Unconstrained fixed income may offer a compelling solution for today s bond market challenges
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- Prosper King
- 8 years ago
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1 INVESTMENT OPPORTUNITIES The market direction and your portfolio Unconstrained fixed income may offer a compelling solution for today s bond market challenges Why now? n Elevated risks and prolonged dismal yields continue to plague conventional bond investors. n Treasurys may not offer the safe haven they have in the past especially if interest rates start to rise. n Professionally managed fixed income strategies that take an unconstrained, flexible approach to finding the current strongest bond opportunities may help allocate duration, sector and credit risk more effectively, seeking to enhance returns and better manage capital across full market cycles. There is no assurance the stated objectives will be met. Summary Investors today find themselves in an unusual quandary. Historically, they have thought of fixed income investments as a relative safe haven to offset more volatile and risky investments in other parts of their portfolios, including equities. The risk of capital loss in bond portfolios was generally viewed as limited. That premise no longer holds. After decades of falling interest rates and the past several years of unprecedented global monetary intervention, investors in conventional bond strategies are becoming increasingly concerned about potential losses if interest rates rise. They are reconsidering the role of fixed income as a return seeking component of an asset allocation, and are seeking strategies that avoid uncompensated risk. We believe that unconstrained fixed income strategies are a potential answer to these concerns. Unconstrained approaches are able to allocate capital and adjust their risk exposures dynamically, across the fixed income spectrum, with fewer constraints. Figure 1: How much more upside left for interest-rate sensitive securities? 16 Percent year U.S. Treasury yield Through April 30, Source: Bloomberg. Past performance is no guarantee of future results, which will vary. Treasurys are backed by the full faith and credit of the U.S. government with respect to the timely payment of principal and interest.
2 The trouble with treasurys Fixed income returns are made up of compensation for taking interest rate exposure (duration and convexity) essentially the yield on government bonds and compensation for taking exposure to credit risk, in the form of credit spreads. Historically, most bond investors have used a broad market index as their portfolio benchmark. These indices are usually dominated by high-quality assets: government and government-related bonds, asset backed securities, and investment grade corporate debt. What these assets have in common is that they are all highly interest rate sensitive. (For example, Treasurys are essentially pure duration, and even investment grade corporate bonds are relatively sensitive to interest rates.) This duration-sensitivity used to be a good thing for index investors. They participated in a phenomenal 30-year rally as interest rates declined from double digits in the early 1980s to the record lows of recent years (Figure 1). Since the 2008/09 financial crisis, markets have been driven by massive liquidity injections by central banks, with bond purchase programs driving down the yields of government and other high-quality bonds. The trouble now is that yields don t have much further to fall. In the current environment, the risks and opportunities have changed, and investors have to look beyond interest rate exposure for their returns. The investment landscape has changed The risk/return trade off offered by duration-sensitive assets has changed. The most obvious aspect is the scarcity of yield as falling coupon rates have made things increasingly difficult for income investors. More fundamentally, the whole concept of high-grade bonds as safe haven assets is being called into question. In the past, investors have been well compensated for taking interest rate risk, not just in the form of income, but also as yields fell, in the form of capital appreciation. For 30 years, investors were commonly advised to have 40% of their portfolio in bonds because these were negatively correlated to equities and provided ballast in times of stock market upheaval. And, historically, Treasurys have been an effective safe haven. Most recently, they massively outperformed equities when risk aversion spiked during the Lehman Brothers collapse in However, Treasurys usefulness as a diversifier rests on their potential to appreciate and, given today s low level of yields, that potential is now severely limited, irrespective of whether risk aversion increases. It s not safe to assume that the periods of strong negative correlation with equities we ve seen in the past will be repeated in the future. (For example, the correlation between U.S. Treasury prices and the S&P 500 was positive for much of 2014 as both Treasury prices and equity prices rose.) Figure 2: Barclays U.S. Aggregate Bond Index historical price return, income and total return Price return Coupon income Total return 10 Percent 5 0 (5) (10) Through December 31, Source: Barclays. Past performance is no guarantee of future results, which will vary. The Barclays U.S. Aggregate Bond Index is a broad-based index that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities, with maturities of at least one year. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index. 2
