Institutional Group Fixed Income for Nonprofits Strategies to consider in a rising rate, low return environment

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1 Institutional Group Fixed Income for Nonprofits Strategies to consider in a rising rate, low return environment Following over 30 years of a secular bull market in bonds, the recent sharp rise in interest rates has many investors questioning their fixed income strategies. The suggestion in late Spring 2013 that the Federal Reserve may begin to taper its purchases of Treasury and agency mortgage-backed securities triggered a rise in intermediate Treasury yields of over 100 basis points in six short weeks, and has been accompanied by massive liquidations of fixed income mutual holdings, particularly in the municipal bond, high yield and emerging market debt markets. These liquidations have served to drive yield spreads wider in most non-government sectors, leaving little room for profit in any fixed income sector. With these dramatic shifts in market sentiment, now is a good time for nonprofit organizations to assess fixed income strategies for their portfolios. Any discussion of investment strategy must first start with an assessment of the investor s objectives. Foundations investment policies are typically focused on several objectives, including income and return generation to meet short-term annual spending and operating needs, as well as preserving the long-term purchasing power of the corpus for future beneficiaries and assuring the viability of the foundation s purpose. The fixed income asset class may be used in different ways to help achieve these objectives. Exhibits 1, 2 and 3 show various recent allocation studies representing not only the well-publicized university endowment segment, but also private foundations and community foundations. Allocations to fixed income in many nonprofits portfolios have steadily decreased over the past decade, as the outlook for bonds was presumed gloomy and hedge funds became an alternative way to get the low correlation benefit bonds brought to the investing table. SEI has seen similar movement with its crosssection of institutional nonprofit clients as well, and more recently has been advising those with larger allocations to core/intermediate strategies to consider diversifying some of the duration risk in exchange for other opportunities in the fixed income space. Exhibit 1: College & University Endowments 2012 Asset Allocation by Size Allocation ALL Over $1B $501M - $1B $101M - $500M $51M - $100M $25M - $50M Domestic equities 15% 12% 18% 25% 31% 35% Fixed income 11% 9% 12% 16% 22% 24% International equities 16% 15% 17% 18% 18% 16% Alternatives 54% 61% 48% 36% 24% 19% Cash/Other 4% 3% 5% 5% 5% 6% Source: 2012 NACUBO-Commonfund Study of Endowments 2013 SEI 1

2 Interesting to note in Exhibit 1 is the spread between the largest and smallest endowments, ranging 9-24 percent in fixed income. Access to less liquid alternatives tends to be more limited and expensive for smaller investors, thus the higher allocation to fixed income for smaller asset pools. The following table, focusing exclusively on private foundations with less than $50 million in assets, shows similar fixed income allocations in the low 20-percent range as the smaller university endowments in Exhibit 1. Exhibit 2: Private Foundations 2012 Asset Allocation by Size Allocation ALL $10M-$50M $1M-$10M Under $1 M Equity 44% 41% 46% 50% Fixed Income 22% 23% 21% 23% Other 18% 23% 14% 8% Cash 16% 13% 19% 19% Source: 2013 Foundation Source Annual Report on Private Foundations Exhibit 3 reports on community foundations where the fixed income allocation range seems to be less disparate; even the over $500 million portfolio size allocates 20 percent to fixed income. Community foundations might have less predictable cash inflows, therefore higher liquidity needs, which might be the reason behind relatively lower allocations to alternatives. They might instead put more of their diversification bucket into the risk management benefits of fixed income. Exhibit 3: Community Foundations 2013 Asset Allocation by Size* Allocation Over $500M $250M - $499M $100M - $250M $50M - $99M $25M - $49M US Large Cap Equity 28% 26% 25% 30% 30% US Mid Cap Equity 5% 2% 5% 3% 4% US Small Cap Equity 4% 7% 7% 6% 5% Total US Equity 37% 34% 36% 39% 39% Non-US Large/Mid Cap Equity 15% 12% 15% 14% 13% Non-US Small Cap Equity 0% 1% 2% 2% 2% Emerging Markets Equity 5% 6% 5% 5% 4% Total Non-US Equity 20% 18% 22% 22% 19% Total Equities 57% 52% 58% 61% 57% Domestic Fixed Income 15% 14% 14% 14% 20% High Yield Fixed Income 2% 2% 2% 3% 1% International Fixed Income 3% 3% 3% 3% 2% Total Fixed Income 20% 18% 19% 19% 23% Total Alternatives 21% 28% 21% 17% 17% Total Cash/Equivalents 2% 2% 2% 3% 3% Total 100% 100% 100% 100% 100% n = 11 n = 14 n = 23 n = 23 n = 24 *As of March 31, 2013 Source: Council on Foundations 2013 Annual Community Foundation Survey The risk management benefit of diversification is historically one of the primary roles of fixed income in investor portfolios. In fact, this is a cornerstone of Modern Portfolio Theory. Providing a negative correlation with equities is the premier objective of fixed income allocations in balanced portfolios. However, in looking at various subsectors of fixed income, certain sectors are more effective at providing this benefit than others. Many fixed income sectors actually have high levels of equity beta and are rather ineffective at providing diversification benefits. Exhibit 4 provides correlations of various fixed income subsectors based on a 25-year history ended September 30, SEI 2

