The case for shifting benchmarks to global absolute return for bond funds
There is a seismic shift in fixed income investment strategy, away from the use of bond indices that have been the traditional mainstay of benchmarking performance and monitoring risks in bond portfolios towards the use of absolute return benchmarks. "At the moment LIBOR products are all the rage and I can see why," states Margaret Frost, senior investment consultant and head of bond research in the UK for Watson Wyatt. "It's because short rates are rising and yield curves are flat. In a bear market for interest rates, LIBOR products make sense."
Other investment consultants concur: "LIBOR benchmarks are preferable because people should not be looking for duration any more," adds Jasper Kirstein of Kirstein Finans in Denmark. "They should not care whether the benchmark has a duration of seven, five or three because what they should really be looking for is alpha generation and alpha generators are better suited to a LIBOR plus environment. The yield curve is completely flat, so why bother about whether the duration is two, three or five years? I don't think that's the way they perceive it yet, but I do expect them to at some stage."
But is there also a more fundamental reason why LIBOR benchmarks should be preferable to using long-dated bond indices? Many would argue that this is indeed the case and reflects the culmination of the process of separating alpha and beta in bond portfolios that is an unstoppable phenomenon that will radically alter the conceptual approach to the management of bond portfolios.
Stephen Birch of Hymans Robertson sets the UK historical context as follows: "In the mid 1990s it was just gilts … Towards 2000 the benchmark remained a mixture of gilts and index linked but you were also allowed to buy the odd credit despite the credit market being sufficiently immature that it was not part of your benchmark … Back then the credit market was regarded like EMD is today, an opportunistic play. Around 2000, credit started to be added to the benchmark, and in mid 2000 we started to get the odd manager, particularly a global manager with a UK presence, starting to argue for opportunistic non-UK bets."
That began with investment grade sovereign debt, and continued, for example, with US Treasuries, and investment grade overseas credit as a substitute for sterling. "Then in 2003-04 you started seeing all the managers adding the complete universe," continues Birch. "Initially there was very much a long-only off-benchmark mentality: ‘I will only buy Treasuries or European bonds if I think they will outperform the UK benchmark'."
Around 2004-05, Birch adds, demand started to transfer to long/short, so UK clients could benefit from taking a negative view on the European or US bond markets: "Today we are at that point where there is a UK benchmark but a lot of latitude to invest overseas. With LDI slotting into place, I believe that within three to four years the current way that bond managers manage money will go, replaced by some sort of an LDI structure. By that I mean interest rate and inflation exposure with a cash benchmark portable alpha approach on top … That will substitute your current sterling, typical FTSE 15-year gilt, benchmark."
There are a number of reasons that make the case for using LIBOR benchmarks for the management of the actual bond portfolios so powerful. These include:
q The structural demand for long term bonds driving down yields;
q The compression of risk spreads in all asset classes;
q The growth of derivative markets, making it easy to add a beta exposure to whatever is required;
q The requirement to diversify risk exposures through accessing global bond markets and the ability to take the maximum advantage of the skills that any manager has in the investment marketplace.
Long-term bond yields have been driven down by price insensitive investors and are currently at levels that many would argue do not make them economically attractive. "The problem is that the amount of liquidity in the global system is just so great and growing that many markets are not correctly priced," believes David Buckle at Principal Global Investors. "What has happened de facto is that China has grown not by sourcing growth through its own consumers but from US consumers."
Indeed, China has managed to maintain an undervalued renminbi through the continuous purchase of US Treasuries, which has resulted in a fall in long-term bond yields, enabling US consumers to borrow cheaply for consumption, with the cheap items being imported Chinese manufactured goods. To balance that back out, China has to buy more Treasuries.
Buckle sees this as a vicious circle that is accelerating. "It has given tremendous wealth to China, which is a natural evolution of the global economy, but now the global financial markets are no longer big enough to support the excess liquidity that is being generated from the process. That distorts consumer behaviour. Because there are so many people purchasing bonds, bond yields around the world are probably 100 basis points below where they should be." As a result, it becomes advantageous for consumers to borrow.
