Most of our clients have a long term view, which is just as well given what has happened over the past six months,” says Margaret Frost, head of fixed income research at Watson Wyatt.
The ramifications of the US sub-prime mortgage crisis are still reverberating throughout the global marketplace and causing a reassessment of investment strategies. While some investors have been badly burnt through large exposures to the lower-rated tranches of the sub-prime market, the overall rise in spread levels does create more attractive investment opportunities and illustrates the benefits of adopting a global approach to bonds.
However, as Keith Patton, head of fixed income, Europe, at Aberdeen Asset management points out: “Unless clients give flexibility to add value, they will get disappointed and go passive, asking what is the point? The space for adding value is the global space. But what does it mean? Is it global macro economics? Is it global as an asset class, or global fixed income as a source of alpha? Quite often people interchange these meanings. The three are very distinct.”
What is clear though, is that in the search for higher returns in their bond portfolios, investors are increasingly investing globally across a diverse set of debt asset classes even though the benchmark is local, whether a local bond index or a set of liabilities.
This is the ‘global alpha-local beta’ paradigm that is sweeping the institutional bond markets and which will lead to an increased focus on global rather than purely local bond markets.
After-effects of US sub-prime crisis
The US sub-prime crisis has clearly given rise to a profound shift in the international bond markets extending beyond the ABS marketplace. As Jean François Boulier, head of euro fixed income and credits at Crédit Agricole Asset Management (CAAM) says: “There has been a contagion effect in credit right across the world.”
Patton explains that banks focus on value-at-risk (VAR) and downside risk. “Their worst case scenarios were beaten by a long way over the summer months,” he says. “Thousands of risk managers are re-evaluating VAR and downside risk assumptions. As a result, many will take smaller risks and have smaller balance sheets so there will be an indiscriminate widening of the market. It will change and provide opportunities. What is happening is a liquidity crisis not a credit crisis. There is a credit crisis in sub-prime but a liquidity crisis in credit. Spreads in credit are now attractive unless you believe that we going into a global recession. Spreads against the probability of default look attractive.”
Boulier says there is a lot of value in corporates. “Short-term and high-quality credit is a bargain. Swap spreads of 90bps for two years and 120bps spreads on names that are very good credit quality. The trend is actually to diversify way from US fixed income and from US assets of any type. A number of portfolios have had some exposure to US sub-prime and so there is a strong appetite for non-dollar assets.”
However, he continues: “In the first week of August last year, there was a pure liquidity issue, but from the second week onwards the liquidity in corporate bonds was not that great although good enough to trade, and we were hoping to see investor demand and subscriptions into long-term credit funds. But since then, compared to opportunities we come across, we have not found a large appetite from investors.”
Frost is more positive. “Most people are looking at the whole re-evaluation of credit as an opportunity for adding more,” she says.
Managers who managed to avoid exposure to the sub-prime markets have the opportunity to bask in the resultant glow, with Baring Asset Management’s Toby Nangle, director of fixed income, arguing that “the sub-prime crisis had the effect of showing which managers had been taking large risks on credit when only paltry rewards were on offer. Genuine active managers who have been using a robust investment process that includes some sense of valuation have been achieving good performance numbers.”
John Lovito, fixed income lead
portfolio manager at Lehman Brothers Asset Management in London says his firm was fortunate in not holding any sub-prime. “A year ago, we were concerned about the level of spreads in general. We were concerned about firstly the tightness of spreads and secondly the need for return and the use of leverage by investment managers at a time when there were signs of deteriorating fundamentals. We were taking a very conservative stance.”
The most spectacular effect of the US sub-prime debacle has been on the ABS market. Boulier points out that the market has been dropping with no discrimination between US and European assets. “So investors are stuck in a market with very poor liquidity,” he points out. “Since last August, there has been a lot of difficulty in trading issues. It used to be possible to trade €20-50m in a single ABS issue. Now, selling €5m is a great deal. It is also difficult to find the relevant prices for many assets. It is a difficult situation and we have to find ways to work out what the price should be.”
