Structuring a U.S. fixed income portfolio

Transcription

1 By: Keith Brakebill, Portfolio Manager, Global Fixed Research AUGUST 2011 Structuring a U.S. fixed income portfolio U.S. fixed income often makes up a considerable portion of investors portfolios and justifiably so given the attractive risk-return properties that the asset class offers. However, constructing a U.S. fixed income portfolio can be a complicated task. The primary index is not only difficult to replicate, but it also uses a weighting and inclusion methodology that many bond investors would consider less than optimal. On the bright side, the complexity of this asset class creates a rich opportunity set for active management, which Russell believes is an appropriate approach in U.S. fixed income. This paper will touch on each of the aforementioned issues and seeks to provide some clarity for the reader regarding how a well-structured U.S. fixed income portfolio should look. Why bonds should be a part of your portfolio Total return investors 1 typically find bonds attractive, for two primary reasons: diversification and return. Bonds are one of the best diversifiers against equity risk, which still remains the predominant risk in the average investor s portfolio. In addition, bonds have historically produced moderate but positive returns on a more consistent basis than have most other asset classes. Historical correlations in the table below illustrate the low correlations of bonds versus most other asset classes. Exhibit 1: Bonds correlations to other asset classes, 12/2001 6/2011 Barclays Capital U.S. Aggregate Bond Index Russell 1000 Index 0.03 FTSE EPRA/NAREIT Developed Index 0.21 FTSE/NAREIT All Equity REITs 0.17 Russell Global 1000 ex-us Index 0.05 S&P Global Infrastructure Index 0.22 Dow Jones UBS Commodity Index 0.06 Source: Russell database. Correlations performed using monthly data. See appendix for index definitions. Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. 1 There are many different reasons for investing in fixed income, including but not limited to investors liability hedging and cash flow matching needs, but this paper focuses on the use of fixed income by a total return investor. Russell Investments // Structuring a U.S. fixed income portfolio

2 Total return (%) The theory behind the considerable diversification properties of bonds centers on the sensitivity of their prices to interest rates. Historically, as interest rates fall, bond prices go up, and vice versa. Interest rate expectations tend to decline as economic growth and inflation expectations fall. This is precisely the time when equities are likely to be performing poorly, and hence the positively performing bond allocation that results from falling interest rates can provide a diversifying return pattern to the overall portfolio. On the flip side, when the economy is heating up, equities tend to be performing well, and interest rate expectations are usually on the rise. As a result, bonds tend to underperform equities in such environments. With respect to returns: the primary index for investment-grade bonds in the U.S., the Barclays Capital U.S. Aggregate Bond Index, has been remarkably consistent in delivering moderate positive returns in many market environments, as illustrated in the chart below. Exhibit 2: Barclays Capital U.S. Aggregate Bond Index historical returns month Total Return (%) Average Source: Russell database, Barclays Capital. Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. While we all know that past performance offers no guarantees going forward, the consistent nature of historical bond returns is reassuring to investors. Additionally, the average annual return of near 9%, with only two years of negative total return, looks particularly attractive. However, the low yields we currently observe on investment-grade fixed income might suggest that future returns are likely to be below average. Still, investors should recognize that a market that is pricing in low interest rates for the future is also likely expecting to see low returns across many asset classes, at least relative to historical averages. Another strategic rationale for holding bonds includes that of certainty at least of cash flow certainty. In a world where outcome-oriented solutions e.g., liability-driven investing, target-date structures, post-retirement income distribution strategies are increasingly popular, bonds play a key role in the portion of the portfolio designed to capture predictable cash flows, given that most bonds offer fixed schedules of coupon payments and return of principal. Uncertainty over the timing or quantity of those cash flows typically arises only Russell Investments // Structuring a U.S. fixed income portfolio / p 2