3 One way to think about the risk/return trade off is breakeven levels: How much of an increase in interest rates would it take for bond investors to suffer a loss? For example, in 1999, rates rose dramatically, and bond prices fell by more than 7%, but coupon income was high enough to absorb most of that, and the total return on the Barclays U.S. Aggregate Bond Index fell by just -0.83% (Figure 2). Today, that layer of insulation is awfully thin. At the end of April 2015, the average yield on the index was only 2.1% less than half of what it was at the start of At those levels, yields would only need to rise 0.4% before the Barclays Aggregate would start to suffer a loss. A different landscape calls for a different approach Concern about rising rates and a desire to manage downside risk are fueling investors interest in unconstrained bond strategies. As the name suggests, unconstrained is a go-anywhere approach that gives managers the flexibility to allocate capital more efficiently, taking the risks that they believe offer the best compensation at different stages in the economic cycle. They are able to invest in a broad global opportunity set spanning sectors, such as emerging markets and high yield corporates as well as investment grade securities. They are not tied to a traditional benchmark, so they can choose how much interest rate exposure they take. Foreign securities may be subject to greater risks than U.S. investments, while high-yield securities ( junk bonds ) are also generally considered speculative because they present a greater risk of loss than higher-quality debt securities. To varying degrees, they typically also use hedging instruments and short positions to manage risk. The use of short selling could result in increased volatility of returns. History has shown that no single fixed income sector performs well in every environment, so increased flexibility and a dynamic approach can provide the potential for enhancing returns. For example, if the economy is moving into an expansion phase, credit-risk driven securities, such as high yield corporate bonds, have historically tended to outperform Treasurys. Conversely, if the economy is heading into a slump or risk appetite is falling, managers might choose to reduce their credit exposure and take on more duration. The 2008/09 financial crisis is a good example: Duration assets outperformed credit during the crisis, then credit sharply outperformed Treasurys in the recovery. Some market participants argue that unconstrained investing is simply about replacing interest rate risk with credit risk. But the reality is much more nuanced. The Global Fixed Income Team at MacKay Shields believes that unconstrained investing is more accurately described as an approach that takes risks the manager believes offers the best compensation during a given stage of the long-term market cycle. The landscape is a moving target; duration is of great concern in the current environment, and investors are better compensated for credit risk. So today, many unconstrained portfolios hold more credit than duration. (For example, we think high yield bonds Figure 3: Central Bank Policy and Stages of the Economic Cycle BUY RISK SELL RISK Real Gross Domestic Product (GDP) Trough Expansion Peak Contraction Central Bank Policy n Central bank loosening n Interest rates low n Credit spreads wide n Central Bank on hold/tightening n Interest rates rising n Credit spreads tightening n Central bank on hold/ loosening n Interest rates high but falling n Credit spreads tight but widening n Central bank loosening n Interest rates falling n Credit spreads widening This graphic is for illustrative purposes only. It represents a stylized economic cycle and does not represent the GDP growth of any given year. All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. Source: MacKay Shields 3
4 currently continue to offer an attractive risk/return trade off.) But the opposite is likely to happen at some point down the road. A key objective of unconstrained managers is to correctly identify shifts in the landscape and adjust the portfolio accordingly, and flexible mandates allow them to do so. Implementing an unconstrained strategy A go-anywhere strategy seeks to identify the prevailing risks and return opportunities during any given stage of the economic and market cycles. This includes having a strategy in place for when tail events occur those rare but extreme market shocks that result in outsized losses, as happened in 2008/09. The leaders of our Global Fixed Income Team have worked together for more than 20 years. Based on their experience over several market cycles, they believe the best way to implement an unconstrained strategy is to integrate a rigorous fundamental bottom-up investment approach with a topdown macroeconomic overlay. As part of the top-down element of our investment process, we analyze the economic underpinnings of the market s risk cycle. This takes into account the stages of the economic cycle, and the impact of monetary policy on the capital markets (Figure 3, prior page). Central bank monetary policy action is the single largest contributor to credit availability and an important driver of the inflection points in the market cycle. Our macroeconomic analysis enables us to identify credit excesses and cross sector developments more clearly, allowing us to reposition our portfolios in anticipation of cyclical turning points. The bottom-up component of our investment process continuously feeds into the macro analysis to help identify significant changes in financial market conditions, economic developments, and areas of credit excess. Thus, the primary sources of value added (and overall portfolio performance) are asset allocation across credit sectors and security selection within those sectors. Maneuverability is also important to flexible investment approaches, and in this respect, we d argue that smaller funds have a potential advantage. Large volumes of money have been put to work in the non-traditional space in recent years (according to Morningstar, that bond category received inflows of more than $76 billion in the two years from 2013 to 2014), and fund sizes are growing. Against