On the Frontline of Fixed Income

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1 CALLAN INVESTMENTS INSTITUTE April 2012 Exhibit 6 Research On the Frontline of Fixed Income A Roundtable Discussion with Callan s Bond Experts The historically low yields that prevail in the fixed income marketplace pose a challenge for investors. Risk is asymmetric the likelihood of a meaningful decline in interest rates is far less than that of an increase in the coming years. Returns delivered by the Barclays Aggregate over the last year (+7.8%) or decade (+5.8% annualized) 1 are not replicable over the near or intermediate term. Interest rates across the non- U.S. developed markets also lack appeal. As a result, some investors are pushing their investments out on the risk spectrum in a quest for return. Given this backdrop, we assembled a group of Callan s bond experts to address some of the issues that fixed income investors are facing in this low-yield environment., CFA, Senior Vice President and Callan consultant, sat down with her Callan colleagues to discuss the fixed income landscape. Roundtable participants include Steve Center, CFA, Brett Cornwell, CFA, and Matt Routh from the Global Manager Research Group and Kristin Bradbury, CFA, from the Independent Adviser Group. Read their full biographies at the end of the paper. What did 2008 teach investors about their overall fixed income allocations? How is that impacting allocations today? Steve Center The 2008 credit crisis revealed that many institutional investors did not realize the risks that their fixed income managers were taking. Some strategies marketed as lower-risk core options were revealed to be core plus wolves in sheep s clothing. This development caught some investors by surprise, particularly those who believed their fixed income allocations were serving as a low-risk anchor to windward that would diversify their equity allocations. Many fixed income managers were systematically overweight to highly correlated riskier bond sectors, and it is now apparent the overwhelming majority did not realize the actual risks they were taking. 1 Periods ended December 31, Knowledge. Experience. Integrity. 1

2 Post-2008, investors have taken a step back to reconsider the overall purpose of their fixed income allocation. For some, a true benchmark-aware, high-quality core portfolio makes the most sense, as they are ultimately concerned with the ability of their fixed income portfolio to diversify other investment risks. Factors such as low volatility, high liquidity and principal preservation tend to be far more important than capital appreciation and yield for these investors. Others are concerned with hedging a discrete risk, such as a pension liability or inflation. For these investors, customized strategies have continued to gain traction. Long duration and liability-driven investment strategies have remained popular with investors looking to hedge longer-dated liabilities, even in the current depressed interest rate environment. In the macro-driven environment of the past three years, how well have top-down managers performed versus bottom-up bond selectors? Matt Routh Since the financial crisis of late 2008, many investors have viewed macroeconomic developments such as fiscal stimulus, politics and fiscal crises in Europe as the key drivers of fixed income market returns. In this type of environment, an investor could be forgiven for thinking that old-fashioned security selection should be a bond manager s last worry. However, Callan conducted a cursory analysis to compare the performance of bond managers that focus on macro factors (top-down) versus those who begin with looking at an individual bond s fundamentals (bottom-up). We selected the 15 top-down and bottom-up core plus fixed income managers with the best performance on a three-year basis from Callan s Core Plus Fixed Income Style group. Managers were labeled as topdown or bottom-up based on their self-reported philosophy in Callan s database. Common investment philosophies held by top-down managers emphasized active duration management, yield curve management and sector allocation decisions based on macroeconomic views. Bottom-up managers focused on individual bond analysis, constrained their duration exposures closely to the index and allowed their views on fundamentals to influence their sector allocation decisions. The three-year returns for these two groups are as follows: Exhibit 1 Returns for Selected Managers in Callan s Core Plus Style Group Three Years ended 12/31/2011 Top 15 Bottom-Up Managers Top 15 Top-Down Managers Average 5.95% 4.80% Median 5.74% 4.36% High 8.66% 8.63% Low 3.97% 2.54% Both the average and median bottom-up fixed income managers performed better than their top-down counterparts over the period between January 2009 and December These results do not imply that bottom-up managers will perform better in all market environments. Rather, the key lesson is that fundamental analysis and bond security selection remain important and can be a key driver of returns, even in markets seemingly driven by dramatic macroeconomic events. 2