Buckle goes on to explain that this is something that has been flagged by central banks and asset managers, and is the most serious outcome of the US imbalance. "It's really how that sorts itself out that governs where markets are going to go," he adds. "In terms of economic theory, most people buying bonds aren't rational investors. Central bank foreign reserve managers don't have a profit maximising objective.
"That is why spreads are tight and why things like private equity have taken off. Clearly China is the biggest foreign reserve manager closely followed by Japan, but you also have Bank of Korea, Bank of Brazil, Russia, and then you have the treasury managers in the Middle East. All of this money has found its way into the investment sphere."
For Buckle it is the magnitude of the reserve holdings that is the most serious problem that arises out of the US deficit. "So much money which shouldn't really be in financial markets is sloshing around. As a result, the US doesn't have control of its monetary policy. It can control the funds rate but it can't control the 10 year rate, China has control of that and has forced it down, encouraging consumers to aggressively refinance," he concludes.
The issue for pension funds has been that this has all arisen at a time when there was pressure to consider the whole issue of mismatches between pension fund liabilities and assets with almost a doctrinaire approach, in many cases, to liability driven investment. Anton van Nunen, of Van Nunen & Partners in the Netherlands, has strong views on the consequences of this.
"I hate liability driven investment," he comments. "If you can afford otherwise you should forget about liability hedging … I think it has been a very expensive game until now. What I see is that all pension funds, that were in trouble concerning their funding ratio, listened to their consultants when interest rates were at 3% and bought the French government bond issue of 3% for 30 years … I know that pensioners were not at the table when things were discussed but the decision was taken and people will be in poverty for the next 30 years … I think pension funds felt the fear in the market that maybe interest rates would go down a bit more and then they would be in deep trouble so they listened to the consultants and said, ‘Lets lock in and sit at the table and shiver'."
Van Nunen believes that a lot of companies have earned a lot of money with their swaps and their long-duration bond game, and pension funds have made some terrible mistakes. "I can understand why they made those mistakes but I think consultants should not have led these small pension funds into the trap … It is the smaller pension funds that fell into this hole. Larger ones were able to wait. They were a [consultation] partner of the regulators but the smaller pension funds were not, so they acted on the advice of the consultants, which was lousy."
Hyman Robertson's Birch adds that investors have to decide what level of precision to offer from a product point of view: "I think that most people buy a very limited level of precision … It's crazy going for a completely matched solution when you still have 50% in equities," he says. "My view is that most clients can probably achieve most of what they are looking for with a couple of swaps because most clients aren't in a fully funded state where they are looking to match."
Irrespective of one's views on the applicability of LDI, what most managers and consultants do agree on is the ability to harness extra return through accessing a global universe of bonds. This has been driven by the explosive growth in the size of the debt derivatives marketplace. "The equity market globally is worth $27trn. Fixed income markets in cash are of a similar size. The global derivatives market in equities is about $5trn, but in fixed income it's about $290trn," he says. "This means huge amounts of liquidity and a huge growth in the opportunity set."
Watson Wyatt's Frost sees that clients are starting to accept that alpha can be generated from a very diverse stream of investment strategies in bond markets, but that you have to give managers more flexibility. "The evolution in client thinking is simply that, if you only allow your manager to make a couple of bets, [such as] duration and/or yield curve, or only operate in the domestic market, then you are forcing them to make sub-optimal choices," she says.
"You are forcing the manager to bet on duration or a yield curve shift and both of those things are notoriously hard to get right. I think clients are finally starting to realise that whether they are in the US, UK and Europe. The ability to invest in non-benchmark securities has become very widely accepted as a way to generate alpha. Obviously it is increasing risk, one goes with the other, but it's not exponential. If the strategies are diversified enough, risk is not increased by as much as you would expect."