3 Rolling three-year average return (%) when the issuer s economic situation becomes so dire that default is a serious risk, but default is uncommon among investment-grade issuers. In fact, since 1920, the average annual default rate on investment-grade corporate bonds is only 0.15%. 2 The chart below demonstrates the consistency of coupon returns over time. In both rising and falling rate environments, income from coupons and paydown of mortgage principal, rather than price appreciation, is the primary driver of return for the BC U.S. Aggregate Bond Index. Exhibit 3: Components to Return Price and Coupon Total Return Price Return Coupon plus Paydown Source: Barclays Capital. December 1, 1983 to June 1, 2011 Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Cash flow patterns The typical fixed income security offers a series of semiannual coupon payments, say 5% of the principal invested, and a final balloon payment, which returns the principal on the maturity date. This is the structure of cash flows for most Treasury bonds and corporate bonds. Investors and issuers alike often prefer this structure, because of the certainty about the timing and the quantity of future payments; hence, the term fixed income. There is, however, one important exception for investors in U.S. fixed income. Agency mortgage-backed securities, as well as some asset-backed securities, do not return principal on a fixed date, and though the amount of the coupon payment is fixed, the number of coupons is not. Instead, principal is returned to bondholders as homeowners pay down the principal on their mortgages; and once effectively all of the mortgage principal has been paid off, the coupon payments end as well. As a result, if many homeowners choose to prepay the principal on their mortgages, the cash flows will come faster, and vice versa. Given the uncertainty of these cash flows, mortgage-backed securities are generally considered poor hedging assets for liability-driven investors, but with complexity comes opportunity for return-seeking investors. 2 Corporate Default and Recovery Rates: Moody s Investors Service, February Russell Investments // Structuring a U.S. fixed income portfolio / p 3

4 Benchmark Most return-seeking fixed income allocations are structured around the main investmentgrade fixed income benchmark for U.S. investors, which is the BC U.S. Aggregate Bond Index. The index is typically segmented based on sector, credit quality (default risk) and duration (sensitivity to interest rate changes). Major fixed income sectors can be categorized as follows (with total market capitalization in parentheses): U.S. Treasuries ($9.1 trillion 3 ) Government agency debt ($2.5 trillion 4 ) Agency residential mortgage-backed securities ($6.8 trillion 5 ) Non-agency residential mortgage-backed securities ($896 billion 6 ) Commercial mortgage-backed securities ($749 billion 7 ) Asset-backed securities ($1.3 trillion 8 ) Corporates ($7.6 trillion 9 ) Emerging market debt ($6.2 trillion 10 ) The U.S. government is often assumed to be the highest credit quality borrower, and returns and risks for other instruments are often specified in terms of their spread to U.S. government bonds. The spread is the observed yield premium over U.S. Treasuries that the market demands for taking on a particular issuer s default risk. Recently, there has been heightened concern about the assumption that the U.S. government is the highest-quality borrower. While ideally all issuers would price off of the lowest-risk issuer, this need not be the case. Most likely, if the creditworthiness of the U.S. government were to fall below that of other issuers, those higher-quality borrowers would simply trade at a negative spread to Treasuries, reflecting their lower level of risk. It is highly unlikely that another issuer of higher quality would offer as broad and liquid a yield curve as U.S. Treasuries, which would be required to serve as a better baseline asset. Below you can see the historical duration of the BC U.S. Aggregate Bond Index, which has held reasonably constant at four to five years. The recent increase is likely the result of increased issuance of medium- to long-term Treasuries. 3 Source: SIFMA, 13 June Ibid. 5 Global Securitization Update 2010, SIFMA, July Ibid. 7 Ibid. 8 Ibid. 9 Source: SIFMA, 13 June Source: Goldman Sachs Asset Management. Includes local and hard currency sovereign and corporate debt as of April Russell Investments // Structuring a U.S. fixed income portfolio / p 4

5 Exhibit 4: Modified duration Source: Barclays Capital. December 29, 1989 to December 31, 2010 Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. The Barclays Capital U.S. Aggregate s credit quality and sectors are weighted as follows, in pie charts as of June 2011: Exhibit 5: By credit quality A, 10% Baa, 9% Exhibit 6: By sector U.S. MBS 33% U.S. Treasury 33% Aa, 5% ABS 0% Aaa, 76% Source: Barclays Capital; credit quality ratings are reflective of assessed default risk as determined by an independent ratings agency. Those rating range from Aaa as the highest quality to Baa as the lowest quality within investment-grade bonds. Issues rated below Baa are considered high-yield. CMBS 2% Corporate 20% Source: Barclays Capital. Government -Related 12% Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Russell Investments // Structuring a U.S. fixed income portfolio / p 5

