Ask any manager of US fixed income why investors need to be invested in US fixed income and they will tell you that no bond market is so large or so wide or so deep or so liquid. Worth an estimated $7trn (E6trn) it dwarfs every other market in the world. It is, for instance, 20 times the size of the UK fixed income market.
It is not only the size that is attractive but the variety of assets, says. Besides government and corporate debt, the US offers agencies like Freddie Mac and Fanny Mae, with some 50% of the US fixed income market; mortgage backed securities (MBS) which have no real counterpart worldwide other than in Denmark; and preferred debt, subordinated debt with investment grade quality.
This diversity enables European pension funds and other institutional investors to broaden their exposure significantly, says Andrew Gordon, fixed income portfolio manager and managing director at BlackRock International in the US, “From the European investor’s point of view, going for either a US mandate or a global mandates recognises that the US is a pretty big capital market with a lot of different sectors and securities. So rather than just focusing on your home market you’re broadening your exposure to those other sectors and securities.”
European pension funds may like the size and depth of the US market but may feel that it does not match their risk profiles. A UK pension fund, for example, may want the depth of the US fixed income market but the profile of the UK corporate bond market. UK currency specialists Record Currency Management and NISA Investment Advisors, a specialist US fixed-income manager have devised ‘matched international bonds’ to provide a solution.
Record Currency Management agrees credit limits with the client and buys US bonds to within those limits. Using a series of forward exchange contracts and two interest rate swaps, it converts the returns to match the sterling benchmark set by the client to meet their fund’s needs.
Peter Wakefield, head of sales and marketing, at Record Currency Management says: “The aim is to create a portfolio of US bonds which is altogether more diverse, so that you have far less value concentrated in the individual issuers. It’s much more liquid so there’s more opportunity for active management. At the same time the derivative and foreign exchange structure brings the whole thing back to a euro-based yield curve environment so that your portfolio doesn’t move according to what happens in the US but more according to what happens in the UK or Euroland.
“We are looking to market this as an alternative to UK bonds rather than a head to head competition with people who are looking specifically for US bonds. The selling point is that this resolves the major difficulty of the UK bond market – that it is just not big enough.”
Besides diversity and depth, the US fixed income market offers opportunities to add some risk and make some money, chiefly in ‘spread’ products such as high yield debt. Peter Wilby, chief investment officer, fixed income at Citigroup Asset Management, says: “Where the US fixed income market does add significant value is in the fact that the sectors are much more widely developed than in Europe and that is where you get the opportunity to earn substantially more - or less - than governments. And that is in particular is where you are seeing people’s ability to add credit risk.
“Even if one has the ability to allocate around the world , in the end you wind up coming back to the US market. That’s where the opportunities are and that’s where the developed market is. A lot of the credit risk either comes back to much of the US high yield market - the broadly developed BBB and A markets.”
Wilby includes emerging market debt in US spread products. “I would argue that the fixed income emerging markets is a dollar bloc generally and is a dollar predominated market as well.”
The growth of spread products at the expense of government debt has been the story of US fixed income over the past eight years. Traditionally, the Lehman Government/ Credit Index, the natural choice of pension funds, was dominated by treasuries. In 1996, treasuries comprised 65% of the index, compared with only 26% of investment grade corporate debt
However, by 2001 Treasuries and corporates were level pegging at 41% each. Since then, corporate debt has moved ahead. Lehman Brothers predicts that weight of corporates in the Lehman Government/Credit is projected to reach 61% by 2009.
As spread products have displaced government debt, aggregate indices that contain these products have grown in popularity, notably the Lehman Aggregate. This reflects the changing objectives of institutional investors, including pension funds. In the past, pension funds that merely wanted to match their liabilities would choose the Lehman Government/Credit benchmark.
However, today some investors are looking for the highest returns in every asset class and regard fixed income as a total return vehicle. These will favour the riskier more aggressive benchmarks like the Agg and the Universal that offer more opportunities for beating the benchmark.
“In terms of US only mandates there’s two routes pension funds can take,” says Gordon of BlackRock. “One is a specialised mandate versus a specialised index. Those we see out of Europe now are based on the concept of increasing exposure to corporate bonds and therefore using specialised mandates versus credit indices. The other is dedicated exposures to either high yields or emerging markets.”
Less common for European pension plans is a US mortgage only mandate, he says. “Generally pension plans look for a longer duration type mandates and the duration of the mortgage market and the structure of interest rates is actually very low right now.”
The alternative to the specialised mandate is the aggregate mandate. At BlackRock these take two forms: core, generally versus an investment grade index like the Lehman Aggregate, and core plus. “Core plus gives the manager the ability to make opportunistic allocations to sectors like US high yield and emerging markets and also non US securities.”