3 Exhibit 4: 25-Year Correlation of Absolute Returns for Fixed Income Subsectors* Correlation of absolute returns Barclays Aggregate Treasury TIPS Corporates MBS Emerging Markets Debt High Yield Bank Loans S&P *As of September 30, 2013 EMD data starts 3/31/1994; TIPS data starts 12/31/03 Sources: Barclays Capital U.S. Aggregate Bond Index and underlying components, BofA, JPMorgan EMBI Global Diversified Index, Barclays Capital HY Index, Barclays Capital Bank Loan Index Not surprisingly, some of the riskier sectors of the bond market actually contain positive correlations with equity markets, as measured by the S&P 500. Corporate bonds intuitively are often as dependant on corporate operating performance as equities, particularly lower quality bonds. Over this time, longerduration, higher-quality bonds provided the best diversification benefits, as these assets are often a safe haven when equities are under duress. It is important to point out that investment grade securities, in general, as evidenced by the Barclays Aggregate Index, also provided a meaningful diversification benefit, albeit not as powerful as a portfolio that is exclusively Treasuries. When implementing fixed income strategies that are designed to provide diversification benefits, investors should be careful not to introduce too much equity beta. Many active fixed income strategies managed against the Barclays Aggregate Index often include non-benchmark exposures, such as high yield and emerging market debt to enhance the return pattern relative to the benchmark. Such strategies fell short of their primary purpose during the financial crisis of 2008 as the non-government sectors massively underperformed Treasury securities. When designing and implementing such strategies, investors should be careful to properly limit the use of more aggressive sectors. The proper limit will of course depend on the overall beta risk embedded in the total foundation portfolio and the risk tolerance of the governing fiduciaries. Investors that use fixed income as a source of portfolio diversification and risk management should always maintain some exposure to intermediate and possibly longer duration investment grade securities, despite their views on interest rate direction or opportunities in lower quality bonds. Inflation-Protected Treasuries (TIPS) also fall into this category and have the dual benefit of inflation protection, albeit sometimes for a premium, which will be discussed in more detail later in this paper. The following provides an overview of different fixed income strategies, and how to use them in a continued low rate environment. Income Generation An obvious benefit of fixed income securities is the income component of the total return provided by the instruments coupon. The interest rate provided to the investor is typically compensation for interest rate risk, credit risk or structure risk inherent in the bond. Additionally, investors should be paid a liquidity premium for less liquid instruments. Fixed income strategies are often quite effective in allowing investors to target an income objective for their portfolio, particularly in trying to meet predefined liabilities, such as a foundation s annual spending objectives. One strategy, for example, would be to immunize annual spending from market fluctuations by utilizing a laddered bond portfolio that staggers the maturities based on pre-determined cash flow needs. It is important to quantify the return and risk impact this might have on the total portfolio, somewhat dependent on market expectations. Specific income generation may also be a requirement for those restricted endowments where donors have stipulated that only income earned on their donation can be spent year to year. The interest-bearing feature of bonds tends to dampen their price volatility, as the investor s total return is made somewhat more certain by the securities coupon. In Exhibit 5, the components of total return in the fixed income market are broken out over more than 13 years. In 13 of the 14 time periods, the coupon of the bond generates more of the total return than the price change, although the absolute amount of the coupon is trending lower following in the path of interest rates SEI 3

