Fixed income has enjoyed a great run in recent years. In the five years to March 2013, the Barclays US Treasury Long Duration Index annualized return was 8.3% with a Sharpe ratio of 0.6. The Barclays Aggregate Bond Index (the Agg) had an even higher Sharpe ratio of 1.3 with an annualized return of 5.5%. By comparison the S&P 500 had annualized at a 5.8% return with a Sharpe ratio of 0.3. Recent years have been truly good times for bond managers, and during this period plan sponsors have generally increased allocations to fixed income. According to JP Morgan, G4 pension funds and insurance companies (including the U.S., UK, Euro area and Japan) increased their bond allocations from approximately 43% in 2008 to 51% in 2013.
However, the previously benign fixed income market environment quickly changed last year following a series of speeches and statements in which the Fed indicated that the roughly $85 billion per month bond purchase program (QE) would not be a permanent policy feature, and in fact tapering of these purchases was expected before year end. This led to a tumultuous second half of the year in fixed income markets. The 10 Year Treasury Note quickly jumped 100 bps and mortgage rates climbed even higher. Outflows dominated price action in bond markets, with about $70 billion of outflows from bond mutual funds in 2013, leading to poor performance across almost all fixed income sectors. The Agg ended the year down 2.02%. In December the Fed announced that it would begin tapering, and outlined a path towards broader policy normalization (rising rates) in years to come. Suddenly what was for decades a comfortable overweight in fixed income portfolios is now leading to some sleepless nights.
First, Do No Harm
Generally speaking there have been three primary responses to the shift in monetary policy among plan sponsors. The first is simply to do nothing. The thinking here is that a well-diversified portfolio features elements that should do well in any environment, thereby relieving the long-term investor of the requirement to correctly anticipate which asset class will do well in the immediate future. After all, accurately predicting the future is something that human beings have historically struggled to do well.
However, even without a crystal ball, basic bond math would seem to indicate that forward looking returns in fixed income will not be the same as they were prior to 2013. A simple back-of-the -envelope calculation suggests that with today’s 10-year yield of just under 3%, rates would need to collapse to Japan levels (10 year JGB at 0.7%) for fixed income to pull off another five years of great performance like it did between 2008 and 2013—a move like that is certainly not in line with the Fed’s forward guidance or recent economic data. It also seems likely that as monetary policy becomes more hawkish, volatility in interest rates should also increase because of policy uncertainty. Therefore, the prospect of doing nothing with long duration fixed income portfolios probabilistically points to lower returns with higher volatility.
Down The Rabbit Hole…
This brings us to the second approach to dealing with this rising rates conundrum, reaching further down the credit curve with fixed income allocations. The key underlying objective function here is to increase the spread per unit of duration in the portfolio by either shortening the duration of the portfolio (e.g., adding in floating rate bonds) or increasing the spread (e.g., lowering the average credit quality of the portfolio). Corporate balance sheets today are generally healthy. Economic growth has been sluggish, but doesn’t appear to be vulnerable and in fact has recently been gaining momentum. Overall credit spreads seem set to tighten based on the fundamentals. Furthermore, the added spread to the portfolio can alleviate interest rate increases by providing a cushioning against rising rates. Plan sponsors following this path have increased allocations to areas such as U.S. high yield, emerging market fixed income, CMBS, etc.
The “going down the rabbit hole” approach can help cushion a portfolio from losses due to increases in interest rates, but it also has the effect of increasing the correlation of fixed income allocations to equity allocations. The end result is that a plan sponsor’s overall portfolio can suddenly become more sensitive to gross domestic product (GDP) cyclicality.
Additionally, the scramble for yield phenomena has been going on for a while. In 2009, almost any spread asset was a good buy. After five years of steady inflows, today most fixed income sectors appear to be on the rich side. In the few areas where value can still be found, security selection is paramount. CMBS, for example, now looks unattractive as a unhedged, long-only trade in light of the looming debt wall (around $395 billion expected to mature between 2014 and 2017), but there are still many specific situations that may pay off handsomely. In short, owning spread product has shifted from a ”wave it in trade” to a more difficult security selection exercise, and a tactical, trading-oriented approach is also warranted. (See PAAMCO Viewpoint “CMBS 2014: A Changing Landscape” by Austin Head-Jones, available on www.paamco.com.)
Exhibit 1: Betas of the S&P 500 TR Index with Credit and Hedge Fund Indices
April 2008 – December 2013 (Source: Barclays and Credit Suisse) *Updated through November 2013
Crises Lead to Innovation
Finally, some plan sponsors are following a third approach to this problem by rethinking the role of fixed income in the portfolio. By carefully defining the characteristics that fixed income fulfills for their portfolio (i.e., low correlation to equity, lower volatility than equity) they can then be creative about finding alternatives that offer similar attributes but with better return prospects.
For example, hedge fund portfolios can be constructed to have low volatility and low correlation to equities. Some plan sponsors are beginning to include alternatives within traditional long-only fixed income allocations. While long-only fixed income prospects are diminished by higher rates and higher volatility, the return prospects for many fixed income hedge fund strategies are actually improving. Fixed income relative value trading has become potentially more lucrative recently because as interest rate curves shift, pockets of relative value can appear and be exploited. Additionally, the increased regulatory environment faced by investment banks has led to a reduction in bank trading activity in many fixed income sectors, thus providing more relative value opportunities for hedged, trading-oriented strategies in many bond markets such as RMBS, CMBS, municipals, etc. Finally, after years of globally coordinated easing monetary policy, the macro environment is also shifting. There is now greater dispersion of economic performance across regions as well as in the monetary policy response. This dispersion is benefiting a range of directional long/short hedge fund strategies in FX and fixed income.
To conclude, traditional fixed income investors have enjoyed a great ride over the last 30 years as interest rates have drifted steadily lower. Now, however, interest rates are simply too low to provide the same returns, and seem poised to transition to a path of normalization. Doing nothing or going further down the credit curve have been typical responses but have drawbacks in either poor prospective returns or lower portfolio diversification benefits. Alternative investments such as fixed income-focused hedge funds can provide an important solution here, and innovative plan sponsors are finding new ways of layering these into their portfolios.
Sam Diedrich, CFA, CQF is an associate director and portfolio manager for the fixed income relative value strategy at PAAMCO. He is responsible for manager research and portfolio construction within the strategy. In addition, he also serves as the main point of contact for certain institutional investor relationships. Prior to joining PAAMCO, Sam worked as an electrical engineer for the Johns Hopkins Applied Physics Laboratory (Laurel, Maryland). Sam received his MBA from the University of Chicago Booth School of Business, his MS in Electrical Engineering from Johns Hopkins University, and his BS in Electrical Engineering (Distinction) from the University of Washington.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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