Time to widen fixed income horizons
Why invest in global bonds? One simple answer would be because they make money in times when it is hard to make money. Government bonds, traditionally the heart of any global bond portfolio, have been one of the few asset classes other than gold and real estate to appreciate in value
The JP Morgan global government bond index shows a total return of almost 30% over the past three years, a period when the Nasdaq Composite lost three quarters of its value.
However, government bonds are becoming progressively displaced in global bond portfolios by credits or corporate debt. The principal reason for the change is the shortage of government debt. Says Stewart Cowley, head of international fixed income funds at the Newton, one Mellon’s independent asset managers distributed by Mellon Global Investments, says: “There basically isn’t enough government debt to go around for pension funds any more. Certainly not of the right sort.”
The culprits are governments that have changed the way they fund their debt, he says. “They are funding their budget deficits by issuing short-term debt. This is exactly what the pension funds don’t want. We call it pay-as-you-go economics – because they’re keeping their funding within an economic or market cycle, as opposed to what they used to do, which was to put off problems to the next generation by issuing very long-dated debt.”
As a result, there are far too many pension funds chasing far too few fixed interest assets. Corporate debt, an alternative to bank financing, has filled the vacuum. This is reflected in the weightings within the new generation of global bond indices, the global aggregates, which include corporates as well as government debt. In the flagship index, the Lehman Global Aggregate, the weight of corporate has grown from 17.97% in January 2000, when the full index started, to 21.73% in March this year.
So what is the pull of the global bond fund? The principal benefit for European pension funds is diversification. James Martielli, head of fixed income manager research at multi-manager SEI in London, says: “They have the pick of the world in terms of securities, and there are also different sources of returns available to them.
“In a euro fixed, investment grade only mandate there are not as many levers to pull as in a global fixed income mandate. You are diversifying out into opportunity sets and sources of alpha which may be uncorrelated to the sources of alpha you get from a domestic-only type of mandate.”
European pension schemes should decide for themselves whether to run a hedged or unhedged mandate. “There is no blanket answer because every scheme is different and has its own particular needs. Currency exposure might be desirable to some and not others.”
Another imperative for pension funds is the need to achieve some solid if unspectacular real returns. Bob Michele, global head of fixed income at Schroders, says that European plan sponsors have historically been under-invested in international fixed income. “The volatility in the equity market has caused them to think that rather than just covering whatever any under-investment they have had historically in fixed income, maybe they actually want to over-invest in that area going forward so that they have some stability in their return profile.”
Michele says they must look beyond Europe for this, since European bond markets are relatively narrow: “Almost by definition, they are starting to look more aggressively into the global bond markets. It’s not so much that they want multiple currency strategies. It’s that they want to give their manager a broader opportunity set within the asset class to look for value.”
Global bond mandates could confine themselves to government debt, since there are a wide range of government markets to choose from. However, the two areas where pension funds are looking for global choice are corporate bonds and inflation-indexed securities, Michele says: “The concern is that if they put all of their corporate allocation into Europe they don’t get much diversification and liquidity and so they may be encouraging their manager to be too aggressive in that market. Instead, they could look at the entire global corporate bond market, but hedge the currencies back to euros.”
They can also adopt the same strategy in the inflation-indexed bond market. “Many plan sponsors want some allocation to an asset class that gives them real return that they can rely on. But they are stuck mostly with the French market. If they can go into the sterling index-linked market or the US TIPS market and hedge those back to euros they can be pretty comfortable with that.”
A more recent role for global bond funds is risk management. Pension fund managers may want to put the lid on their volatile portfolios with global fixed income mandate. Cowley says: “We’re increasingly finding that people are using global fixed interest as much for risk management as for returns. The reason they come to us is not because they really like fixed interest, but they just want to calm things down a bit.”
Once a pension fund has decided to go into global bonds, which index should they choose? Essentially, there are two broad types of benchmark – world government and global aggregate.
The traditional choice has been between the Salomon Brothers World Index Market, with 612 issues with a market value of $7.5trn (e6.9trn) at the end of 2002. This includes 17 government bond market, although it is effectively describes a three-bloc world consisting of the US (22.7%), Europe (38.7%) and Japan (28.7%).
There has been a steady migration to a new sort of benchmark the global aggregates which includes credits as well as government This produces a quite different country weighting.