4 Exhibit 5: Return Components of Fixed Income Source: Barclays Capital U.S. Aggregate Bond Index In designing income-oriented strategies, investors must be careful to gauge their tolerance for interest rate risk, credit risk and structure risk. Higher levels of income are typically accompanied by higher levels of volatility commensurate with these risks. For example, yield premiums in the corporate bond market move relative to the market s expectations about default risk. Recessionary periods are often accompanied by wider yield spreads, implying underperformance of corporate bond holdings. Similarly, in the structured products markets (e.g., agency mortgage-backed securities and asset-backed securities), yield spreads move relative to the market s interest rate volatility. High volatility tends to make the cash flow of structured securities less certain, requiring a higher yield spread. Changing allocations to the corporate and mortgage sectors in the pursuit of yield should be done with consideration of the yield premiums received relative to the fundamentals of credit quality and volatility of the underlying assets. Astute active managers can add value to this judicious process. Absolute Return Many investors will actively shift their fixed income strategies to optimize the absolute return of their portfolio. This often involves adjusting the portfolio duration in anticipation of a movement in interest rates, pursuing higher levels of income and price appreciation by going down in credit quality or pursuing opportunities outside the U.S. in global bonds and emerging market debt. Using fixed income in this fashion is in direct contrast with strategies that seek to acquire diversification benefits and often require a specific view of the strategy being pursued. Since many of these strategies have higher correlations with equities, they may result in higher levels of volatility of the total portfolio and an erosion of the Sharpe ratio, which is a measurement of risk-adjusted return. The exception, of course would be if a piece of the equity allocation is exchanged for these beta-sensitive fixed income classes, which does have the benefit of diversifying return sources out of equities with generally less volatility. In today s environment, many investors are questioning holding bonds at all with interest rates so low, and are considering shortening the duration of the bond portfolio to achieve better absolute returns as interest rates rise. While the diversification benefits of a traditional core fixed income strategy can be an expensive insurance policy against a flight to quality, shortening duration represents a significant shift in the overall risk/return profile of the entire portfolio and the necessity of being right about the interest rate view is essential. When considering an absolute return strategy with a fixed income allocation, it is more appropriate to consider the return prospects against all asset classes, not just fixed income. There has been a growth in popularity of unconstrained bond funds in the last several years that seek to offer the manager greater flexibility to adjust interest rate risk and sector exposure. While these funds offer some strategic 2013 SEI 4

5 appeal, they will often have higher levels of volatility in their return pattern and may not be relied upon to achieve the requisite diversification benefits. Their success is contingent on the manager s tactical strategies being correct consistently, something that is not easily achieved even by the best professional investors. Pursuit of absolute return in fixed income must be done with complete awareness of the sacrifices that might be made at the expense of loss of diversification benefits. Fixed income strategies employed by hedge funds are often a common way to enhance the absolute return of a portfolio and doing so in a way that has low correlations with the equity market. These strategies include levering opportunities in the mortgage and corporate markets, including distressed debt, implementing long/short credit strategies, and global macro strategies that may also involve management of currency exposures. These can be effective ways to find favorable absolute return that is not correlated to equity market returns or interest rate directions. However, they will generally not react the same way as Treasuries when there is a flight to quality, so one risk question Investment Committees should answer is how much flight to quality insurance their portfolio needs. Deflation Hedge The best way to hedge against the rare event of deflation is to own intermediate or long duration, noncallable, liquid fixed income instruments. The asset class that best fits this description is U.S. Treasury securities, as a significant component of the level of interest rates is the market s expectation for inflation. Accordingly, disinflation and, more profoundly, deflation, are typically accompanied by falling interest rates, which enhance the return of fixed income assets. Deflationary environments are typically coupled with extremely sluggish economic conditions, if not recessions or depressions. Corporate entities typically underperform in these environments, and with limited pricing power, their cash flow generation critical to debt service is impaired. Default risks increase and corporate bond performance lags the broader fixed income market, particularly in below investment grade sectors. Similarly, mortgage-backed securities also underperform in such environments as lower interest rates allow borrowers to exercise their call option and refinance their mortgages, causing mortgage securities to underperform the broad market. This leaves Treasury securities as the premier asset class within the fixed income markets in a deflationary environment. Treasuries have the additional benefit of being highly liquid instruments. This is a characteristic that is highly valued during weak economic conditions that typically accompany a deflationary environment. While Treasury securities offer the purest form of deflationary protection, investment grade fixed income securities, broadly speaking, can also serve to achieve this objective. Most fixed income strategies that are managed relative to the Barclays Aggregate Index can provide some measure of deflationary protection. Such portfolios should limit their lower quality corporate bond exposure in implementing the strategy. The deflationary hedge value that investment grade fixed income offers is critical to hedging non-fixed income exposures, such as equities, that typically underperform in such environments. This vitally important characteristic is related to the diversification benefits discussed below. Inflation Hedge Many investors, particularly foundations, purchase TIPS or other similarly structured inflation-linked securities as protection against a rise in the inflation rate while also maintaining the flight-to-quality insurance embedded in Treasury bonds. While this strategy can help to minimize the erosion of purchasing power of a portfolio, the inflation linked return is only part of the return component of these securities. They also carry a fixed rate coupon, which reflects the prevailing real interest rate (i.e., net of inflation) at the time of their issue. Like all other fixed rate bonds, these securities have interest rate duration that is correlated to changes in real rates. If real interest rates rise, as they often do during economic expansions, prices of TIPS will drop accordingly. The inflation-linked component of return will reduce the securities price volatility as it relates to interest rate changes that are driven by changes in 2013 SEI 5

