Determining a fixed income benchmark and investment parameters for central banks
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1 Determining a fixed income benchmark and investment parameters for central banks Determining an appropriate benchmark for a fixed income investment program is an essential but often challenging decision. Michael Warzinek explains the factors for central banks to consider. He also explains how to develop suitable investment parameters Introduction In developing an external investment program, formulating a benchmark is one of the more difficult decisions the investing organization has to make. The decision is based on factors unique to each organization, which can often be personal or political in nature. In this article, we draw on our extensive experience with public institutions to shed light on the key factors that investors should consider. Investment objectives Before thinking about selecting an appropriate benchmark and parameters, the objectives of the investment program must first be established, which may include: Aiming to maximize the value of the investment portfolio in a manner consistent with capital preservation and liquidity Broadening and potentially reducing the risk of the investment portfolio by diversifying both in terms of assets and management style Hiring one or more managers that, over a proven period, have added value to a benchmark consistent with a projected risk and return profile Hiring an investment manager that can provide investment knowledge, insights and skills that will enhance the internal capabilities of the investment department at the institution Formulating a benchmark With the objectives established, there are several important considerations to take into account when determining an appropriate benchmark and investment parameters, in particular: Investment horizon Risk/return profile These are discussed in detail below. Investment horizon The investment horizon may be influenced by many factors, such as liability structure, trading patterns or cash flow. If funds are available only in the short term and cash flows are erratic, then a benchmark with a short term investment horizon may be appropriate. If a longer time frame and positive cash flows are anticipated, then a more mature benchmark can be adopted. This would encourage investment in longer maturity fixed income securities, and would imply that more risk could be adopted by the portfolio with the consequent potential for greater returns. The increase in volatility as the investment horizon lengthens can be illustrated by charting historic 12-month rolling returns. Chart 1 shows the Citigroup World Government Bond Market Performance Index, with the U.S. dollar hedged split into different maturity buckets.
2 It is worth noting that only the 1-3 year bucket shows positive performance on a rolling 12- month basis since inception. All other subcomponents and the all-maturities index moved into negative territory at the end of month returns (%) Chart 1: Rolling 12-month returns for Citigroup WGBI It is therefore important to identify the contributors to risk within a fixed income portfolio. Broadly speaking these are: duration positioning, exposure to different bond markets and currencies, and credit risk. They are discussed in detail below. Duration positioning An increase in interest rate sensitivity (duration) tends to bring about a proportionate increase in risk and return. In deciding on the duration of the benchmark, the investor should consider how extending duration may raise volatility and increase the potential for below average shortterm returns. Chart 2 below highlights how the risk/return profile changes as a result of extending duration in the U.S. debt markets. This pattern of risk and return increasing with duration is characteristic of all global fixed income markets Chart 2: Risk/return of U.S. Treasurys (June 1999 June 2009) Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan yrs 20+ yrs Citi WGBI Citi WGBI 3-5 years Citi WGBI 7-10 years Source: Datastream Citi WGBI 1-3 years Citi WGBI 5-7 years Citi WGBI 10+ years Return (% p.a.) yrs 3M-sw ap 5-10 yrs 3-5 yrs Risk/return profile The organization s risk appetite should also be reflected in the investment portfolio s benchmark. If the stated return objectives of a mandate are out of line with the risk tolerance of the organization, this could lead to the manager failing to meet the overall investment objectives. Understanding how volatility of returns will affect the portfolio is important when thinking about the desired risk/return trade-off. For example, under adverse market conditions, could the investing organization tolerate a single month/quarter/year of negative returns? Source: Datastream Standard dev. (% p.a.) Country/market allocation All debt markets with relatively liquid, freely convertible currencies should be considered for an investment program. By granting such flexibility to the manager, the portfolio may be able to benefit from opportunities for additional return that different markets periodically offer. In addition, exploiting low correlations between
