Greater diversification, a broader opportunity set and on average a higher information ratio might in summary be the case for allocating to global fixed income. If equity volatility wasn’t enough of an inducement, asset/liability modelling also favours bonds over equities. With low yields, and expensive domestic long bonds, investors are having to take a different approach to generate much needed additional return. Investors have a plethora of choices in terms of benchmark and operating guidelines, the latest manifestation being the setting of swaps rates as a return target as opposed to selecting a benchmark index.
For global companies with widespread liabilities, a global fixed income mandate is an easy sell, as exposures can be matched to liabilities in each country of operation. But Bruno Crastes, head of global fixed income at Crédit Agricole Asset Management/Crédit Lyonnais Asset Management (CA-AM/CLAM) suggests that currency matching is not the only reason to consider a global mandate. Declares Crastes: “the question is whether global fixed income will outperform a domestic liability and if the fund is prepared to make the most of a decorrelated investment universe”. Typical information ratios of 0.3-0.5 for a global bond fund manager, versus –0.2 for most domestic bond managers imply that it is easier to create performance as a global manager.
European plans that used to allocate to bonds issued in the legacy currencies have lost that diversification with the arrival of the euro and must look to countries beyond the Euro-zone for diversity. Relative to the dollar and euro denominated bond markets, the UK bond market is small with few liquid issues. Paul Craven, head of UK business development at PIMCO, comments that pension plans seem to be taking a more global stance, often allowing investment in foreign bonds within domestic mandates, providing they are currency hedged. Says Craven: “Investors are increasingly aware of the greater opportunity set outside the domestic market and not only are they prepared to invest in similar bonds to the domestic market, but we are also seeing more interest in high yield and emerging markets.”
Historically, there has been little interest from US investors in global fixed income, other than opportunistically within US dollar mandates. However, additional yield and greater diversification is causing some US investors to re-allocate away from traditional US dollar fixed income mandates, according to Northern Trust director of global fixed income, Wayne Bowers. Strong demand is coming from Asia, for two reasons: yields on Japanese government bonds (JGBs) are very low and most Asian currencies are pegged to the dollar. Richard Stephens, head of government bonds at ISIS Asset Management, comments that an increasing proportion of its mainly UK client base are looking beyond UK gilts, and proposes global fixed income as a better diversifier than UK corporates. Alternatively, Mark Hamilton, senior fixed income portfolio manager at Alliance Capital Management, manager of $10bn (E8.1bn) in global fixed income, notes global credit as a strong growth area, and remarks that some clients may be leapfrogging the traditional global government product, moving directly to global credit.
Global fixed income mandates broadly divide into three types. Traditional mandates take in government and highly rated paper issued by other quasi-governmental agencies, typically AAA or AA rated, within the main economic blocks of Europe, US and Japan The second type of mandates includes corporate paper and mortgage bonds, so long as it is investment grade, and are typically measured against an aggregate index. Yet broader mandates have some allocation to emerging market and high yield paper, and are measured against an index like the Lehman Multiverse.
For global unhedged mandates, typical operating guidelines would be 1.5% tracking error with 75 bps outperformance, so an information ratio of 0.5. Alliance operates a 1.0-1.5% tracking error target on global government products, but takes more risk on aggregate and broader mandates, at up to 3%. Global credit attracts a lower tracking error target, because of the asset’s higher inherent risk.
The benchmark will be a function of the plan’s risk appetite, and what constitutes the benchmark will determine the manager’s focus. The variety of paper that can be included in a mandate is steadily increasing, from a decade ago, when it was primarily developed markets. Now many mandates include emerging markets, of which a number are now investment grade. The Lehman Multiverse index is the basis for one of Robeco’s most popular products, the E3.6bn Rorento fund. Head of fixed income at Robeco, Edith Siermann, sees broader benchmarks as a distinct trend, commenting that whereas managers can take off-benchmark bets, for the fund profile it is better to have greater diversity within the benchmark. The Rorento fund operates with a tracking error of 4%, with the emerging markets and high yield portion attributing around 0.5%.
Northern Trust’s Bowers comments on the move to incorporate some emergent European countries into mainstream benchmarks: “Euro entry may be a requirement before managers are allowed to invest, but there may be occasions, if fund guidelines allow, to take non-benchmark positions, in the knowledge that, within a short period of time, a country will be part of the benchmark.” Crastes of CA-AM/CLAM, whose focus is government and swap proxies of minimum AA grade, favours going off-benchmark into emerging markets, provided holdings are limited to 5%. “If, in asset allocation, one adds a more volatile asset its returns can quickly overwhelm the rest of the portfolio,” explains Crastes.