3 With yields as low as they are in the investment grade space, what are the options for investors seeking to boost their fixed income returns? Matt Routh The lack of yield in the investment grade space is a concern for investors attempting to extract fixed income returns in line with historical experience. The effective yield for the Barclays U.S. Aggregate Bond Index as of year-end 2011 was at an all-time low of 2.24%. As a result, some investors are looking to fixed income sectors outside those contained in this investment grade index. Exhibit 2 Historical Effective Yields 21% Barclays Aggregate Bond Index ML High Yield Master II Index JPM EMBI Global Composite Index S&P Leveraged Index 18% 15% 12% 9% 6% 3% 0% 4Q02 4Q03 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09 4Q10 4Q11 High yield corporate bonds are one alternative to the low-yielding bonds within the Barclays Aggregate. The solid balance sheets of U.S. corporations have led to historically low default rates among high yield bond issuers. Though the yield advantage on these securities relative to Treasuries has declined significantly in recent months, the sector continues to attract interest from yield-hungry investors. Emerging markets debt has seen similarly strong demand. The governments of many emerging nations have stepped up their fiscal oversight and monetary management, leading to stronger GDP growth than some of their floundering developed counterparts. Nevertheless, yields overall remain high relative to U.S. Treasuries and this sector may offer compelling returns, albeit with higher historical volatility than the developed fixed income markets. To hedge against the possibility of rising interest rates, some investors have turned to high yield bank loans (which are issued by companies rated below investment grade). These loans pay floating-rate coupons and represent the senior-most debt issuance of a corporation, and thus occupy the top of the capital structure. This market is subject to volatile capital flows and, like emerging markets and high yield, may also experience periods of illiquidity in distressed markets. Knowledge. Experience. Integrity. 3

4 Further, these types of securities are more volatile and have greater potential for capital losses than the investment grade market. With this heightened level of risk, however, comes the potential for compensation in the form of higher yields. We note that on a risk-adjusted basis (as measured by Sharpe ratios in Exhibit 3), excess returns for indices representing emerging markets, high yield corporate and bank loans were lower than the Barclays Aggregate Index over the last five and 10 years. Over these time periods, investors in these asset classes received less return per unit of risk than those in the investment grade space. Exhibit 3 Sharpe Ratio for Periods ending December 31, 2011 Last 5 Years Last 10 Years Barclays Aggregate Bond JP Morgan EMBI Global Merrill Lynch High Yield Master II S&P/LSTA Leveraged Loans What is the best way for investors to access these specialized strategies? Is a core plus mandate enough, or does a separate allocation to a specialized strategy make more sense? Matt Routh Investors have increasingly looked beyond investment grade sectors to improve their potential return opportunities above those offered by portfolios benchmarked to the Barclays Aggregate Index. In a lowyielding environment, these allocations (e.g., emerging markets, opportunistic, high yield, bank loans) are particularly attractive on a relative basis. We have seen investors gain exposure through both core plus mandates and core/satellite structures that access discrete allocations to these sectors. Most core plus managers tactically allocate to these alternative sectors within a pre-specified maximum. These managers often utilize analysts with sector expertise that are dedicated to high yield or emerging markets securities, or may choose to access such markets through dedicated commingled funds. In high yield, some firms dedicate analysts to all securities within an industry, regardless of their credit rating. Many of the professionals focused on these sectors also manage separate dedicated strategies, showing further commitment to their abilities. Additionally, core plus fixed income managers can tactically shift their weightings to sectors such as high yield, emerging markets and international as they deem appropriate. Investors with separate allocations to these dedicated strategies are able to determine their strategic weightings, but may find that tactically shifting allocations is extremely difficult and also very expensive. Thus, an investor may prefer to maintain exposure to specialized strategies via the core plus manager. For investors that require higher allocations to these sectors than the core plus manager holds, one solution is unconstrained bond strategies. These products are less restricted in their ability to allocate to many of these sectors and often aren t anchored to a benchmark like the Barclays Aggregate. This can lead to much higher or lower allocations in areas like non-u.s. fixed income than a traditional core plus strategy would have, depending on the manager. 4

