Looking for the sweet spot
Sometimes what appears to be a creeping change can turn out to be the forerunner of a seismic shift and that may be the case for what is happening in global bond mandates. Richard Wohanka, CEO of Fortis Investments and with a bond background himself describes the situation: “In the old days, it was all government bonds and duration and currency was all that was required. Five years ago, there was a shift to credit, but it was regional, the euro and the US. Fairly recently, investors have begun to see credit on a global basis.”
What has caused this move? “In the past, outside the US there really was not a lot. The big change has been the birth of the euro,” according to Ian Kelson at T Rowe Price. “The creation of the Euro-corporate market was a key development in making the global aggregate approach attractive.” As the US market accounts for around 50% of the total world supply of investment grade debt, US houses have an inbuilt advantage in offering global aggregate bond capabilities. For European fixed-interest managers, a major business issue going forward will be their strategy to compete with US firms for global aggregate bond mandates.
Bond managers such as Charles Dolan of Standish Mellon have found that while “central banks and international agencies are sticking to government benchmarks, we are definitely seeing a trend amongst pension plans for global government benchmarks to move towards the aggregate”. To be able to compete in all sectors of a global aggregate portfolio requires expertise in credit and asset-backed securities as well as government bonds covering the full range of not only developed but also emerging market investment grade bonds. This requires large resources, which, as Kelson points out, means “a lot of smaller boutiques stay in government bonds and are not credible for global aggregate portfolios”.
The giants of the fixed-income market such as Pimco, with $30bn (e23.4bn) in global bond mandates alone, pride themselves on having a depth of capability across the full range that most firms would find hard to match. Pimco’s Mike Amey argues that there can also be advantages obtained through the large size of assets under management. “With emerging market debt, there are significant advantages in size. You get much better access to the issuers. If you are a buyer of $5m, it is not the same as if you are buying in size.” However, there can also be disadvantages.
The whole Hungarian bond market is less than the size of one US treasury issue of $30bn which leads Kelson to argue that “while it is good to be a large house with lots of resources, being too large is bad since to trade a decent size in Hungary is very difficult. There is a sweet spot where a firm is resource rich but still asset light so you can move around” – a position that Kelson claims describes T Rowe Price.
European fund managers without US corporate and asset-backed bond capabilities need not despair too soon. As Bruno Crastes, the London-based CIO of Credit Agricole Asset Management (CAAM) points out, with a global aggregate benchmark: “92% of the risk is government, so if you have a good foreign bond process, you can manage global aggregate portfolios.” As a result, while he finds that “a lot of pension funds have placed an emphasis on the credit resources available to them when choosing a new manager”, he argues that “there could be a different right approach – when 92% of the risk is government, you also need a performing specialist in country and yield curves”. However, in order to expand the investment universe towards US credit in particular, CAAM has been building up its own resources for the past year in its Paris-based credit team.
Other European fund manages such as Dexia Asset Management have already managed global aggregate mandates for a number of years. Vincent Hemelink, the global head of fixed income, also makes the point that “credit benchmarks are not built on a company’s nationality but on the currency of issuance. For example, in the iBoxx Euro Corporate, 17 % are US issuers, within the Lehman Euro Auto, 40% are US-based companies. So European asset managers have already a lot of experience of analysing US issuers.”
Some European fund managers such as Fortis Investments, are trying to tackle the dominance of US houses head-on. According to Wohanka, “at Fortis, it used to be just Europe and the US didn’t matter. We already had a large European capability, the problem is competing with American houses. We have started the process of building up the structure in New York and Boston for credit and asset backed bonds. At the end of the year, we will have 22 people doing US credit and global aggregate mandates.” Fortis is unusual in this respect though, with Wohanka arguing that “we don’t see ourselves as European although our principal shareholders are Belgian and Dutch”.
Paul Volcker initiated a period of two decades from the early 1980s that were characterised by central bank policies focused on an overriding concern to stamp out the spectre of inflation that had disrupted the world economies during the 1970s. Post 9/11, the US has led the world in avoiding the spectre of recession through aggressive priming of the domestic economy fuelled by low interest rates and the build-up of debt.
Pimco’s Amey describes the 1980s and 1990s as a period when “capitalism in its purest form was at the fore” and goes on to say that “now we have more government intervention, which is more inflationary. Currently, in the US and UK, inflation is low while there is more government intervention so there is a world where the yield curve is steep – we can expect that to continue.” Corporate bonds are “priced for perfection to some degree”, according to Amey, “the fundamentals for corporates are as good as they could ever be. US corporate profitability is at a 40- year high.