3 markets and diversifying the portfolio may reduce the volatility of returns. exposure not only mostly increased risk, but was also detrimental to return. Currency exposure Currencies should be managed as a separate strategic element in an investment portfolio, even though they are subject to similar fundamental influences as fixed income securities growth, inflation, trade balance, and so on. This is because the timing, magnitude and in some cases the direction of currency movements can differ from those of the related fixed income market. Currency exposure tends to bring additional risk without a proportionate compensation in return, even in a weak U.S. dollar environment. This is partly due to the volatility of currency movements relative to the more directional movement of interest rates. Chart 3 shows how exposure to currency unhedged significantly increases risk. Chart 3: Risk/return of (hedged and unhedged) and U.S. bonds - weak dollar Return 8.5% 8.0% 7.5% 7.0% 6.5% 100% hedged 100% U.S. cash 0% 1% 2% 3% 4% 5% 6% 7% Risk 100% unhedged 100% U.S. bonds Source: Datastream (10 years to Sept 1999) The risk/return dynamics of investing in unhedged depend on the performance of the U.S. dollar versus other major currencies. As chart 4 shows, when the U.S. dollar was strong, overseas currency Chart 4: Risk/return of (hedged and unhedged) and U.S. bonds - strong dollar Return 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 100% 3-mth LIBOR 100% hedged 0% 1% 2% 3% 4% 5% 6% 7% Risk Source: Datastream (10 years to Sept 2001) 100% U.S. bonds 100% unhedged Chart 3 above plots the risk/return characteristics of investing 100% in U.S. government bonds (Citigroup WGBI U.S. Treasurys), which over the time period returned just over 7.60% for a risk level of around 4%. As exposure to hedged (U.S. dollar Salomon fully hedged WGBI) increased incrementally, so too did returns increase, so that a portfolio invested 100% in hedged global bonds would have returned around 8.10% over the period. Due to the benefits of diversification, risk actually decreased as exposure to hedged increased. Credit risk By credit risk, we are referring to the risk of investing in the agency and corporate sector, rather than investing only in government guaranteed securities. Returns increase as one moves down the credit curve, but so too does the volatility and the probability of default (see table below). For high quality portfolios, we suggest staying within investment grade credit and targeting an average portfolio rating of AA or better, as volatility increases sharply as one moves from investment grade to sub-investment grade.
4 Tracking error impact of corporate credit over U.S. government bonds (short duration) Credit rating Tracking error Investment grade AAA 1.50% AA 1.66% A 2.79% BBB 2.83% Sub-investment grade B 10.27% Source: Merrill Lynch US Credit Indices (1-3yrs), Citigroup US Treasurys (1-3yrs) Tracking error and potential sources of added value As suggested above, there are various sources of potential return for a fixed income investment program, each of which implies a level of additional risk. The table below shows different possible sources of added value available to a fixed income portfolio, and the impact on tracking error for each one. We would note that, in our view, a multi-disciplinary approach to portfolio construction can generate diversification benefits to reduce the overall tracking error impact of the above sources of added value. We believe substantial value is available within the credit markets. This can be shown by comparing the theoretical values of spreads given historical default and recovery rates with the actual spreads available in the market (chart 5). Such spreads occur for many reasons, including liquidity, higher transaction costs, sector risks and the specific risks of the individual issuers. That is why, in our view, superior analysis and credit awareness could add significant value to a portfolio. Chart 5: Theoretical vs. actual spread values Valuation Source: Moody s Aaa Aa A Baa Ba B Theoretical Actual Tracking error impact of different potential sources of added value on a government portfolio Source of added value Tracking error impact Increasing duration 1.89% by one year Allocating 10% to corporate credit AAA 0.41% AA 0.38% A 0.53% BBB 0.67% Allocating 10% to: High Yield (B) 1.53% Emerging Debt 1.45% Currency 10% EUR vs US$ 1.03% 10% JPY vs US$ 1.11% 10% GBP vs US$ 0.95% Source: ML, Citigroup, as of May 25, 2009 The key message regarding these potential sources of added value is that credit provides a high information ratio (i.e., a high return for the level of risk taken), while currencies provide a low information ratio. It is only when we move close to sub-investment grade debt that the tracking error impact of credit begins to increase substantially.