Indeed, Frost adds, it is a risky strategy to set client guidelines that only allow a manager to take duration bets in the domestic market. "Many fund management firms have reacted to this by greatly expanding their global fixed income capabilities and offering access to global alpha opportunities while still satisfying domestic benchmarks," she adds.
BGI's Webb explains that his firm considers global fixed income to be one world these days, whether the underlying mandate is a gilts mandated benchmark or not: "We think the best way to build a portfolio is to get active return from anywhere, so we are not constrained," he says. BGI has developed a suite of quantitative strategies based on four types of model, according to Webb, including economic factor models that look at fundamental factors that drive an asset class.
Relative value models look for pricing discrepancies, barbells, butterflies and so on, using leveraging technologies, while technical models - momentum trading and so on - can be applied to government curves or credit curves, getting in at the start of a trend and staying with it. "[With] trading/surprise models, the news is significantly better than the market had expected and we back test it to show that we can still capture some of the value," he adds.
While accessing a global universe of alpha opportunities can be undertaken with any benchmark, Van Nunen sees that the benefit of having a EURIBOR type benchmark is that you are not constraining alpha managers to beta benchmark. "I want the manager to take risk and I want to have another risk in my portfolio besides beta risk, so why should I give the manager a benchmark where he will be comparing his risk with a beta benchmark?" says Van Nunen.
"As a consultant, I would say that if I hired a tennis player I would like him to use both of his hands, not bind one hand … So you should give [the manager] a benchmark that he would like. You are in a position to see whether this benchmark fits the overall risk budget and, if it does, you should hire the manager and give him all the freedom he wants, because that's what you are paying him for."
Although he would advocate hedging currency he adds: "What I see is that you save a lot of risk which can be used to get a more active manager or another benchmark … I think you should avoid the currency risk."
While many managers have been offering cash funds for some time with LIBOR benchmarks, these have tended to be low alpha products designed to offer high credit quality liquid alternatives to cash deposits. Where the opportunity may lie is in offering high alpha bond portfolios with an absolute benchmark, which can offer the flexibility to be combined with long dated swaps if required for LDI purposes, or be used as stand alone investments.
Institutional investors, however, do have to be comfortable with the fact that high alpha pooled funds will also have higher risks and therefore can be subject to periods when they under perform LIBOR. This is no different to hedge funds with absolute return objectives, but with the added attraction that the main source of high return/risk trade-offs can be through diversification across the global opportunity set rather than the more elusive and capricious source of pure management skill.
A good example of a LIBOR-benchmarked high alpha fund is Principal's Global Strategic Income fund, which, although recently launched in Europe as a Dublin-based UCITS, is substantially the same as a fund launched in Australia three years ago that tapped the expertise of Principal's global fixed income team and also that of its two specialist subsidiaries, Post and Spectrum, that focus on US high yield and US preferred securities respectively.
"We keep the duration low so you don't have a lot of swings and roundabouts from the interest rate movements," explains Nick Lyster, the CEO of Principal's European business. "We keep the maturity profile on the physical part of the portfolio as low as we can so spread movements have a lower impact. A lot of the portfolio is less than two to three years maturity, and in the high yield space, for example, it isn't benchmarked to a high yield index so you don't have that kind of duration orientation or maturity or credit rating spread, just a bunch of guys focusing on the covenants of the individual bonds and trying to create a low-risk, high-yielding portfolio."
Pooled bond funds with a LIBOR benchmark have very powerful advantages for pension schemes as they enable the alpha and beta decisions to be clearly separated, with exposure to beta - that is, a set of domestic liabilities, undertaken cheaply and, most importantly, with great flexibility through a small number of swap transactions that ideally should be done independently of the bond mandate, enabling bond managers to be replaced if necessary without having to unwind a complex series of associated swaps.
However, pension funds should also be aware that, while there is every rationale for having exposure to high alpha absolute return orientated bond funds, locking in current 30-year bond yields with swaps may be taking a big bet that China will continue purchasing US Treasuries at disadvantageous terms for decades to come, a view most China watchers would surely disagree with.