European investors are showing increasing interest in another alternative - a global fixed income mandate that includes the US fixed income market. These will be typically structured versus a Lehman Global Aggregate type index of which the US is roughly 50%.
Significantly the ‘Agg’ adds mortgage backed securities (MBS) to the Lehman Government/Credit’s universe of Treasuries, agencies and corporates. US MBS are now an important part of the Lehman Aggregate and their share of the index equals Treasuries and corporates combined. This strong presence of MBS means that if a US fixed income bond portfolio is invested against the Agg, it is bound to be invested in MBS.
Jérome de Dax, managing director of SG Asset Management, which acquired US MBS specialist TCW last year, says that the Agg has introduced European investors to MBS. “If your benchmark is the Lehman Brothers Aggregate 40% of the index is US MBS. So you have to be invested in MBS. Even in the Lehman Global, the US MBS represents 18% of the index, almost twice the US Treasury share of 10%.”
One attraction of MBS is that they have no credit risk (although they do have prepayment risk – the risk that the mortgagee will refinance). This distinguishes them from corporate bonds. Yet their yields are similar to corporate bonds, which have higher yields than treasuries.
However, the main attraction is its risk-adjusted return, says Jeffrey Gundlach, group managing director for US MBS at TCW, the US subsidiary of SG Asset Management: “If you take a historical view of risk-adjusted return the asset class that has for the last 15 years had the most dominating Sharpe ratio is the MBS sector. That’s the primary reason why investors anywhere would be potentially attracted to US MBS. Share ratio historically has been about double the Sharpe ratio of corporate bonds and Treasuries. And the reason for this is that they have had relatively high yields and relatively low volatility.”
Currently MBS are enduring an “excruciatingly high” level of prepayment risk, says Gundlach, as interest rates stay low and homeowners refinance. As a result durations are short – under two years – and yields are low. “Mortgage investors are right in the cross hairs of the Federal Reserves attempt to reflate the economy. Over half the mortgages in the US have refinanced in the past year.”
Gundlach says in this environment the only attraction of MBS is to provide protection against an increase in interest rates. This is because MBS are characterised by what is called ‘positive convexity’. Convexity is another word for prepayment risk – the risk that a bond will be paid off early. Negative convexity occurs in Treasuries and corporate bonds when a rise in interest rates causes a rise prepayment risk. However MBS behave differently. When interest rate rise people generally do not refinance. So the prepayment risk of an MBS actually decreases as interest rate rise.
“If rates went up to where they were a year ago you would have very big losses in long term Treasuries and long term corporate bonds. The 10 year Treasury, for example, would lose 12.5% of their value. Mortgages, on the other hand, would show positive returns.”
However, the current short duration of US MBS makes them less suitable for pension funds with their longer horizons. Some pension funds have stripped out US mortgages from their benchmark in customised versions of the Lehman Agg. This increases the duration of Agg to from 4.5 years to 5.3 years.
The traditional route for bond investors in search of higher yields is to move down the credit curve. Although pension funds tend to categorise high yield bonds as an alternative asset class, larger funds in the Netherlands, Scandinavia and Switzerland have come to see them as a necessary component of their fixed income asset allocation. The US high yield bond market has an added advantage of being more mature, liquid and broadly based market than other high yield markets,
“A lot of plans realise that the sort of returns they got before they can’t expect to get going forward in the lower risk types of bonds. So there has been very much an interest in carry-trades and spread products,” says Lee Thomas, a managing director and senior member of PIMCO’s portfolio management and investment strategy groups.
They also enable investors to get involved any corporate recovery that is underway without necessarily being invested in equities. “There is a lot of disenchantment with equities yet investors still want the returns. So high yield debt and corporate bonds seem attractive, particularly in the US where the stock market is getting close to fair value but is still not cheap. So if you like the prospects for the US economy turning around and starting to recover over the next two years, but at the same time you think the stock market is too expensive, then the solution is to participate in the recovery through corporate and high yield debt.”
One disincentive to invest in high yield is the high level of defaults. According to JP Morgan Chase, defaults have continued to climb from $55bn in 2002 to $75bn in 2003, although the default rate has fallen from above 8% in 2001 to below 6%. Managing defaults is a matter of staying away from sensitive sectors such as telecom and focusing on well-capitalised companies with free cash flow.
Sandy Rufenacht, portfolio manager at Janus, says: “We like to see predictable earnings streams, in companies that are actively seeking to de-leverage their balance sheets, with free cash flow in excess of the debt amortisation schedule.”
Rufenacht says access to a company and its management is important and he will pull out if company visits are not allowed. “Any deterioration in access to a company and its management will be a sell trigger, alongside more quantitative factors such as a significant tightening of the spread, or a shift in the downside risk.”