6 Sector weights (%) The below chart also shows the historical sector weights of the Barclays Capital U.S. Aggregate Bond Index over the past ten years. Exhibit 7: Historical annual sector weights of the Barclays Capital U.S. Aggregate Bond Index U.S. Securitized: MBS, ABS, and CMBS U.S. Treasury US Aggregate: Government-Related U.S. Corporate Investment Grade MBS = Mortgage Backed Securities / ABS = Asset Backed Securities / CMBS = Commercial Mortgage Backed Securities Source: Barclays Capital. Data as of December Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. The major trend we observe in recent years is the increasing index weight to U.S. Treasuries. Because the index is weighted by market capitalization of debt outstanding, the U.S. government s large budget deficits and subsequent debt issuance are making Treasuries a larger portion of the index. The problem with passive fixed income While the benchmark provides an excellent measure of trends within the investment-grade U.S. fixed income category, using it as an investment strategy has some disadvantages. In light of these limitations, we discourage investors from implementing their U.S. fixed income allocations through passive replication of the benchmark. The capitalization weighting of the BC U.S. Aggregate Bond Index leads to greater weights for entities that issue more debt. If the idea of investing more capital in issuers that have more debt sounds like a questionable fixed income investment strategy, that s because it probably is. However, this is precisely the strategy passive managers offer. While investors could conceivably choose a different benchmark with a different methodology, such as constant sector-weighted, such indexes have yet to gain much traction in the marketplace, and only a handful of money managers have experience in trying to replicate such indexes. Another strike against passive fixed income strategies is that pure replication of the primary benchmark is impossible; there are approximately 10,000 issues in the index, many of Russell Investments // Structuring a U.S. fixed income portfolio / p 6

7 which do not trade frequently or at a reasonable bid/ask spread. The fixed income market is a largely over-the-counter market for cash bonds. As a result, price transparency and liquidity can vary significantly, based on the nature of the securities traded, the size of the trade and the time period. While most government bonds have proven highly liquid in all environments, structured products and corporate bonds can become significantly less liquid in down markets. While there are better vehicles for passive fixed income, such as large mutual funds, which are not subject to the same intraday liquidity requirements, those vehicles still generate a relevant amount of tracking error due to the intricacies of index replication. Russell believes that if investors are going to incur tracking error risk, they should do so in a manner that is expected to lead to outperformance over a market cycle. Additionally, index inclusion rules can be quite arbitrary. For example, floating rate bonds, 144A corporate bonds (which include many small or non-u.s. companies issuing in dollars), and non-agency mortgages are all excluded from the BC U.S. Aggregate Bond Index, despite presenting characteristics very similar to many bonds that are included in the index. Even agency mortgages were excluded from the dominant benchmark for many years until finally gaining inclusion. Truly passive managers are barred from investing in these assets until they join the index, which creates a structural opportunity for active managers to invest in a broader opportunity set ahead of the index and passive managers. The active opportunity set Fixed income has a relatively high level of active management potential, due to the market s inherent inefficiencies. Varying market liquidity and a diversity of market participants driven by non-total return motive (e.g., liability hedging, capital requirements, tax status, etc.) give an astute active manager an opportunity to add value over passive indexes in a variety of diversifying ways. Common strategies in fixed income include sector rotation, security selection and interest rate management. Russell s experience suggests that security selection and sector rotation tend to be more consistent sources of excess return, as the pricing of interest rates tends to be relatively more efficient. Still, inefficiencies do exist in yield curve pricing, and active strategies that take advantage of this are often highly diversifying to security and sector selection strategies. A common sector rotation strategy would be to sell Treasuries and buy corporate bonds when corporate bond spreads are historically high and expected to fall, or to buy agency mortgages and sell corporate bonds when spreads are tight and interest rate volatility appears to be mispriced. A manager employing a security selection strategy might analyze the fundamental credit metrics of Company A s bonds versus those of Company B and find that Company A is unjustifiably priced lower than Company B, despite its more stable cash flows. In such a case, the manager would purchase the bonds of Company A and sell any Company B holdings. An active interest rate view could be expressed by purchasing long duration bonds in the expectation that interest rates would fall on the long end of the yield curve. The availability of security selection opportunities is clearly demonstrated in the chart below, which depicts the significantly higher degree of dispersion in corporate bond yields, as compared to Treasuries, across bond maturities. This dispersion represents an opportunity for active managers to find mispriced securities, and it supports a strategic overweight to corporate credit to maximize the portfolio impact of those security selections. Russell Investments // Structuring a U.S. fixed income portfolio / p 7