Boulier adds that his firm uses a mark-to-model approach. “When liquidity came back to some extent in October, we saw that the mark-to-model prices were not far out from the market prices, but we don’t feel comfortable. Even originators and structurers who issued deals are not so active in the secondary market.”
So the future for the ABS market does look uncertain with no new issuance at all. Boulier concludes: “We need to find ways of getting a minimum liquidity and find some sort of agreement with dealers so there is some sort of liquidity in future, otherwise, the market will disappear altogether.”
With increased volatility, there is increased uncertainty over the future. Nangle argues: “Many government bond markets have discounted a sharply slowing global economy next year, and it is hard to see the western market growth accelerating, with the hangover of a variety of property market corrections, the continuing credit crisis, and a weakening employment environment.
Government bond yields are still driven to a large part by the non-profit maximising activities of entities such as central banks and sovereign wealth funds from Asia and the Gulf.
Nangle continues: “To get excited about government bonds you need to take the view that the west will experience a growth recession, with 2008 GDP numbers coming in shy of 2% in the major markets. However, receiving somewhat less market focus is the inflation that has persisted into the downturn and which has every sign of accelerating at the headline level at least.
“Profit share as a percentage of GDP is extremely high and worker incomes have been falling in real terms, leaving the consumer in a weaker position and heightening the prospects for labour activism into 2008. Central banks will thus have to contend with slower growth, falling consumer power, and not immodest levels of inflation. Any Middle Eastern and Asian currency revaluations in 2008 will put further upward pressure on European and American inflation.”
Not surprisingly, Nangle finds it “hard to get excited about the level of nominal government bond yields”, but instead, believes that “inflation-linked bonds in some select markets, local currency emerging market exposure in countries that follow a tight money policy, and financial credit exposure all look interesting for 2008.”
Benchmarks and mandates
Frost finds that there has been a general loosening of guidelines, which has enlarged the overall opportunity set, and led to a large overlap of mandates.
She says: “Bond mandates are not local even if the underlying bond benchmark is. Index-linked mandates tend to be more passive while most active mandates are for aggregate indices or credit indices with a lot of our mandates in sterling being pure credit - we haven’t seen a gilt mandate in years. But the iBoxx indices and sterling credit are not highly diversified opportunity sets. They are heavily weighted to financials, which increases the attraction of diversifying away from pure sterling credit into a global opportunity set.”
Investors need to be clear about what they are trying to do, whether it is beating a benchmark, seeking absolute returns or trying to beat inflation. As Patton explains: “With the exception of a number of multi-nationals and government-led organisations, the majority of corporations have domestic liabilities. What most clients should be doing is to use the global opportunity set with global fixed income but setting a domestic benchmark - separating the opportunity set from the benchmark, then using swaps to match.”
Money market funds, bond funds with absolute return targets, or hedge funds? The staggering growth of the fixed income derivatives marketplace has enabled a complete separation of the search for returns in bond portfolios from the management of liabilities. The creation of pooled, absolute return-focused approaches to fixed income investment with cash benchmarks gives rise to higher return strategies that can be combined with tailored swaps to satisfy whatever the local liability driven benchmark that is required. This gives the benefits of access to global and often illiquid sources of alpha, while having a relatively liquid investment product through the use of a pooled vehicle incorporating a proportion of liquid instruments to manage cash flows.
Moreover, the matching of liabilities by a swap can be undertaken completely separately from the search for alpha with an absolute return focused bond mandate. As Nangle explains: “Our absolute return product, with a target of LIBOR plus 3%, can serve as the alpha portion of an LDI strategy for pension funds, but we do not structure the cash flow matched swap portion of LDI portfolios.”
One problem now arising is a great deal of confusion in the marketplace between what is a money market fund that is being used purely as a source of liquidity and what is a bond fund with an absolute return objective which may be expressed as an outperformance target against LIBOR or EURIBOR. As Boulier explains: “The more aggressive absolute return bond funds are targeting a 4-5% outperformance. They are sold by firms like us. We have been launching long/short credits and a number of specialised funds - high yield and in general interest rate investments. They are sold to institutions and corporate treasurers. But all these funds have been redeemed dramatically over the last quarter. The outflows have been sizable and affected all funds, so there is a lot of thinking going on about how to differentiate these funds from cash money market funds.