“Going forward from here, it will be much harder to sustain the levels of growth seen in the 1990s and it is more likely to be lower than expectations so corporate bond spreads are susceptible to widening from here.” The historically tight spreads, as Standish Mellon’s Dolan puts it, “are wafer thin and just compensating for default, not liquidity risk”.
The short end of the US yield curve has been supported by foreign central banks and as Amey describes, “the rise of China and the Asian block as a separate economic entity in its own right has now created an adjunct to the dollar. China has retained its dollar peg and Japan has bought a huge amount of treasury issuance.” The pressures on China to revalue its exchange rate could lead to a revaluation of US treasuries if there is a such move which “suggests that the best value is not in US bonds”.
For Pimco, Amey argues: “There is better value in Europe. From a secular perspective, Europe still has issues to grapple with. To reduce the size of the government sector, and high labour costs which they are unwilling to tackle. A long unwind of labour costs would give a deflationary pressure. So we have low nominal growth and low inflation.” Laurence Linklater at T Rowe Price also concurs with these views: “The basic reality is that we are in a low-yield environment and low returns, assuming inflation is under control and there are no shocks. The presumption is that US rates are going up to 3-4% in terms of Fed Funds. This has been largely anticipated in bond markets but there is some scope for bonds to drift upwards, in the short-dated area and in Europe.”
Emerging market debt is seen by many managers, including Pimco, as an attractive component of a global bond portfolio, even if it means straying outside the index universe. For Amey, “we are overweight EMD. It is better value than corporate bonds. With corporates, you cannot see how things can get much better. The difference now is that most emerging markets benefit from low interest rates and high commodity prices. They are lending to the US and building up their foreign exchange, which will protect them if there is a downturn.” T Rowe Price’s Kelson, generally concurs with this view: “There are lots of opportunities in credit and in some convergence markets; it was Italy and Spain in the 1990s. Now it is Poland, Mexico and Hungary, which are much smaller markets.”
When it comes to deciding on benchmarks, bond managers such as Standish Mellon’s Dolan find that “the world divides into two, those wanting an aggregate benchmark and those wanting a government bond benchmark. It then subdivides into those wanting global and those wanting an international, that is global ex-Japan, or global ex-US and so on. Then you can have hedged and unhedged, so you have a lot of different combinations.” This can make life complicated since as Dolan exclaims: “We only had two clients with the same benchmark!”
James Hurlin at Fortis, who finds that “most of our benchmarks are government bond indices”, sees the JP Morgan Gov Bond index as the main one with “most mandates allowing opportunistic forays into other areas”. When it comes to aggregate indices, Lehman Brothers have the dominant position with the Lehman Brothers Global Aggregate index, which was introduced in 1999. With around 10,000 bonds in the index while a traditional global government index has 600-700, “the difference between global aggregate and global government is very stark”, points out Kelson, who explains the reason for the dominance of Lehman as the fact that “Lehmans have a stranglehold in the US so it has carried through into the global index. This is 50% government and 50% a mixture of agencies at 10%, corporates at 20% and mortgages at 20%, all at investment grade. It generally represents the benchmark and style that superceded the global government indices that were the staple for 20 years of doing global government bonds.”
One key issue is whether bond mandates should be hedged or not. James Binny, director of FX at ABN AMRO Bank argues: “The relative volatilities of currencies are higher than that of bond markets so there are few arguments for running bonds on an unhedged basis. Bond markets are highly correlated so most global bond mandates must be done on a fully hedged basis. Currency will be an area where people can take opportunistic bets. You need to be rewarded for any risks you take.” Given the ease with which currency exposure can be separated from yield curve and credit exposures, this is an argument that is hard to refute.
Managing an aggregate global bond portfolio requires a clear framework for setting risk and return parameters for the portfolio before coming down to the level of stock selection. Breaking down the components would typically be along the lines of:
q A view on the duration of the portfolio versus the benchmark;
q A view on the slope of yield curve;
q Asset allocation among the major blocks of the US, Japan, Europe and the UK, together with allocations to peripheral markets to these such as Canada, Sweden, and so on ;
q Allocation between government bonds, investment grade corporates, high yield, asset-backed securities and emerging market debt before;
q Finalising stock selection.