8 Yield to worst (%) Exhibit 8: Yield dispersion Years to maturity U.S. Investment Grade Corporates U.S. Treasuries Source: Barclays Capital. As of 9/30/2010. Data is historical and it not indicative of future results. Constructing an active portfolio Russell has a set of active fixed income beliefs that help inform how we think active portfolios should be constructed. These beliefs can be summarized by five basic tenets. First, a strategic overweight to spread sectors such as corporate bonds, mortgages and asset-backed securities relative to Treasuries should benefit fund performance over time and maximize the security selection capabilities of sub-advising managers. Second, a consistent allocation to BB high yield will allow skilled active managers to take advantage of a persistent market inefficiency. Institutional constraints such as guidelines and capital requirements tend to create a situation wherein BB bonds that are likely to be upgraded to investment grade status stay at the lower BB prices until the formal upgrade occurs. An unconstrained active manager can move into these securities ahead of a ratings upgrade and capture the upward price movement as new buyers become eligible to purchase. Third, Russell believes that sector rotation is an investment strategy through which return-seeking managers can add value by taking advantage of market mispricings and investors with non-return-oriented objectives. Fourth, generating modest leverage through derivatives and enhanced cash positions should be additive to fund performance over time, because it allows managers to capitalize on inefficiencies in the cash market generated by money market guidelines. Russell Investments // Structuring a U.S. fixed income portfolio / p 8

9 And finally, the primary U.S. fixed income index is a slow rabbit that is not fully indicative of the investable universe, which gives active managers an opportunity to invest in return-enhancing off-benchmark securities. Taking these principles into consideration can lead to a portfolio that will look similar to the benchmark with respect to duration and yield curve exposures, but that will typically have a lower credit rating and hold a lower allocation to Treasuries. However, because of Russell s belief in sector rotation as a strategy for adding value, Treasury and non-treasury sector weights may vary widely around benchmark weights, depending on market pricing. Typical sector allocations fall within the following ranges: Treasuries, 10% 50%; Government Agencies, 0% 15%; Investment Grade Corporates, 10% 50%; Residential Mortgage- Backed Securities, 20% 60%; Commercial Mortgage-Backed Securities, 0% 15%; and Asset-Backed Securities, 0% 15%. Also, while the benchmark contains no high yield corporate bonds and only small amounts of emerging market debt, Institutional investors will often maintain allocations of 0% 20% to either sector, depending on risk appetite and the current point in the market cycle. Russell believes that skilled active managers are able to manage this allocation to extended sectors in a way that adds value to client portfolios. In particular, granting such managers the leeway to invest in BB high yield and in higherquality emerging market countries prior to their qualification for index inclusion can give active managers a structural advantage over the index and passive managers. Other active management considerations When allocating to U.S. high yield and emerging market debt, particularly if the allocation is expected to be strategic in nature, investors should consider the makeup of their overall portfolios. As the correlations table below demonstrates, those two sectors have considerably higher correlations to U.S. equities than more traditional fixed income sectors do. Exhibit 9: Correlations from January 1993 through June 2011 Russell 1000 Index U.S. Treasuries U.S. Treasuries U.S. IG Corporates U.S. Investment Grade Corporates U.S. MBS Emerging Market Debt U.S. MBS EMD U.S. High Yield Source: Russell Database and Barclays Capital. Correlations calculated using monthly data. Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. While one could argue that the secular improvement of emerging market fundamentals should lower this correlation over time, it remains elevated compared to investment grade U.S. fixed income. Given the relatively high excess return opportunities available in both U.S. high yield and emerging market debt, institutional investors seeking relatively high strategic allocations to those sectors would likely benefit (through additional excess returns) from hiring dedicated specialists rather than simply asking their broad market fixed income managers to allocate more to the sectors. However, this is not to say that even those clients who hire dedicated extended-sector managers should not allow their broad market managers continued leeway to invest in those off-benchmark investments. Indeed, the flexibility to move in and out of those sectors ahead of market movements can be a powerful tool for adding to client returns. Russell Investments // Structuring a U.S. fixed income portfolio / p 9