“There needs to be more clarity in the segmentation of the market,” says Boulier. “In the sales approach, a number of these products were sold quickly on short term performance but suddenly people discovered last August that part of the performance depended on things they were not comfortable with. The industry needs to come back with more education.”
This confusion extends when a potential investor is willing to extend the universe of managers to include fixed income hedge funds and related strategies. Nangle says: “We are seeing interest from Europe and the Far East for 130/30 global fixed income mandates. Clients and prospects are increasingly asking themselves what they can do to allow their managers to increase their information ratios and 130/30 is a sensible move to make in this context.”
But what is the difference between a fixed income hedge fund manager and a traditional fixed income manager? Lovito points out: “We are not a hedge fund. Do we use long/short techniques? Yes.” Patton says that there is no difference between what a hedge fund does and what his firm does. “Any fixed income fund takes views on credit, interest rates and currencies. You could always short currencies,” he says.
“With interest rates, the average duration of a benchmark is five years. At any time, we may be between four and six years so a manager is always short or long. So the concept of long or short interest rates is the same as that in a hedge fund. The area that is more embryonic is credit.”
Frost sees little difference between traditional fixed income managers and fixed income hedge funds except in fees. “There is often a skills gap between the more traditional long only domestic orientated bond managers and the hedge funds, especially in the areas of shorting, risk measurement and trading skills but we find these characteristics are evident at managers who have more of a long only product base,” she says.
“What is key is the ability to think symmetrically about every strategy, be it long or short, and that is where the most competition for client assets will be fought over in the future. The experience of the last six months has shown that many plus 2% products were just relying on credit beta to get the target return.”
The main distinction apart from fees is the return targets. Patton says: “The typical fund targets 1-2% outperformance. Hedge funds are going for 12%. There is a growing market for somewhere in between. What is interesting about that is the market for institutions. Hedge funds are trying to get into that by getting to know the institutions.”
For Frost, a truly global manager would need to have expertise in all areas, both credits and securitised assets. “There are not many UK fund managers with expertise in US mortgages,” she says. However, that does not preclude the majority of managers who do not satisfy that criteria to be able to access the global opportunity set.
She continues: “You can be global but you need to be self aware. If you are not good at something, you should not be doing it.”
That justifies the role for specialist managers in sub sectors such as emerging market debt (EMD), but for Frost a specialist is a specialist. “EMD is EMD, not global. If a scheme is big, they want diversity and there is always room for a specialist. If there are too many specialists, there are governance issues such as who does the asset allocation? We are clear on the idea of having both specialists and global players. If a scheme is big enough, it can justify having a number of managers who are generalists and a number of specialists round them. But it is key to determine where the responsibility for asset allocation lies.”
Since half the world’s debt markets are in the US, Frost believes that US managers start off with an inherent advantage, as long as the product looks appropriate. Although, she adds that investment opportunities of the future may be elsewhere, such as Asia. It is not surprising that the influx of new US managers to Europe is still continuing.
“We are fairly new to Europe and are building up our capabilities in London,” says Lovito. “We are based in London not just to gather assets, but for investment reasons. It straddles the time zones.”
When it comes to European managers, Frost says: “We don’t look at a lot of continental managers with a global strategy set. They tend to be in a continental milieu, whereas a lot of UK managers have big businesses in the US.”
Getting where you want to be
Accessing the global opportunity set while maintaining an awareness of liabilities is the global alpha-domestic beta paradigm that is causing a seismic shift in the management of fixed income. The requirement to be able to assess the different opportunities in the global debt universe and include them in a well structured portfolio while retaining the flexibility to adjust exposures in response to market dislocations, does place strains on all but the largest fund managers and pension schemes.
The universe of fund managers who can truly undertake a global asset assessment and allocation in the debt markets is not large. Although, the largest pension schemes may be able to make asset allocation decisions internally and choose a collection of specialist managers, this route is not open to most pension schemes.
In such cases accessing the global opportunity set through pooled bond funds with an absolute return benchmark combined with swaps where necessary to partially match liability streams can have powerful advantages as they enable the alpha and beta decisions to be clearly separated.