Mark Wirth of Northern Trust Global Investments explains how the group is achieving superior fixed income returns
OUR philosophy of fixed income investment management is built around the concept of consistency -- of using a reliable and disciplined process to deliver consistently superior investment returns in all types of market environments.
We remain firm believers that the structural changes in the global economy are too significant to ignore, even in the face of increased cyclical inflation fears. Appreciating that a majority of investors have yet to fully embrace our constructive longer-term view, and recognizing that--by most measures--bonds were overvalued following last fall’s market turmoil, we have been recommending neutral portfolio durations throughout 1999. While this positioning has not protected us from this year’s backup in interest rates, it has limited our losses. As we look into the near future, a further rise in rates--absent some unanticipated breakdown in economic fundamentals--would likely cause us to move to a more constructive duration stance. While maintaining our neutral positioning on interest rates we have sought to add value by managing our portfolios’ exposures to the non-Treasury sectors of the bond market. Although corporate bonds are viewed as the most common type of “spread” paper, our preferred spread-overweight decisions have primarily been in residential and commercial mortgage debt. Amid this year’s backup in interest rates, these particular overweight decisions have generated meaningful excess returns above Treasuries and other less volatile spread sectors. This out-performance, coupled with our belief that current Treasury rates are close to pricing in investors’ worst-case views of inflation risk, has prompted us to consider modifying our spread positions to stress less volatile, more liquid securities, such as the government agency market. In recent years, issuers of agency debt have taken aggressive steps to become liquid “benchmark” names that can be viewed as higher yielding substitutes for “on-the-run” Treasury issues. Given the desirable liquidity now provided by these multi-billion dollar global issues in the agency market, we think this sector offers increasingly attractive opportunities to maintain spread exposure while taking on minimal credit risk.
Notwithstanding this push by agency issuers to improve the marketability of their securities, overall liquidity in non-Treasury debt markets has significantly diminished over the past year. Importantly, the reasons behind this change go beyond Y2K-related concerns in the marketplace. Media-documented changes in the structure of the bond market and shifting relationships between broker-dealers and buy-side investors have significantly reduced the amount of capital available for market-making activities. While these changes may be beneficial for buy-and-hold bond investors they also create greater challenges for fixed income portfolio managers seeking to capture relative value opportunities via active trading strategies. As such, decisions to adjust portfolio exposures in response to a perceived relative value opportunity increasingly require careful consideration of trading liquidity, along with the expected value pay off.
Interestingly, we think market liquidity also has important implications for Federal Reserve policy actions. During last fall’s market turmoil, Alan Greenspan identified decreased liquidity in the credit markets as a threat to the smooth functioning of the economy and, accordingly, a reason for lowering interest rates. Although current conditions are better than what existed in those dark days, some of the same “poor liquidity” signals are flashing at present. Within the overall context of monetary policy-making, we expect the ongoing desire to maintain smooth-functioning financial markets to temper the degree of additional tightening actions undertaken. As stated previously, with fed funds having traded in a narrow 1.25% band over the last five years (which is one-half the range experienced during the 1994 interest rate cycle), much of the monetary authority’s policymaking now comes in the form of posturing, as opposed to actual interest rate moves. We expect this modus operandi to continue.
Investment Process Overview: The Relative Value Approach:
Northern Trust became one of the first “relative value-based” fixed income managers more than 10 years ago, introducing an innovative approach to fixed income investing which would prove to offer a number of distinct advantages over more traditional investment styles. Instead of structuring portfolios solely around the interest rate forecast and attempting to add value through interest rate “bets”, as traditional top-down approaches would dictate, our style incorporates key elements of a bottom-up approach, focusing on identifying relative value at the issue level, while closely monitoring and controlling portfolio risk relative to a client-selected benchmark.
While we consider the same factors as other fixed income managers - duration, yield curve exposure, sector weighting, quality and security selection - it is the way in which we approach these decisions that differentiates us. We combine a rigorous fundamental analysis of the economic environment with disciplined, quantitative based analytical capabilities to make fair value determinations of the key components - interest rate levels, credit and quality spreads - and determine the likelihood of change, or volatility, in each. Based on our fair value assessments, portfolios are managed to emphasise areas where we believe an investor is more than adequately compensated for the risks assumed. (See Graph One).
Risk Assessment
The evaluation, assessment and complete understanding of risk is fundamental to our approach to fixed income management. We evaluate risk at both the portfolio and the security level. In our view, risk is a relative term, with risk increasing as portfolio attributes begin to differ from normal or benchmark attributes. We control portfolio risk in traditional ways, including through the establishment of limits for factors such as duration, sector concentration and credit quality. In addition, we also utilise a multi-factor risk model to statistically link the portfolio’s estimated return variability to that of its benchmark.