10 Liquidity Issues As mentioned above, the fixed income market is a largely OTC market, and the liquidity of that market can vary by sector, security, maturity and market environment, among other factors. Liquidity can generally be observed through the bid/ask spread brokers quote for a given security. While Treasuries have proven highly liquid in all market environments, nonagency mortgages, U.S. high yield corporates and even investment grade corporates have seen liquidity dry up in periods of profound market downturns. Because of the cyclical nature of liquidity in some of these markets, investors with short-term cash needs may want to be cautious with respect to making sizable allocations to certain sectors. At times there may be no bid for certain securities and even securities with tight bid-ask spreads may not trade for days at a time. These issues can serve as a hindrance to passive managers or amateur traders, but experienced, professional traders in these markets may be able to use such variations in market liquidity to their advantage in generating investment returns. For example, when bid-spreads are wide, long-term investors can acquire securities at relatively depressed prices by providing liquidity to forced sellers. Conclusion As an asset class, U.S. fixed income offers a variety of compelling risk and return characteristics that merit considering a substantial allocation in a diversified total return portfolio. Additionally, the cash flow certainty the asset class can provide is particularly useful for liability-hedging institutional investors or those seeking relatively certain cash flows in retirement. While the asset class does offer varying liquidity profiles and some complex structures that may not be desirable for all investors, those shortcomings are key reasons why investors should strongly consider taking an active management approach to fixed income. In an asset class where tracking error versus the benchmark is difficult to avoid even for passive managers, Russell believes investors would be best served to take such risks by implementing active strategies that take advantage of the market s inefficiencies. In the construction of a fixed income portfolio, the BC U.S. Aggregate Bond Index is generally the agreed-upon starting point for duration, quality and sector positioning. Actively managed portfolios, however, can and should have some meaningful differences. In particular, an active manager should have a bias toward holding a higher allocation to lessefficient sectors of the market, such as corporate bonds. The multitude of securities excluded from the index for rather arbitrary reasons despite their similar risk characteristics should be a part of the active manager s opportunity set. Furthermore, the benchmark s market-capitalization approach to weighting securities is not a very appealing passive strategy for bond investing, and an astutely managed active portfolio can sidestep the potential trap of investing more in an issuer simply because it has more debt outstanding rather than because there has been any improvement in underlying fundamentals. The U.S. government is a prime example these days. Finally, many investors will want to consider holding a strategic allocation to extended sectors, such as emerging market debt and U.S. high yield corporates. The excess return potential from these sectors is high relative to most fixed income sectors, so investors seeking higher or more consistent allocations than the 5% 15% typically held by broad market managers should consider hiring dedicated specialists to maximize those return opportunities. Investors should note that high yield and emerging market debt display hybrid performance characteristics of debt and equity, so any decision on how much to allocate to either of these sectors should take into consideration the makeup of the overall portfolio. Russell Investments // Structuring a U.S. fixed income portfolio / p 10

11 Appendix Index Definitions Russell 1000 The Russell 1000 Index measures the performance of the large cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the Russell 3000 Index. Barclays Capital US Aggregate Bond Index The U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. > Barclays Capital US Aggregate Treasuries Index > Barclays Capital US Mortgage Backed Securities (MBS) Index > Barclays Capital US Corp High Yield Index > Barclays Capital US Corp Investment Grade Index > Barclays Capital Municipal Bond Index > Barclays Capital US Emerging Markets Index FTSE EPRA/NAREIT Developed Index (Global) Designed to track the performance of listed real estate companies and REITs worldwide. FTSE NAREIT EQ (U.S.) Includes only U.S. REITs. Russell Global 1000 ex-us The Russell Global 1000 ex-u.s. Index measures the performance of the large cap global equity market excluding the United States. It includes 1,000 of the largest securities based on a combination of their market cap and current index membership. S&P Global Infrastructure Index Provides liquid and tradable exposure to 75 companies from around the world that represent the listed infrastructure universe. To create diversified exposure across the global listed infrastructure market, the index has balanced weights across three distinct infrastructure clusters: Utilities, Transportation and Energy. Dow Jones UBS Commodity TR Index Designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities. Russell Investments // Structuring a U.S. fixed income portfolio / p 11

12 For more information: Call Russell at or visit Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Diversification does not assure a profit and does not protect against loss in declining markets. Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Liability Driven Investment (LDI) strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to; interest rate risk, counter party risk, liquidity risk and leverage risk. Interest rate risk is the possibility of a reduction in the value of a security, especially a bond or swap, resulting from a rise in interest rates. Counter party risk is the risk that either the principal or an unrecognized gain is not paid by the counter party of a security or swap. Liquidity risk is the risk that a security or swap cannot be purchased or sold at the time and amount desired. Leverage is deliberately used by the fund to create a highly interest rate sensitive portfolio. Leverage risk means that the portfolio will lose more in the event of rising interest rates than it would otherwise with a portfolio of physical bonds with similar characteristics. The trademarks, service marks and copyrights related to the Russell indexes and other materials as noted are the property of their respective owners. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: August 2011 (Disclosure revision: December 2014) USI Russell Investments // Structuring a U.S. fixed income portfolio / p 12