5 Choosing investment parameters Our approach is to encourage investors to allow the investment parameters to include all the possible sources of added value, but to manage the overall portfolio risk using a tracking error constraint. Typical parameters for a +1% outperformance target of a global portfolio are shown in the following table. Typical parameters for a +1.00% outperformance target Tracking error range Market selection 0% 2.5% All inv. grade countries Modified duration +/- 2 Yield curve No maturity restriction Currency Non-govt. allocation Credit rating Security selection AAA to AA A BBB Max 10% active risk per bloc 0% 30% Average portfolio rating AA- Max 10% per issuer Max 5% per issuer Max 3% per issuer Summary This document is intended to prompt further discussion regarding investors exact requirements and to serve as a guide to the questions they may wish to answer before formulating a benchmark and investment parameters. Key questions: What is your investment review period? (1 month, 1 quarter, 1 year?) What is your tolerance for negative returns over this period? (1month, 1 quarter, 1 year?) Are you trying to match any future liabilities? What are these? If not, do you have an internal rate of return target? DB Advisors approach DB Advisors seeks to add value to the benchmarks we invest against by reducing volatility and aiming to provide superior returns. We use a multi-disciplinary approach, which includes: market selection, duration, yield curve positioning, non-government security selection, credit rating, individual issuer selection and currency. These broad capabilities enable us to create customized solutions designed to meet the specific needs of each client. About the Author Michael Warzinek is a Managing Director and the Product Head for Fixed Income at DB Advisors. Based in Frankfurt, Michael works with central banks and sovereign wealth funds worldwide to develop fixed income investment solutions to meet their requirements. Michael joined the firm in 1987, covering the dollar-bloc markets and managing global bond portfolios, primarily for central banks and government agencies. He has also worked in London as a fixed income portfolio manager, responsible for South American clients and for central banks globally. Contact: Michael Warzinek Tel.: michael.warzinek@db.com DB Advisors Mainzer Landstr Frankfurt/ Germany
6 DB Advisors is the brand name for the institutional asset management division of Deutsche Asset Management, the asset management arm of Deutsche Bank AG. In the US, Deutsche Asset Management relates to the asset management activities of Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company; in Canada, Deutsche Asset Management Canada Limited (Deutsche Asset Management Canada Limited is a wholly owned subsidiary of Deutsche Investment Management Americas Inc); in Germany and Luxembourg: DWS Investment GmbH, DWS Investment S.A., DWS Finanz-Service GmbH, Deutsche Asset Management Investmentgesellschaft mbh, and Deutsche Asset Management International GmbH; in Australia, Deutsche Asset Management (Australia) Limited (ABN ); in Hong Kong, Deutsche Asset Management (Hong Kong) Limited; in Japan, Deutsche Asset Management Limited (Japan); in Singapore, Deutsche Asset Management (Asia) Limited (Company Reg. No N) and in the United Kingdom, RREEF Limited, RREEF Global Advisers Limited, and Deutsche Asset Management (UK) Limited; in addition to other regional entities in the Deutsche Bank Group. This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute Deutsche Bank AG or its affiliates judgment at the time of issue and are subject to change. This document is only for professional investors. This document was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. No further distribution is allowed without prior written consent of the Issuer. The forecasts provided are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. For Investors in the United Kingdom: Issued in the United Kingdom by Deutsche Asset Management (UK) Limited of One Appold Street, London, EC2A 2UU. Authorised and regulated by the Financial Services Authority. This document is a "non-retail communication" within the meaning of the FSA s Rules and is directed only at persons satisfying the FSA s client categorisation criteria for an eligible counterparty or a professional client. This document is not intended for and should not be relied upon by a retail client. 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An investment with Deutsche Asset Management is not a deposit with or any other type of liability of Deutsche Bank AG ARBN , Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank AG Group. The capital value of and performance of an investment with Deutsche Asset Management is not guaranteed by Deutsche Bank AG, Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank Group. Investments are subject to investment risk, including possible delays in repayment and loss of income and principal invested. For Investors in Hong Kong: Interests in the funds may not be offered or sold in Hong Kong or other jurisdictions, by means of an advertisement, invitation or any other document, other than to Professional Investors or in circumstances that do not constitute an offering to the public. 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