Over the course of a cycle, Hamilton asserts that benchmarks including non-governments perform better on a risk-adjusted basis. “The additional yield more than adequately compensates for the greater risk of downgrade and default over the long-term,” comments Hamilton. But Jörg Sihler, European head of fixed income at Deutsche Asset Management, comments, “clients with a higher risk appetite could include corporate paper within the benchmark, but they could also permit a percentage of off-benchmark investment. The manager would then buy corporates only when he had a strong view, which might make for a better result for the client.” Deutsche runs E7bn in global fixed income mandates, across 50 mandates, with widely differing investment universes, duration and currency policies.
Alliance’s Hamilton comments, “there will often be opportunities in securities outside the benchmark, such as convertibles or preferred shares. Another possible addition to portfolios has been subordinated bank debt, which has offered a lot of value in recent years. Generally off-benchmark investments are permitted to the tune of 5-10%.” For PIMCO it is more important to have the ability to trade derivatives, such as swaps, futures and options, than to have a broader mandate. As PIMCO head of UK bonds, Mike Amey, explains, “corporate paper may be priced differently in different markets and, by allowing the use of derivatives, pension schemes can extract that advantage”.
Most managers are happy to accept mandates linked to any index provider’s family of indices, but some have preferences, largely a function of ease of access to information. Within the government bond sector the JP Morgan and Citigroup (formerly Salomon) indices are dominant. Some indices have gained particularly wide acceptance in certain market segments, for instance the Lehman Aggregate, which takes in corporates and mortgage bonds. In terms of actual performance over the long term, there is little difference between the results of each provider, for the same bond market sector.
Bespoke benchmarks are an increasing trend, as Sihler comments, “Central banks often have individual risk/return expectations and pension funds have different asset/liability patterns.” A common feature of bespoke benchmarks is the exclusion of Japan, which has been as much as 40% of global government indices. As Hamilton remarks: “The construction of bond indices favours the most profligate issuers.” The yield on Japanese bonds is extremely low, making them unattractive for clients that are focused on current yield rather than total return. Northern Trusts’s Bowers postulates: “Currently intermediate Japanese government bonds yield less than 1%. This is insufficient yield premium for the risk that Japanese rates will start to normalise over that time period.” PIMCO’s Amey sees downside risk in Japanese bonds, commenting: “If inflation were to rise, new issues of JGBs would come at higher coupons, and this would depress the price of existing bonds.”
A more recent development is the use of benchmarks based on long maturity sterling swaps, seen by some plans as a better match for liabilities than an index. As Hamilton relates: “A gilt index as a benchmark naturally inclines the manager to invest in gilts. Having a swap index and the ability to invest in any instrument, using currency and interest rate swaps to bring the exposure back to a sterling base, gives the manager greater latitude to take a more active strategy around the fund’s liabilities.”
According to Sihler, the universe chosen will impact the type of bets that the manager is able to make and so the sources of performance. “In global core mandates, risk is allocated on average 25% to duration, 20% to yield curve plays, 20% to asset allocation 30% to currency and just 5% to security selection. Against an aggregate mandate, more performance will come from asset allocation and security selection, and less from duration, yield curve and currency.”
Two distinct styles of management become apparent when talking to fixed income management. Some focus on forecasting movements in interest rates within different economies, using this to determine the optimal duration and asset allocation. Others take relative value bets, underweighting benchmark assets that are expensive and overweighting similar types of exposure that are offered cheaper. As Crastes relates: “Managers can add value by exploiting domestic investor boundaries. UK pension funds that buy 30-year paper are suffering a 1.5% yield disadvantage versus similar global paper. Equally, US Treasuries are very overrated because of buying by Asian banks.”
Northern Trust takes a top-down approach for global government mandates, exploiting the different direction and speed of economic cycles. Bowers explains, “We try to understand central bank policy and look at how this is priced into various yield curves. This involves making an assessment of future growth and inflation trends. Because of the differentiation between economic zones, and the different mentality of central banks, this can lead to meaningful relative value opportunities.”
PIMCO prefers to take more yield curve and credit bets, diversified across a wide range of instruments, as opposed to relying solely on interest rate views. Amey explains: “Instead of being dependent on a single investment view, our portfolios contain many numbers of relative value bets, with ideally more going well than not. Our aim is to have a set of absolute volatility characteristics that are better than the benchmark, but with higher performance. To do this requires a spread of expertise across all market segments.”