5 For some investors, exposure to non-u.s. fixed income via a core plus or unconstrained strategy is appropriate, but for others we see stand-alone allocations. For those with dedicated exposure to global and international mandates, does active management make sense? Brett Cornwell The merits of active versus passive management have long been debated across asset classes. The key factor in each asset class is whether the market is too efficient to allow active managers to consistently add value, or alpha. In global and international fixed income, we believe there are opportunities for skilled active managers to add alpha. These opportunities can come from at least two major sources of inefficiencies in the global bond markets, namely the ability to identify mispriced or undervalued risk and superior macroeconomic forecasting. First, the global bond markets expose investors to country and currency risks in addition to the other risks inherent in U.S.-based mandates. It is difficult and increasingly complex to measure these risks, leading to potential mispricing. Skilled managers can add value by identifying mispriced or undervalued risk and exploiting the inefficient pricing mechanism. Exceptional macroeconomic forecasting is a second area where managers can add value through active management. Based on the outlook for the global economy, the managers adjust various risk factors in the portfolio such as country and currency exposure, duration, credit quality or yield curve risk differently than the market or benchmark against which they are measured. Active management allows a manager to focus on those countries with the most attractive economic and interest rate cycles, and over- or underweight these countries relative to the benchmark. Finally, historical returns indicate that active global bond managers have been successful at adding value over time. The median manager in Callan s Global Fixed Income Style group outpaced the Barclays Global Aggregate Index during seven of the last 10 calendar years and has outperformed the Barclays Global Aggregate in 51 of the 76 past rolling 12-quarter periods, or 66% of the time. What benchmarks are frequently used for global and non-u.s. fixed income mandates, particularly in the emerging markets? How do the many emerging markets debt indices differ? Kristin Bradbury Both Barclays and Citigroup have popular non-u.s. indices for developed markets, while JP Morgan is the definitive source for emerging markets. Frequently, products that invest only in government debt are measured versus the Citigroup World Government Bond Index (WGBI). This index comes in ex-u.s., hedged and unhedged versions. For global investment grade products, the Barclays Global Aggregate Index is often used. Also under the Barclays umbrella, the Multiverse is a comprehensive global index that represents the union of the Barclays Global Aggregate and Global High Yield Indices. Knowledge. Experience. Integrity. 5

6 Emerging markets debt indices are far more complicated. The number and variety of indices has ballooned as these markets have evolved and attracted increased interest from investors. JP Morgan covers dozens of indices in its monthly publication Emerging Markets Bond Index Monitor. The U.S. dollardenominated family of indices includes the EMBI+ and the EMBI Global, both of which are market cap weighted indices. The EMBI+ includes bonds issued by EM sovereigns and quasi-sovereigns, and has strict liquidity requirements for countries to be included. The bulk of this index (57%) is investment grade with 31% BB and 12% B rated. The EMBI Global is a broader version of the EMBI+, but with some of its liquidity requirements relaxed. As of January 31, 2012, the EMBI Global included debt from 44 countries. This index also comes in a diversified version, which is uniquely weighted to limit the weights of the countries with larger amounts of debt outstanding. For example, the largest issuers in the EMBI Global are Mexico (13%), Russia (10%) and Brazil (9%). In the diversified version, Brazil is 7% while Russia and Mexico are both 6%. JP Morgan also has a family of local currency-denominated indices that cover government bonds. The GBI-EM is the narrowest version and includes only regularly traded, liquid, government bonds. As of January 31, 2012, the Index included the debt of 12 countries. The GBI-EM Global is slightly broader, but is still considered to be an investable benchmark and includes only countries that are directly accessible by most international investors. It excludes countries with explicit capital controls. Currently, it is comprised of the same countries as the GBI-EM, plus Thailand and Indonesia. Finally, the GBI-EM Broad includes some countries that have capital controls and/or regulatory or tax hurdles for foreign investors. This index also includes China s and India s debt. All three indices also come in diversified versions that limit the weights of countries with larger amounts of debt outstanding to a specified portion of their eligible debt. JP Morgan additionally publishes indices for other segments of emerging markets: The Emerging Local Markets Index Plus (ELMI+) tracks total returns for local currency denominated money market instruments in 23 countries. The Corporate Emerging Markets Bond Index (CEMBI) covers U.S. dollar-denominated corporate bonds in 30 emerging markets. The broad version covers five more countries. Both CEMBI indices come in diversified versions that cap the weights of the largest constituents. The Next Generation Markets Index (NEXGEM) launched in December This is JP Morgan s first index for frontier markets and tracks U.S. dollar-denominated government bonds in 18 frontier countries. 6

