Amid Growing Interest in Opportunistic Fixed Income, Execution Matters (Archived)
David Leduc, Standish
But it’s not just higher rates that are forcing a major rethink of traditional bond investing. Everything from new banking regulations, aging populations, and growing markets outside the US are fundamentally changing the fixed income landscape as we once knew it. So it’s not surprising investment managers have been suggesting that bond investors consider moving away from traditional benchmark-bound strategies to more flexible, opportunistic fixed income approaches that target a positive return across all market cycles. These strategies are better equipped to seek return across a far larger universe of global fixed income and credit markets and can use a wider range of tools to nimbly rotate in and out of sectors as opportunities and risks change.
But as investor interest grows in opportunistic fixed income, we think it’s important to understand exactly how these strategies work so that investors avoid trading one kind of risk for another. These approaches come in different shapes and sizes and therefore operate differently. Some of the opportunistic approaches that have performed well over the last five years, when credit spreads were wide and market liquidity abundant, might face greater challenges in this new period of tighter spreads, less liquidity, limited inventory, and higher volatility.
Execution Matters: Security Selection Becoming More Important in New Market Environment
The chart overleaf illustrates that over the last three years, the average return in the unconstrained universe has exhibited an extremely high correlation to high yield credit spreads.
As such, the most recent period was characterized by many opportunistic approaches being able to generate positive returns from a fairly straightforward sector selection to riskier areas of the fixed income universe like high yield.
Looking ahead, there are at least five major changes that might make such a blunt sector selection approach less effective:
- By the end of 2014, the Fed is expected to have completely ended its Quantitative Easing policy, meaning less market liquidity and potentially higher interest rates
- The process of rolling back unprecedented Fed liquidity is likely to increase market volatility
- Spreads have currently become much tighter in many fixed income sectors
- As Basel III banking regulations and the Volcker Rule begin to bite, sharply reduced dealer inventories may impact retail bond market liquidity
- Retiring baby boomers are likely to increase competition for scarce fixed income assets
In this uncertain environment, we believe individual security selection will be even more important than intelligent sector rotation. As a result, we feel that thoroughly understanding a manager’s ability to capture opportunities at the security level and the factors that affect that ability will be an essential consideration for investors over the next few years.
Size Matters: Transacting in Cash Bonds
Strategies with very large asset bases may be more challenged by their large size to capture individual security-level opportunities in more obscure corners of certain sectors and regions. This is an important constraint when it comes to, say, high yield bonds or subprime asset-backed securities. A new issue in the high yield market, for example, might be as small as $300-500 million, and the allocation to any one manager even smaller at $20-50 million. As the following tables illustrate, a smaller asset base may help lead to capturing more meaningful, high conviction exposures compared to approaches with larger asset bases.
Average Deal size of New Issue US HY = $500m
|Size of Asset Base||% of deal required to take 1% position in the Strategy|
Source: Standish, for illustrative purposes only, not reflective or any actual bond deal or mutual fund portfolio.
The size of the asset base also dictates how managers can transact in global fixed income and credit markets. Beyond a certain size, it becomes more difficult to transact in cash bond markets. Larger managers may need to gain exposure to certain parts of the market through derivative contracts, introducing additional counterparty and liquidity risks that must be managed. While derivatives can be useful tools for managing interest rate changes and other kinds of portfolio risk, we think it is important for investors to understand: 1) to what extent derivatives are part of the portfolio; and 2) whether managers are using derivatives to manage risk or as a way to generate excess return, as each of those approaches has different portfolio management implications. Comparing the holdings across different opportunistic fixed income strategies reveals significant disparities between managers invested mainly in cash bonds and with relatively little exposure to derivatives, and other managers who rely far more heavily on derivatives like futures, swaps and credit default swaps and have less than 50% of their portfolios invested in cash bonds.1
Transparency Matters: Understanding How Derivatives Are Used in Portfolios
A recent study of nearly 80 high net worth investors in the US revealed that more than half of them were not at all familiar with derivatives.2 As more investors consider making opportunistic fixed income strategies a meaningful part of their core fixed income allocation, we believe it is important that they understand not only what their managers are invested in, but how they are achieving that exposure. For strategies that make significant use of derivatives, investors need to increase their knowledge of the role they play in the portfolio and how the additional risk they might introduce to a portfolio is managed.
The fixed income environment is changing, and as a result we believe opportunistic fixed income strategies with the flexibility to go anywhere are better suited to today’s market realities than traditional, duration-heavy core holdings. But because these strategies come in different shapes and sizes, we think it is important for investors to drill down into what they’re actually investing in and understand both the what and the how of investing in this new fixed income landscape.
1. Standish analysis based on Morningstar data, as of March 31, 2014.
2. High Net Worth Investment Pulse Survey, administered by Capital Position Ventures, March 2014.