that BlackRock are “pretty defensive on corporate bonds right now as we do not think the sector offers good relative value”. In the US bond market, which they segment into three product sectors: US mortgages, US corporates and swap spread products, they see the best value in commercial mortgage backed securities (CMBS), according to Andrew Gordon.
In Europe, with a similar breakdown into the credit sector, and the so called swap spread sector in the Pfandbrief and regional government debt, they “feel very strongly that euro swap spreads do not offer a lot of relative value. Whereas the US swap spreads are 45 basis points, in Europe they are 10. So from a portfolio construction point of view we are prepared to be radically underweight of those sectors of the portfolio. So if Pfandbrief is 3-5% of the index most of the our portfolios are at 0%. We will look for other places that show better relative value, for example, UK swap spreads.”
With major US managers as well as long established European managers competing in the European institutional marketplace for global bond mandates, it is interesting to look at what structural differences there could be between them. With the best European and US houses, there may not be much to choose between them but further down the pecking order, as ABN AMRO’s Abberley points out, “US houses have an advantage on credit having done it since the 1970s, while Europeans have done it only for the last seven years. Active fixed income management is also more strongly embedded in the US than in Europe where prior to the mid-80s, it did not exist. However, leaving aside the top tier of US houses, he sees European firms as generally ahead in risk systems as “because they were later in the game, they had to start with a clean sheet of paper and the world has been transformed through data availability and the sophistication of software”.
For European investors, widening the universe to incorporate global bonds certainly makes sense, but the issue is how should the risks against a domestic liability driven benchmark be controlled. When it comes to hedging for example, while in terms of return, the results according to Abberley “depend on the time periods and are not stable over time. The default option for global portfolio is currency hedged – so you get diversification without too much variation from liabilities arising from currency”.
Dada also agrees that “fully hedged is the way to go. Unhedged allocations should be undertaken only when there is a specific underlying view that the currency is in a down trend and an explicit willingness to underwrite the volatility over the specified period of time. And given this volatility the allocation needs to be sized accordingly”.
Producing tailor-made portfolios with a domestic benchmark while accessing the global opportunity set does require the ability to control risk in a sophisticated manner. Firms such as BlackRock and PIMCO have developed extensive in-house analytical systems that for example, enables BlackRock to “model the liabilities and have the ability to implement a swap overlay, and secondly to implement the strategy of our global bond portfolios”. So for a Dutch pension scheme, Gordon explains, “we will get a portion of all the duration that we need from a swap overlay which will free up capital to pursue relative value strategies in the global bond market” a strategy that PIMCO also pursue for their continental European and UK based clients according to Dada.
Gordon goes on to explain that, “for example, we think US AAA commercial mortgage backed securities (CMBS) is an attractive sector globally, while the euro swap spread products are not because spreads are so narrow, so we will own those securities in our euro only long duration mandates for the Dutch pension plan but hedge the duration risk in those securities via futures so we are left with the relative value of CMBS versus Treasuries”.
The amount of benchmark risk that is able to be taken clearly depends on the sponsor’s particular circumstances. As a result, according to Creswell, Payden & Rygel, “monitors the liability stream and the size of any funding surplus relative to the asset base. Providing a fund is in surplus, it is preferable to be mandated to look for value wherever it may exist, in whatever market, hedging out currency risk. This approach requires close liaison between manager and plan sponsor with the manager constantly monitoring the risk it is taking relative to the surplus and the liabilities”.
Cresswell goes on to add that “where no surplus exists or a fund is in deficit, this approach can only be undertaken with the express backing of the plan sponsor, which will have ultimate responsibility to make good any shortfall”. The objective of such an approach is clearly that those institutions that adopt active global strategies should benefit from making lower overall contributions to their fund.
For European institutions, adopting a liability driven approach, whilst seeking excess returns through accessing the global universe, a key issue is to what extent imprecise long-term liabilities should be precisely matched and at what cost. The alternative route is that of allowing managers with domestic liability driven benchmarks to widen their opportunity set by relaxing investment restrictions, especially in relation to the investable universe, including active currency management and widening tracking errors.
Given the imprecise nature of any liability estimates, is there a case for pooled global bond funds partially hedged back into domestic currency with a domestic long-term benchmark such as over 15-year index-linked gilts? CAAM believes there may be and is actively exploring ways of structuring such a product with the idea that it could act as a complement to a purely domestic manager and fully hedged bond portfolio or fund according to Crastes. Rather than going down the route of matching estimates of liabilities precisely and then seeking expensive portable alpha solutions (ie, hedge funds) on top, they advocate the idea of a pooled fund that has the objective of beating a liability related benchmark such as over 15-year index-linked gilts but having access to a global opportunity set in a fund that can also use derivatives to optimise the risk relative to this benchmark whilst seeking excess alpha outside the domestic bond market.
How popular such concepts will be remains to be seen, but it is clear that adopting a liability driven approach to investment does not necessarily mean you are forced to invest only in a domestic market. Accessing global markets in a risk-controlled manner to satisfy domestic liability driven benchmarks is something that all pension schemes need to consider.