Successful managers are those which are best able to allocate the risk in their portfolios to the sectors where they believe they are able to add most value and to reduce risk where they have little value to add. Given that global aggregate portfolios are still somewhat new, with managers still building up resources, the split between sectors may well change for many managers as they build up or buy in expertise. CAAM, for example, while able to offer a limited active credit exposure, also has an approach where it indexes the credit exposure in the mandate. “You can replicate the corporate bond exposures acceptably with 50-60 bonds,” says Crastes. The approach relies on a “separate risk allocator who acts as a portfolio architect”. He delegates amounts to different teams in emerging market debt, government bonds and so on. “The added value is in putting amounts where the returns are likely to be the greatest. The role of the architect is to anticipate risk to ensure the stability and robustness of the portfolios.” With such government-dominated portfolios, they would have only 30-50 bonds apart from any credit element, with turnover between 50-100% annually.
Pimco has the view that “maximising the opportunity set is the best way to operate”, according to Amey, and its portfolios “will have 300-400, perhaps 500 bonds. Our whole game is to have as many small positions as possible, rather than a few large ones.” Global aggregate portfolios are managed through Pimco’s top-down process which relies on a three- to five-year view on the secular outlook, which Amey describes as “trying to gauge our thoughts on the factors which will be present in markets for a number of years to come. For example, the rise in leverage and in consumer debt in the Anglo-Saxon world has changed the reaction function of monetary policy by central banks which don’t need to have as strict a monetary policy as they did in the past, so the cycle will be less strong than in the past.” Using derivatives where possible is an essential part of their process and for liability driven investment. Amey advocates using swaps, futures and options to hedge the liabilities and then use the global opportunity set to add value.
Standish Mellon is unusual in relying heavily on a “knowledge-based” analytics systems developed in collaboration with a US electronics company to process information from the market using “fuzzy logic”. Running since 1994 at Pareto Partners, also part of the Mellon stable, “the system gives signals on currencies over multiple horizons, risk-free rates, credit sector allocation and most importantly, making interest rate calls” according to Dolan. Country selection is based on the models although “we make sure the answers are consistent with the experts in that area”. On the credit side, the manager relies exclusively on more conventional credit analysts with ratings and valuations done separately. “The analysts are graded on their ability to predict upgrades and downgrades,” according to Dolan, since “if you can anticipate by as little as three months, you can make significant amounts of outperformance.”
Dexia Asset Management aims to combine fundamental analysis of the credit cycle with the technical supply/demand factors and the use
of quantitative-valuation models. Hamelink explains that “our issuers’ selection tool, a proprietary scoring, can be applied to worldwide issuers. Our scoring methodology is based on financial ratios combined with dynamic variables and quantitative models.” The portfolio management is “organised around three small teams dedicated to one investment process/source of alpha. The first team is responsible for the interest rate strategy and with the selection of government bonds. The second team is dedicated to the credit strategy (top-down allocation as well bottom-up security selection). And the third team is responsible for the currency strategy for the unhedged mandates.”
T Rowe Price uses a formal risk/return framework and explicitly compares expected returns with tracking error and against a ‘zone of indifference’, according to Kelson. “We have to make enough return
per unit of risk to make it worth taking on the position. For example, going overweight Sweden versus the euro is a low volatility trade, whereas taking on the Turkish lira is higher return but also higher risk. The key thing here is the ability to put the different risks, currency, duration and all the other risks into the same dimension.”
Besides this, T Rowe Price uses a series of evaluation measures – “for bond markets we look at real yields, for currency we look at trade weighted exchange rates” – and it also keeps on eye on the technical trends where, according to Linklater, “we get round problems of chartism by combining chart signals using daily and weekly information, trend following and value signals. Having the addition of all these complements the fundamental analysis.”
Fortis also uses a formal risk budgeting process and aims to identify the fundamental and market factors driving the market. As Hurlin says: “We identify the alpha gap and then need to identify the catalysts that will close the gap. Last year, the catalyst was the US employment data. The Fed were not going to start tightening until the employment stats came out, so throughout the year, it continued to be a catalyst and still does.” The process converts yield forecasts of major markets looking into returns, adjusted for historical volatility, to give Sharpe ratios to rank every position.
“This grading gives us a tracking error against the benchmark. We then use our own optimiser to get a portfolio,” Hurlin says.
While US houses as a whole do have a theoretical in-built advantage with their established coverage of 50% or so of the total market, European houses can take comfort in the fact that corporate bond spreads are at such low levels, it is difficult to gain outperformance as a whole from the sector. And with government bonds still accounting for the vast majority of the index, it leaves them with plenty of scope to outperform for the moment. The real issue is whether they can use this respite from competition in the credit markets to build up capabilities for when the market changes again and corporate spreads become wider, as surely they eventually will.