The Lehman Global Aggregate consists of seven groups – the US (45%), Europe (28%), the UK (4%), Nordic countries (1%), Japan (18%) and Asia Pacific (3%) – with 8,012 issues and a market value of $16.6trn.
Michele says it is important for pension funds to make the right choice of benchmark: “For a global bond mandate, choosing the benchmark effectively tells you the range of your return.”
The far higher weighting given to the dollar in the global aggregate will impact expected returns, he points out. “In the global government bond benchmark the US dollar weighting is somewhere about 25%. In the global aggregate the dollar weighting is 22% higher, and 10% of that is a lower weighting in euro and 10% is a lower weighting in yen.
“How the dollar performs against the euro and yen will dominate the return differential between a global government or a global aggregate mandate, rather than what the underlying securities actually do. So benchmark choice is critical for global mandates that are unhedged. For hedged global mandates it’s also important but not nearly as dramatic. Then you’re just looking at how the underlying assets perform.”
Mark Talbot, head of global bonds at State Street Global Advisors in London, says there is something to be said for both indices. “The global aggregate offers greater diversification so over the long term you would expect greater risk-adjusted returns. That clearly has some attractions,” he points out. “On the other hand, you have credit risk in there and if you have exposure to bonds that are downgraded or default you may find yourself at the end of the day doing poorly.”
World government indices still dominate. An estimated 70% of bond mandates still measure performance against the Salomon World Index while the remainder tend to use the Lehman Global Aggregate. However, pension funds are realising that to get involved in corporates they need to use the Lehman index.
For many pensions funds, the Lehman Global Aggregate provides the template for running a global bond mandate, says Tom Pedersen, managing director of T Rowe Price in London. “It’s a little bit like in equities where you have an index manager who manages the overall majority of the asset and then there are the specialist managers below this. The global aggregate index provides the core, and underneath that you then have the different corporate and high-yield specialist managers.
Some fixed income managers suspect that European pension funds are moving away from these benchmarks to scheme specific benchmarks of their own choosing. Newton Group’s Cowley says: “I think it’s going very bespoke. That’s particularly true in continental Europe. For example, we have an Italian pension fund client with a very specific requirement – three funds with different risk profiles which investors can choose between. They have a rolling tracking error, and quite sophisticated requirements in terms of monitoring and risk management.
“The challenge for us is can we handle, from our cost base as a fund management community, that kind of level of bespoke portfolio construction? Because it costs money. Everyone would like to take the unitised approach. There’s evidence on the retail side that everyone is taking a unitised, fund of funds approach, and life companies are taking a white label approach. Whereas on the pension funds side I think it’s going to go very much a bespoke approach.”
Another key decision a pension fund must make is whether the global fund mandate is to be managed actively or passively. Passive managers have two broad strategies. A tiered portfolio of bonds with staggered maturities or a portfolio that attempts to replicate a bond market index.
Replicating a global bond index is difficult, though it can be done, says Talbot of SSgA, which manages two thirds of its fixed income portfolio passively. “Fixed income indices are typically more dynamic than equity indices. The constituents of the FTSE 100 don’t change all that often, whereas bond indices are dynamic – they change month to month. You can track the Lehman Global Aggregate, but it is difficult because it’s a very broad index with over 8,000 securities. So it’s pretty nigh impossible to buy all the bonds in the index, and new bonds will be issued at the time when other bonds mature.”
Much depends on your view of markets. If managers believe markets are relatively efficient, they will choose passive management. However, if they believe there are inefficiencies in the bond market that can be exploited, they will choose active management.
Frederic de Merode, portfolio analyst at Fidelity Investments, says that credit analysts and quants specialists can engineer convergence plays which would be missed by passive management.
“What we will often do on the corporate bonds side is buy an issue from a large European company but priced in dollars and hedge it back to get rid of the currency risk. And you can find some interesting arbitrage possibilities within that.
“Some issues of the same company are priced in another currency for purely technical reasons, and are often priced at a much better level So you can often get a 40 basis point arbitrage level, sometimes more. You hedge back that risk, and even with the additional costs of hedging you can make a very good profit. When the good news begins to come through about the company and the actual capital value began to appreciate within that bond the price often moves a lot more strongly within one issue rather than the other because it’s been mispriced.”