7 What elements should investors be aware of regarding currency? When is it appropriate to use a hedged versus unhedged strategy? Brett Cornwell Investors in non-u.s. bonds must choose whether or not to hedge their currency exposure. The answer varies depending on the investor s goals and risk tolerance. Hedged foreign bond exposure will trade with a spread over the risk-free U.S. Treasury based on the underlying credit characteristics and other factors. Leaving the exposure unhedged introduces currency risk to the portfolio and is essentially a bet against the U.S. dollar. Examining the Barclays Global Aggregate ex-u.s. Index since 1990, we see that during times of U.S. dollar weakness, the Unhedged Index outperformed the Hedged Index, and vice versa. Exhibit 4 Growth of $100 $500 $450 $400 $350 $300 $250 $200 $150 $100 $50 Unhedged Unhedged outperformed hedged by 52% during weak dollar environment Hedged Hedged outperformed unhedged by 75% during strong dollar environment Unhedged outperformed hedged by 68% during weak dollar environment Over the long term, the Unhedged has outperformed the Hedged Index, but the ride has been bumpy. Adding unhedged foreign bonds to a fixed income portfolio will add volatility. If an investor expects U.S. dollar weakness versus the currencies in which the bonds are denominated, it is appropriate to use an unhedged strategy. This is a difficult trade to consistently get right over the short term, as currencies don t always trade based on their underlying fundamentals. The recent strength of the U.S. dollar is a great example of this. Higher inflation expectations, increased government debt levels and large current account deficits cause many to believe the dollar will be under pressure over the long term. But events in the financial markets, such as the ongoing euro zone banking crisis, have caused the dollar to strengthen versus many developed and emerging market currencies as investors sought the safety of U.S. Treasuries. Knowledge. Experience. Integrity. 7

8 What are the pros and cons of unconstrained or opportunistic global strategies (giving wide berth to managers to invest in emerging markets debt sectors) versus a strategic allocation to emerging markets debt? Kristin Bradbury Unconstrained fixed income managers scan the global fixed income landscape for the most attractive investment opportunities by continually assessing valuations, fundamentals, market conditions and a myriad of other factors. These opportunistic managers will tactically invest in emerging markets debt (EMD) when deemed attractive relative to other options. Typically, EMD is not confined to U.S. dollardenominated sovereign debt, but also includes emerging market corporates, local currency sovereign debt or just emerging market currencies. A tactical approach is appealing given that the dynamics of these markets are continually evolving, and technical and fundamental conditions as well as valuations can rapidly change. Hiring an unconstrained manager takes the burden off the investor for determining the right strategic allocation to EMD, as well as how to implement (i.e., in hard versus local currency or in sovereign versus corporate debt). Further, in recent years, the returns of riskier assets have been highly correlated. Thus, the diversification benefit of a strategic allocation to EMD has been reduced. As spreads have compressed especially in the external debt sector valuations are less compelling, also dampening the appeal of a static strategic allocation. However, there are drawbacks to hiring an unconstrained manager. In order for these strategies to produce favorable risk-adjusted results, the manager must make the right tactical choices. That becomes very difficult to measure. Performance measurement can be problematic for managers that have the latitude to go anywhere, many of which consider themselves to be benchmark agnostic. While a global fixed income benchmark like the Barclays Multiverse or Global Aggregate may be appropriate for some, portfolios can look dramatically different from these indices. They may include significant investments in out-of-index sectors, and it is not uncommon for these managers to employ derivatives and long/short positioning. Some unconstrained managers are more absolute return-focused and thus have a performance benchmark of LIBOR basis points, for example. For these reasons as well as the relative newness of these strategies, there is not currently a robust peer group for unconstrained fixed income managers. Finally, it may be more challenging for some types of investors to fit an opportunistic fixed income strategy into a broad asset allocation. While these strategies can be generically categorized under the fixed income umbrella, a more narrow specification (domestic, international, high yield, emerging markets, etc.) is not practical. 8