At the individual security level, risk is evaluated from two perspectives: credit and structure. The creditworthiness of the issuer is reviewed by our full-time professional credit research unit. The structural risk of the security is evaluated by the portfolio management group, using a quantitative modeling process. This process tests the dynamics of complex securities under alternative interest rate environments to assure that all portfolio holdings are properly modeled and incorporated into total portfolio risk. The evaluation and monitoring of portfolio and security risk is a continuous process. We believe risk must be understood and managed as opposed to avoided. By accepting risk intelligently, we believe that we can achieve the investment returns our clients require.
Investment Process: Adding Value and Building the Framework: The Environmental Outlook
As one of the most established and successful fixed income managers based in the US, Northern Trust has developed substantial internal resources to provide our portfolio managers with proprietary research and analysis. In conjunction with our portfolio team, our in-house economic research team conducts extensive fundamental analysis of the domestic and international macroeconomic environments which is a direct input into our interest rate model and is also used in our determination of value at the sector and security level.
Our interest rate model is based on determining when change is occurring in well-defined economic, political and behavioral factors which influence the supply and demand for credit. Where our views differ from the consensus, we determine the potential impact of the consensus moving to our view, to develop a fair value range for interest rates. This range tends to be relatively wide, so decisions based upon it - primarily for duration and yield curve - are generally less frequent, and depend on the magnitude of difference between our outlook and that reflected in the market. ( See Graph Two).
Duration Decision
The duration decision is an extremely important portfolio consideration which we carefully manage from the perspective of two distinct time horizons. For each client, we establish a normal portfolio duration which addresses the client’s need for return and risk tolerance over the longer term. We will occasionally move portfolio duration away from normal to reflect our view of near-term market risk and opportunity. In practice, duration adjustments are seldom made, but when implemented, are always done in a carefully controlled fashion to fit within specified duration criteria associated with each of six expected market environments ranging from bearish to bullish. Our outlook is continuously re-evaluated and updated as market conditions change.
Yield Curve Exposure
Since interest rates across maturities rarely move in tandem, our environmental outlook may also lead to a yield curve decision. While interest rate predictions for different maturities are an output of our interest rate model, we believe yield curve decisions lend themselves to a more quantitative process, as well. There are certain historical norms and value relationships which tend to hold true over time. Using statistical based analysis, we examine the shape of the curve -- the relationship of interest rates for different maturities -- from an historical perspective and within the framework of our current economic outlook to develop what we would define as a "typical" yield curve. We then adjust portfolio cashflows relative to the normal portfolio or benchmark structure to emphasize areas we believe would provide the greatest expected return if the actual yield curve reverts to our historically “normal” yield curve.
While the environmental outlook is primarily used for interest rate decisions, it also plays an important supporting role in sector and security decisions, which are driven principally by intensive quantitative and credit analysis. For example, our economic analysis and its impact on corporate profits influence our credit quality and sector decisions, while the market’s degree of uncertainty regarding our model inputs will influence our volatility outlook.
Risk Premiums -- Relative Value Opportunities
We believe that intensive quantitative analysis of the key “risk premium” relationships - sector, quality, issuer specific and optionality - can contribute to superior investment results. Once again, these relationships must also be evaluated within the context of the overall economic environment, as they are clearly affected by changes in interest rates and other economic factors. For instance, if our forecast is for a recession and we feel risk premiums are at normal or less than normal levels, we typically would emphasize higher quality in our portfolios. Conversely, a more positive economic outlook would suggest broadening the quality range of issues. We believe that within that economic framework, there are excellent opportunities to find additional value across sectors, quality and individual issues. This is due to the fact that the fixed income markets are not perfectly efficient -- in other words, temporary pricing distortions occur within the market where issues, or entire sectors, may be valued higher or lower than their fundamentals and fair value would dictate.
When this occurs, spreads move out of line from their normal relationships, thereby offering favorable buying (or selling) opportunities (See Graph 3).
Sector, Quality, Security Decisions
Again, our research effort is focused on determining fair value ranges for the risk premiums an investor is paid for purchasing non-treasury securities. The analysis focuses on what investors have historically demanded for accepting a specific risk, as well as on establishing normal intra-market relationships among various risk premium. Our spread analysis and credit research methodology is used to identify where quality or sector spreads are trading most favorably at both the sector and the security level. Essentially, we are comparison shopping to find the most attractive way to implement our environmental view, while improving the portfolio’s return/risk profile. Securities are purchased and sectors emphasised when our relative value analysis leads us to determine that the market is overcompensating us for the bundle of risks that the security or sector represents.
Discipline and Consistency - A Continuous Process
In conclusion, fixed income portfolio management at Northern Trust is a dynamic and continuous process. It begins with a carefully constructed environmental framework, and uses an intensive relative value process to select the most attractive building blocks across sectors, quality ranges and individual securities, while keeping risk within our clients’ acceptable ranges. Our ultimate objective is consistency. We believe that by using a reliable and disciplined process, we can consistently deliver superior returns, to meet – and exceed – our clients’ expectations.
Mark J Wirth, CFA, is a senior vice president at Northern Trust Global Investments, the Director of the Fixed Income Management Division and leads the Taxable Fixed Income effort as Senior Strategist, in Chicago