There are other opportunities for adding value by active management. PIMCO, the US flag bearer of active global bond fund management, points out that many passively managed portfolios limit themselves unnecessarily to only to rated credits and will not buy issues rated as junk by one rating agency but not by another. However, active managers are able to buy these ‘split-rated’ bonds.
Global bond funds have historically invested almost entirely in investment grade securities. However, pension plan sponsors would be happy to allow their managers to move down the credit curve if they thought they could make more money, says Michele.
“Most plan sponsors are entirely comfortable today with global investment grade corporates. But a lot of them would like you to look them in the eye and say ‘opportunistically we can make money for you with high yield and some emerging market debt’. It depends on the skill set of the managers. Do they have the resources to look into below investment grade and into emerging market debt and add it to portfolios? If they do, plan sponsors are willing to give out global credit mandates that are mostly in investment grade securities but can go below investment grade.”
However, he warns that European corporate debt is still a tricky market. “Growth is very low and these companies have very heavy debt burdens so the margin for error is as small as it’s ever been.”
Recent corporate collapse and defaults have not helped. Cowley points out that risk in both the high yield or investment grade bond environment has been heightened by events like WorldCom and Ahold. “Some of these so-called investment grade bonds can suddenly turn into pseudo-equity over night. However, there is money to be made in corporate bonds which means fund management companies need the right research and analyst structure to cope with the task of avoiding the losers. At Newton we have merged our equity and credit research teasm so that we can look at a whole company and choose between the debt and equity or indeed have both.”
Allan Mackenzie, managing director of BlackRock in Edinburgh, which has seen global fixed income business increase last year from $1bn to $5bn, says the high-yield market is beginning to gain speed again. “The high-yield market, having been one where there was a lot of focus on it two years ago, lost a bit of momentum. But people are coming back to it because the underlying equities have gone down and that’s been reflected in the yields available in the high-yield market, and people are stretching a bit more for yield again.”
This does not have to be part of a global bond mandate, he says. “We’ve won mandates this year, which have been purely for high yield. That was very much a rifle shot by the client. It really depends what the client is trying to achieve and what level of risk they are prepared to take on their portfolio.”
Pedersen says the appetite for high yield is insatiable. The attraction is the spreads. US corporate spreads over government bonds are nearly 200bps and European corporate spreads over governments are 100bps. “Currently, investors are completely crazy about high yield. I’ve never seen such an amazing offering from pension funds wanting to enter the high-yield market.” High-yield bond mandates rarely top $100m. Yet Pedersen cites a Swiss pension fund offering a $400m high-yield bond mandate. “This is really imposing a lot of capacity restraints on asset managers, to the extent that we’ve closed our product because we simply don’t know what to do with the money.”
The squeeze is at the quality end of the high- yield market, he says. “Normally a good high yield will concentrate his portfolio in double-A and single-A paper. That is historically where the best returns have been. Sporadically you will see the triple-C outperform those two asset classes but always at the expense of a very increased measure of defaults. But it’s the higher quality end of the high-yield spectrum that people are looking at now. That’s where all the pressure is because there isn’t enough paper to go around.”
Emerging market debt is another potential constituent of a global bond mandate, although a number of asset mangers (including T Rowe Price) do not categorise them as international fixed income. Michele feels that emerging markets are easier to navigate this year than high yield, though managers must steer with care. “You will look at them opportunistically as you would high yield. But they are very different opportunities. In high yield you have to go credit by credit. In emerging market debt you’ve got more or less sovereign risk.”
Should corporate, high-yield and emerging market debt be left to specialists? Or can one active manager handle the full universe of global bond funds? The largest asset managers tend to say they can handle everything. Smaller niche managers say that you should leave specialist assets to the experts.
“We would say you should give it to a manager who can do the lot,” says Talbot of SSgA. “If you split it up, say, between a corporate manager and a government manager you have really given away one source of potential return. It becomes that much more difficult to allocate between corporate and government. But if you give the whole mandate to one manager then they can do that much more dynamically. They are probably more likely to outperform their benchmark because they will have greater breadth in strategy of adding value.”
One interesting solution to the question has been provided by multi-manager SEI, which selected two managers – Alliance Capital International and Fischer Francis Trees and Watts – to manage the firm’s global bond strategy.
Martielli of SEI says the aim was to draw equally on the different skills of the managers – one focusing on issue and sector, the other on country and currency – to achieve maximum returns.