9 What are the current opportunities in emerging markets debt? Brett Cornwell There are three distinct emerging markets debt (EMD) subsectors: (1) dollar-denominated government debt (external sovereign debt), (2) local-currency government/sovereign debt and (3) dollar-denominated emerging market (EM) corporate debt. Exhibit 5 Emerging Markets Debt Subsector Indices JPM EMBIG Diversified JPM CEMBI Broad Diversified JPM GBI-EM Global Diversified Type of Debt External Sovereign External Corporate Local Sovereign Duration Yield (%) Credit Quality BBB- BBB BBB+ Spread (bps) / Yield (%) Current Year Average Median High Low For sovereign debt, the emerging economies generally have healthier balance sheets than much of the developed world. They are less levered and exhibit better growth prospects. Growth rates for EM economies are projected to be significantly higher than most of the developed world. With higher growth rates, lower debt levels and room for policy makers to stimulate their economies through monetary and fiscal policies if necessary, the fundamentals for EM sovereign debt remain strong. Therefore, from a fundamental perspective, the case for EMD appears to be intact. The underpinnings of the EM corporate sector also remain strong. EM corporates have maintained healthy leverage profiles, strengthened their liquidity positions and extended their debt maturity profiles. EM corporate defaults peaked in 2009 at 6.1% and have since fallen to less than 1% over the trailing 12-month period ending December However, fundamentals could deteriorate if global growth slows and corporate earnings are impacted. The technical environment varies among the three subsectors. The backdrop has been favorable for sovereign debt as the pace of inflows has been running at the highest levels in over two years. The deleveraging in the developed markets continues to weigh on growth prospects, leading to low and often negative real yields for much of the developed world. Furthermore, policy makers are likely to remain accommodative, keeping interest rates low in an effort to help revive their struggling economies. The higher real yields available from the emerging markets may very well continue to capture the attention of investors in search of yield. Flows into dollar-denominated sovereigns have considerably outpaced the local currency segment, accounting for 90% of year-to-date flows through mid-february. This bias away from local currency debt is likely due to higher volatilities and the sharp sell-off across many EM currencies during The technical backdrop is a bit weaker for EM corporates due to less liquidity with fewer participants making markets. Knowledge. Experience. Integrity. 9