But are the rewards of high yield worth the risk? There is some evidence that the spreads between spread products may be narrowing. Andre Moutenot, head of the US fixed income investment department at Swiss Re Asset Management, has observed that, in investment grade debt, the spreads between 10 year investment grade debt (AA) and 10 year marginal debt (BBB) has narrowed rapidly in the past eight months.
In sub-investment grade debt, the spread between double BBs, which are at the high end of the high yield market and triple CCCs which are almost ready to default is now close to 700 basis points, compared with almost 1400 in October.
“The reason for this is that the equity markets have suffered such falls that people are looking for alternative opportunities to create value in the market place and it’s been happening purely in the credit arena, on the investment grade side but even more tellingly on the high yield side,” he says.
Pension funds that are hungry for yield but unwilling to go down the credit curve have other alternatives to high yield in the US fixed income universe. One is preferred stocks, a subordinated debt market tat has ballooned from zero in the mid 1990s to $200bn today.
Mark Lieb, executive director of Spectrum Asset Management, which specialise in preferreds, says: “Traditionally the way to enhance fixed income credit portfolios was to either go down the credit curve or emerging markets , which can give you better yield abut also much more volatility. The use of the preferreds enables investors to stay with the higher quality issuers and pick up some additional yield.”
The additional yield flows from subordination rather than incremental credit risk, he says. Preferreds are the most subordinated debt in the corporate hierarchy and therefore offer better yields compared with bonds. “Our philosophy is that we’d rather own the subordinated debt of the higher quality company than the senior debt of a lower quality company. And we just want to get paid for that subordination. And that’s approximately anywhere from 100 to 200 basis points better than a senior debt from the same issuer.”
The higher returns are also paid for by a deferral payment period of up to five years. “To classify as a preferred the rating agencies will look at this from the issuer’s point of view and they will give it some equity credit to it, which helps the balance sheet of the issuer. They can do that because preferred securities have a deferral payment period of up to five years. The deferred payment allows the credit agencies to give it some type of equity credit to it, even though it’s really subordinated debt,” says Lieb. “Preferreds aren’t the answer to fixed income yield. It’s one of the tools that pension funds would use.”
The alternative to moving down the credit curve may be moving up the yield curve, Moutenot suggests. “Right now looking at the yield curve between five and 30 years the spread relationship is around 200 basis points. So when you’re looking at a five year rate – that’s somewhere around 2 3/8ths to 2 1/2 – we’ll be getting that much more just from the curve extension.”
Duration management enables bond portfolio managers to squeeze more yield out of the system. Normally duration management involves lengthening or shortening duration against the benchmark. Shortening duration reduces risk and yield. Lengthening it increases yield and risk. But there are other options. One is to ‘barbell’ the duration around the benchmark.
This means holding government securities that are longer and shorter than the benchmark durations in a ‘barbell’ of debt with short maturities at one end and long maturities at the other. “We would do that on a duration-weighted basis, meaning that in the overall portfolio we would sell five year securities somewhere around five years and buy high quality debt in the one or two year period and at the same time buy A rated or better quality debt in the 30 year period. In this way our weighted position still approximates to the duration but with a bias towards catching the curve-flattening trade.
“This means you can actually manage on a barbell and shape your durations. So with our durations now about 10% longer than our index we can move that weighting back to our short term index, given the flexibility and liquidity of the US market place, literally at a moment’s notice. “
With spread products compressing, yields will become harder to find. With US government yields at near record lows, there is no easy money to be made from Treasury bonds. “On 10 year government bonds over the next few years you’d be very lucky to earn just the yield on the bond, so 4% is your total return,” says PIMCO’s Thomas. “That is quite different from the 20 year period from 1980 to 2000 because inflation was constantly falling, interest rates were falling and you expected to earn the yield of the bond plus the capital gain associated with lower interest rates. Those days are now behind us.”
However, there is still a way to make money out of Treasuries in a process known as ‘roll-down’ Thomas suggests. “The trade now is to buy the five year sector of the US market where the curve is very steep and let your position roll down that curve. The mild appreciation of price as a five year note matures into a four year note at lower yields – rising in price simply by surviving for 12 more months. That can produce a very nice return as long as the Fed doesn’t raise interest rates.”
PIMCO calculates that this stratagem, which involves rebalancing and re-extending maturities at the appropriate period ’s end, adds 1% to total Treasury returns. In combination with slightly longer than market durations, an annual return of nearly 5% from Treasuries is possible.
So, in spite of the inexorable rise of spread products and risk assets in US fixed income, there may be more life in government debt than anyone expected.