this backdrop, we think the largest funds may not be as nimble as before, for example, when liquidating positions and switching into new exposures. There can be no assurance that investment objectives will be met. Conclusion We believe in today s environment, investors can t afford to be passive about interest rate risk. The fall in yields that made the traditional benchmark approach successful for 30 years is now in its late stages. The unprecedented liquidity, pumped into the markets by central banks in response to the credit crisis, has kept interest rates extraordinarily low, but sooner or later they are likely to rise. From now on, managers will have to choose their exposures more carefully, and they need the freedom to express their best research ideas across a broad spectrum of fixed income sectors. We therefore believe that for many types of investors, an unconstrained strategy can play a powerful role as an extension of traditional bond management. The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all MacKay Shields Portfolio Management Teams. Any forward looking statements speak only as of the date they are made, and MacKay Shields LLC assumes no duty and does not undertake to update forward looking statements. 4
5 MacKay Shields Global Fixed Income Team Credit specialists focused on risk management The Global Fixed Income Team at MacKay Shields LLC is an integrated team of credit specialists who have worked together for over 20 years and have been shorting fixedincome securities since The team s working knowledge of the government gives them a distinct advantage, since government policies that control the supply of money and interest rates greatly influence the valuation of fixed income assets. Dan Roberts, PhD Chief Investment Officer Executive Managing Director 36 years of industry experience Michael Kimble, CFA Senior Portfolio Manager 31 years of industry experience Dan Roberts heads the team and has primary responsibility for the oversight and asset allocation of the strategy. Dan is uniquely qualified, having held meaningful positions at the U.S. Securities and Exchange Commission, and serving at The White House with the President s Council of Economic Advisors and as Executive Director (Chief of Staff) of the U.S. Congress Joint Economic Committee. Working closely with Dr. Roberts are Senior Managing Directors, Michael Kimble, Taylor Wagenseil, and Louis Cohen, who bring their specific credit analysis expertise to bear on the unconstrained strategies. Taylor Wagenseil Senior Portfolio Manager 36 years of industry experience Louis Cohen, CFA Senior Portfolio Manager 37 years of industry experience 5
6 Multi-Boutique Investments Long-Term Perspective Thought Leadership Before you invest High-yield securities ( junk bonds ) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility. Foreign securities may be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. These risks are likely to be greater for emerging markets. If a security sold short increases in price, the Fund may have to cover its short position at a higher price than the short sale price, resulting in a loss. Because the Fund s loss on a short sale arises from increases in the value of the security sold short, such loss is theoretically unlimited. When borrowing a security for delivery to a buyer, the Fund also may be required to pay a premium and other transaction costs, which would increase the cost of the security sold short. By investing the proceeds received from selling securities short, the Fund is employing a form of leverage. The use of leverage may increase the Fund s exposure to long equity positions and make any change in the Fund s NAV greater than it would be without the use of leverage. This could result in increased volatility of returns. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to economic changes. The Fund may invest in derivatives, which may increase the volatility of the Fund s net asset value. The principal risk of mortgage dollar rolls is that the security the Fund receives at the end of the transaction may be worth less than the security the Fund sold to the same counterparty at the beginning of the transaction. The principal risk of mortgage-related and asset-backed securities is that underlying debt may be prepaid ahead of schedule, if interest rates fall, thereby reducing the value of the Fund s investment. If interest rates rise, less of the debt may be prepaid, and the Fund may lose money. Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. Unconstrained bond funds generally charge higher fees than standard core bond funds. The Barclays U.S. Aggregate Bond index is a broad-based index that measures the investment-grade, U.S. dollar-denominated, fixed rate taxable bond market, including Treasurys, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities, with maturities of at least one year. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index. There can be no assurance that investment objectives will be met. An investment cannot be made directly into an index. Duration is a measure of a fund s interest rate sensitivity. Longer duration = greater sensitivity to rate movements. For more information about MainStay Funds, call 800-MAINSTAY ( ) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing. For more information , option 1 mainstayinvestments.com/dcio MainStay Investments is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 169 Lackawanna Avenue, Parsippany, NJ MacKay Shields LLC is an affiliate of New York Life Investment Management LLC. MainStay Investments is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 169 Lackawanna Avenue, Parsippany, NJ 07054, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC. Not FDIC/NCUA Insured Not a Deposit May Lose Value No Bank Guarantee Not Insured by Any Government Agency MS38p-05/15
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