10 Valuations for external debt appear to be fair based on historical spread levels. Spreads on the benchmark (JP Morgan EMBI Global Diversified) were 349 basis points at the end of February 2012, which is below the trailing 10-year average spread of 394 basis points and slightly above the median of 339 basis points. For context, the Index spread most recently peaked at 796 basis points in November 2008 then fell to 256 basis points in March of In comparison, yields on local sovereign debt are hovering near all-time lows levels that prior to October 2010 have not been experienced since the summer of The yield on the benchmark (JP Morgan GBI-EM Global Diversified) ended February 2012 at 6.29%, well below the trailing 10-year average yield of 7.01%. Nonetheless, the absolute level of yield appears attractive relative to the yields available in the developed world. This should continue to attract investors in search of positive real yields. With regard to EM corporates, the spread on the benchmark (JP Morgan CEMBI Broad Diversified) was 398 basis points at the end of February This is currently above the trailing 10-year average of 366 basis points. What has been the impact on stable value of the recent closures of some stable value commingled funds and the limited number of firms currently issuing book value wrap contracts? Steve Center The stable value marketplace has faced a number of challenges over the last two years, including regulatory changes from Dodd-Frank, tighter investment guideline restrictions from wrap providers, increased wrap coverage expense and a drop in the number of firms willing to issue new book value wrap coverage. These factors have led to the closure of some mid-sized stable value commingled funds. Despite these unfortunate developments, stable value funds have continued to offer a significant yield advantage relative to money market funds and remain quite popular with defined contribution plan participants. It is important to note that stable value funds do face numerous potential headwinds, particularly if interest rates begin to rise. Increased wrap coverage expenses, coupled with wrap providers mandating shorter duration requirements and higher quality guidelines, will make it difficult for stable value funds to offer an attractive yield advantage relative to money market funds when short-term interest rates increase. The Fed s vocal desire to keep rates low for the near term, along with the equity wash provisions that often limit a participant s ability to transfer funds to competing options within a plan, complicates a plan sponsor s decision to add a new stable value fund option to their retirement plan platform. We have seen signs of moderate easing within the book value wrap marketplace. While many banks have cut back issuance or exited the market altogether, insurance companies have been willing to issue separate account wrap coverage. This is particularly true for cases in which an asset manager affiliated with the insurance company can retain a portion of the asset management duties for the part of the fund to be wrapped. Additionally, financial institutions that are new to the market have been exploring the space and are rumored to be issuing coverage later in

11 While all of these factors have made it difficult for plans that do not currently offer a stable value option to consider adding one to their plan, stable value funds remain quite popular with participants when they are offered. Money market funds face very tight investment restrictions under the revised 2a-7 guidelines, and continued regulatory threats may conspire to improve the attractiveness of stable value options relative to money market funds. Callan continues to closely monitor this evolving space. Thank you all for your time and thoughts. Knowledge. Experience. Integrity. 11

12 Biographies Janet C. Becker-Wold, CFA, Senior Vice President. Janet is the Manager of Callan s Denver Consulting office. Janet joined the investment management business in Her experience at Callan includes all facets of investment consulting including investment policy analysis, asset and liability studies as well as manager search and structure. She has a particular expertise in international investing and currency management. Her clients include corporate, public and non-u.s. based funds. Janet is a member of Callan s Management, Manager Search and Defined Contribution Committees. Kristin Bradbury, CFA, Vice President, Independent Adviser Group (IAG) of Callan Associates Inc. Kristin conducts investment manager research and due diligence with a focus on fixed income managers. She is also responsible for conducting manager searches as needed, primarily in the fixed income arena, and for providing client service to IAG members. Steven J. Center, CFA, Vice President. Steve is a fixed income investment consultant in the Global Manager Research Group. Steve is responsible for research and analysis of fixed income investment managers and assists plan sponsor clients with manager searches. He oversees manager searches, conducts in-house and on-site due diligence reviews with portfolio managers and attends finalist interviews. Brett A. Cornwell, CFA, Vice President. Brett is a fixed income investment consultant in the Global Manager Research Group. He is responsible for research and analysis of fixed income investment managers and assists plan sponsor clients with fixed income manager searches. In this role, Brett meets regularly with investment managers to develop an understanding of their strategies, products, investment policies and organizational structures. Matthew K. Routh, Assistant Vice President. Matt is a fixed income investment consultant in the Global Manager Research Group. He is responsible for the research and analysis of fixed income managers. In this role, he meets regularly with investment managers to develop an understanding of their strategies, products, investment policies and organizational structures. 12

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15 Authored by Callan Associates Inc. If you have any questions or comments, please About Callan Associates Founded in 1973, Callan Associates Inc. is one of the largest independently owned investment consulting firms in the country. Headquartered in San Francisco, California, the firm provides research, education, decision support and advice to a broad array of institutional investors through four distinct lines of business: Fund Sponsor Consulting, Independent Adviser Group, Institutional Consulting Group and the Trust Advisory Group. Callan employs more than 150 people and maintains four regional offices located in Denver, Chicago, Atlanta and Florham Park, N.J. For more information, visit About the Callan Investments Institute The Callan Investments Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry. Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business.

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