6 the inflation rate, but they will remain vulnerable to changes in the real rate. The rise in real rates during the summer of 2013 left many investors bewildered at the substantial negative returns in this sector. This serves to highlight that while they may offer some inflation protection, other risks inherent in the asset class must be considered. These risks are highlighted in Exhibit 6, which captures the historical return components of TIPS as broken down by their inflation adjustment, coupon payment and price return caused by changes in real rates. As you can see, the inflation component has been only a limited part of the return pattern. Exhibit 6: 10-Year On-the-Run TIPS Sources: 10-Year On-the-Run TIPS, Bloomberg, Western Asset Management The ideal economic condition for inflation-linked securities is a stag-flation environment. The CPI component of return will rise with higher inflation, while real rates may fall consistent with the sluggish economic conditions. Conversely, strong growth with lower inflation is the least attractive environment for these instruments. In the late 1990s, when the economy exhibited this pattern, real interest rates were over four percent and did not fall until the economy began to slow with the bursting of the technology bubble. A more complete strategy for protecting against inflation should also involve exposures to commodities, real estate and inflation-sensitive equities, among other asset classes. This should be done in the context of broader asset allocation considerations that would be beyond the scope of this paper. Conclusion One final observation worth making is that it is quite common, and appropriate, to mix several of these objectives into the overall fixed income strategy. For example, if the primary objective of fixed income is to provide some diversification benefit to a portfolio s riskier asset classes, then a range of allocations to the Treasury or Barclays Aggregate-based portfolio would make the most sense. This may come at some income or total return concession to other asset classes. To enhance the return of the fixed income allocation and diversify return sources to the overall portfolio, it may be appropriate to add some marginal exposure to high yield or emerging market debt strategies. When doing so, the investor must be able to monitor the potential impact on volatility of the overall portfolio. In conclusion, there is a place for fixed income in a foundation s portfolio, even in a rising interest rate environment. As discussed, there are several risk management benefits of bonds that have low and negative correlations to equities, especially in the Treasury sector that should offset some of a portfolio s decline in a flight to quality scenario. Fixed income return also has a significant income component, which reduces the price volatility of a bond and can qualify for spending use in restricted endowments. There are also absolute return considerations to make when diversifying among various fixed income asset classes. High yield, global and emerging market debt, and some hedge fund strategies, allow investors to diversify their sources of return both outside their equity allocation and within their fixed income allocation. And finally, fixed income is an effective way to hedge inflation risk 2013 SEI 6

7 (e.g., TIPS) and deflation risk (e.g., long duration Treasuries) depending on the outlook for such environments and how much of a hedge is deemed desirable. Understanding the return components of TIPS is especially critical since they are not only driven by price and coupon components but also real rates and market s expectations for inflation. Navigating the right allocations to the various sub-asset classes in fixed income should be a joint effort between the governing body of the asset pool and its investment advisor. For fiduciaries to be effective, it is critical that they are able to assess the impact of the risk management tools employed each time a strategy is being considered for implementation. For investment advisors to be effective, it is critical that they have a thorough understanding of the return objectives, risk tolerance and cash flow needs of their foundation clients. The Nonprofit Management Research Panel, sponsored by SEI s Institutional Group, conducts industry research in an effort to provide members with current best practices and strategies for the investment management of nonprofit foundations and endowments. For comments or questions, please contact SEI at SEIresearch@seic.com or This information is provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company. The material included herein is based on the views of SIMC. Statements that are not factual in nature, including opinions, projections and estimates, assume certain economic conditions and industry developments and constitute only current opinions that are subject to change without notice. Nothing herein is intended to be a forecast of future events, or a guarantee of future results. This presentation should not be relied upon by the reader as research or investment advice (unless SIMC has otherwise separately entered into a written agreement for the provision of investment advice). There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. There is no assurance the goals of the strategies discussed will be met. Bonds and bond funds will decrease in value as interest rates rise. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds. Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results SEI 7