During significant market inflection points, we all struggle to define the ground swell of events converging to change the status quo. Some call it a paradigm shift or a new normal, but the result is the same: investment views and the evaluation of global capital markets have changed once again.
While this paradigm shift has been occurring in the fixed income markets over the course of the past several years, it has recently accelerated in the aftermath of the credit crisis. Although the U.S. debt market remains the largest, most liquid debt market in the world, it is at risk for becoming less dominant in the context of the total global debt markets (both emerging and developed). But, not only have global debt markets changed, so too have fixed income investors. Factors such as pension liabilities, cash flows, liquidity, diversification and alternative sources of return generation are driving new asset allocation modeling. As the landscape of fixed income investing has changed, re-examining the deployment of fixed income allocations is essential in ensuring investors keep pace with the changing paradigm. We believe that benchmark constrained portfolios are faced with several challenges that may be mitigated by allowing a manager the flexibility to invest freely across the fixed income markets:
• First, benchmark constrained portfolios generally have significant sensitivity to changes in interest rates due to the duration of the index. Performing closely in line with a market index will likely hold little attraction if and when interest rates begin to rise.
• Secondly, issuer concentration has reduced the diversification within the aggregate index. In market weighted indices, exposure to individual issuers grows as they increase their issuance of debt. In the case of the aggregate index, the U.S. government has, over time, become an increasingly larger component; first due to increased issuance to fund the federal deficit and second due to effective ownership of Fannie Mae and Freddie Mac. In contrast, the opportunity set in emerging economies is becoming more diverse.
• Lastly, as a global, active, fixed income manager, we believe opportunities exist across the full range of fixed income markets many of which are not represented by standard U.S. benchmarked fixed income products. Active, global investing offers investors a much larger universe of countries, sectors and issuers from which to generate returns and to improve diversification.
In an environment of modest growth, limited signs of inflation and a potentially extended period of de-leveraging, investors are increasingly challenged to find attractive returns. We believe those who adopt a more flexible “multi-sector” approach to investing will be rewarded with greater returns than those who adhere to traditional aggregate benchmark allocations.
High Sensitivity to Changes in Interest Rates
After falling steadily for nearly 30 years, interest rates sit at historically low levels. While it is possible that they could drift lower, the next, longer-term move in rates is most likely higher. When interest rates rise, bond prices decline. When the absolute level of interest rates is high it provides a cushion against this price decline. However, when yields are as low as they are today and rates begin to rise, there is less of a cushion leaving investors at risk for losing money. From September to December, the yield on the 5-year Treasury yield rose 63 basis points from 1.65% to 2.28%. With a similar duration as the Aggregate index, more than a full year’s yield on this bond was erased in three months.
Market Environment May Warrant Deviation from Benchmark Positions
In the aftermath of the credit crisis, debt issuance by developed market governments has skyrocketed leaving many index oriented portfolios highly concentrated in government debt. For example, in the U.S., the combination of an increase in Treasury issuance and ongoing government intervention (through QE2 and nationalizing the GSEs) has resulted in a high concentration of U.S. Treasury bonds in the Barclays Aggregate Index.
In contrast, the opportunity set available outside the confines of a U.S. aggregate index has grown. As the aggregate index gets more concentrated and other, global markets continue to grow, fixed income portfolios benchmarked to an aggregate index may not be as diversified as once thought. When looking at the emerging markets, approximately 84% of the broad market is also government or government related securities.
Although on the surface it appears even more concentrated than the U.S. Treasury portion of the U.S. aggregate index, more than 42 different countries from four different regions compose the sovereign debt available in the emerging market debt universe. Exposure to any one country is limited, providing the benefit of diversification; what happens in one country would not necessarily dominate returns. It also provides diversification from any single economy, i.e., the United States.
With the birth of the local and corporate emerging markets in 2002, the asset class has seen enormous growth. The emerging markets have become more stable, more transparent and more broadly diversified than the emerging markets of the past. Similarly, the impressive growth of the high yield market over time has catapulted this market to nearly 25% of all corporate bonds (by principal amount). Again, access to the opportunity set for both return and diversification benefits would be limited for those investors constrained by the confines of the U.S. aggregate index.
As market conditions and the investment markets have changed over time, a strategy with the freedom to actively allocate across all of the different sectors has the potential to provide superior returns versus a standard index.
Accessing Fixed Income Opportunities
In today’s environment, investors are searching for value and demanding more from their asset managers. Often, this value is found outside the confines of a standard benchmark. In an unconstrained portfolio, there is no obligation to maintain an exposure to any market or sector, so if the manager doesn’t like a market, it’s not owned. Alternatively, as market conditions change and improve, the manager has the opportunity to change positions irrespective of a benchmark’s composition. Similarly, a manager with the ability to access global markets has a greater probability of harnessing a larger universe of investment opportunities.
Through the ability to invest freely without constraint by a market benchmark, an investor has the opportunity to hold only the best investment ideas generated by their investment team. Constraints imposed by a benchmark can force an investor to select less compelling investments to the detriment of returns. Additionally, an investor can hold positions of any size, within any sector or across global markets. Broader investment mandates can uncover and exploit opportunities depending on the availability of these investment options. Although there appear to be many benefits to improve performance potential, many clients fear the perceived risks associated with an unconstrained investment portfolio. This perspective depends on how risk is defined. In our experience, the biggest risk most investors face is the absolute risk of losing money. In this respect, unconstrained funds are arguably better able to withstand this risk than portfolios constrained by an index.
Additionally, by exploiting a variety of fixed income sectors, risk can be better diversified across sectors and investments. Furthermore, if a fixed income investor identifies a potential risk in a sector, an unconstrained manager has the opportunity to avoid the sector completely. This flexibility to avoid potential risk is a significant advantage that is not available to a benchmark constrained manager or a passive portfolio.
Another factor that is vital to the success of an unconstrained portfolio is the expertise of the manager. Once the portfolio constraints are dissolved, the manager has the flexibility to seek positive returns throughout the investment universe. Ultimately, a client is delegating greater authority to a manager to vary interest rate, credit and currency risk. While this agility is a key advantage to an unconstrained portfolio, it is essential to have a manager with broad, global resources and capabilities, a disciplined investment process and the willingness to dynamically vary risk exposures to craft a proper portfolio able to withstand market stress.
Robert Michele is the global chief investment officer within J.P. Morgan Asset Management’s global fixed income and currency group. In this role, he responsible for overseeing the activities of its fixed income investment teams in the United States, Europe and Asia. Prior to joining the firm in 2008, he was the global head of fixed income at Schroder Investment Management.
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