Indexing against bond, and particularly global, benchmarks is hardly passive, involving quarterly rebalancing of portfolios to take account of redemptions and new issues, which creates turnover. The number of constituents in global indices makes the exercise costly, if not impossible, for smaller plans, whose positions may be smaller than market dealing size. Sihler contends that indexed bond management should only be considered by large plans that also intend to employ bond and currency overlay managers.
PIMCO’s Amey takes a somewhat more strident view on indexing bond portfolios, suggesting that passive management forces managers to hold expensive bonds. Amey explains: “In each sub-sector of the bond market there are different investor bases that create supply and demand dynamics. For example, US index-linked paper was initially issued at a 4% real yield, to overcome lack of familiarity, whereas similar UK paper was trading at 2% real yield. Equally, indexing in the corporate bond space can be very dangerous, given the number of companies that get into trouble. An active manager will seek to avoid these types of exposure.”
The main driver of performance of portfolios run against unhedged benchmarks will be currency movement, which could impact positively or negatively. Sihler asserts: “From a long-term perspective, the returns of unhedged mandates are only slightly higher than the hedged, but the risks are decisively greater.” Plans considering moving money out of domestic bonds into a global unhedged mandate might do well to consider the typical doubling of volatility. When hedged, the diversification benefits come through, with 25% reduction in volatility, versus a domestic mandate.
With this in mind, managers encourage clients to operate a hedged benchmark, but all accept both hedged and unhedged and managers report widely variant proportions in hedged versus unhedged mandates. Robeco takes bets of the order of 2.5% to 5% per currency, but currency last year added relatively little to returns, with most of the outperformance of 2.4% coming from duration and credit. Siermann comments that its fully hedged fund, Luxorente, has doubled in size as investors seek the greater stability of a fully hedged mandate.
Northern Trust’s Bowers suggests that small stable amounts of currency exposure following major themes can be alpha generating, and that several 2-5% positions in different currencies can diversify risk premium and alpha. Crastes takes up to 30% of active currency risk, suggesting that, whether used as overlay or with no relation to the underlying bond holdings, it can improve manager information ratio. Amey suggests that, with high currency volatility, even currency bets as low as 1-2% can provide sufficient contribution to total returns. If a fund wants its manager to take active currency bets, then it should consider closely the manager’s capabilities in this area, according to Sihler. “A manager needs a solid macro research process, taking in factors such as foreign direct investment and capital flows. Also the manager must have trading discipline, and know when to harvest profits or cut losses.”
Northern Trust forecasts a 4-4.5% return from the Salomon World Bond index over the next five years, on a hedged basis. This compares with total return in 2003 on the JP Morgan Global Government of 18.63%, 22.09% in 2002 and 4.03% in 2001. Over this period interest rates were falling, which supports bond prices, and there was volatility in currency markets. Amey concurs, forecasting returns of the order of 4-5%, suggesting good performance in real, if not nominal, terms. Amey, however, suggests that emerging markets in particular will do well, as producers benefiting from the rise in commodity prices. Sihler is also positive on the return scenario for aggregate benchmarks and mandates that include emerging markets and high yield, and on mandates that are as a rule fully hedged but allow small active currency bets.
With government indebtedness increasing both in the US and Europe, fixed income managers are not short of supply. The US Treasury issued $56bn of bonds at the last quarterly funding, the main buyer being Asian central banks. Foreign holdings of US bonds have doubled of late, from 20% to 40%, as Asian banks bought dollar assets, to support their own currencies. The UK is running an explicit deficit, as are Germany, France and Portugal, who have each broken Maastricht guidelines. As the debt of developing countries attracts higher credit ratings and lower yields, these too will become more regular issuers.
Opinions differ on corporate issuance trends; Sihler sees banks’ unwillingness to keep loans on their books as forcing corporates to continue to tap the market, as well as continuing flow of exchangeables from banks and insurance companies; Hamilton however sees some stabilisation in corporate bond issuance as companies with high operating cashflow seek to deleverage.
Slowly but surely, the index-linked market is developing, with a wider variety of issuers and a sizeable outstanding dollar amount, some 7% of the total Treasury market. In Europe, France has issued the bulk of the E50-60bn of euro issuance, with more recent issuers Sweden and Greece. Managers, however, seem apathetic on the opportunities offered by index-linked paper, finding it expensive and illiquid. PIMCO’s Amey considers a 2% premium to real yields too low, but comments that they are likely to do well because of government intent to create inflation. Crastes warns that most of the time bond market slumps are caused by a strong increase in real yield, as opposed to a surge in inflation, against which index-linked bonds offer no protection.