Essentials of Fixed Income State Universities Retirement System April 2010
(This page left blank intentionally)
Benefits of Fixed Income Main reasons to invest in fixed income: Diversification Return potential Anchor to windward Hedge known liabilities Hedge inflation
Fixed Income Opportunity Set Global Fixed Income Investable Opportunity Set As of 12/31/2009 Emerging Market Debt 6% High Yield Bonds 2% Mortgage-Related 39% Government 37% All Other Bonds 42% Dollar Bonds 50% Asset-Backed <1% Credit 24% Total Global Fixed Income Opportunity Set $56.9 trillion Barclays Capital Aggregate Bond Index 22% of Global Opportunity Set $12.3 trillion Source: UBS Global Asset Management, Venture Economics, EnnisKnupp, Barclays Capital
Definitions High Yield Bonds: Often called junk bonds, issues that are not rated investment-grade (credit ratings of BB/Ba and below). Dollar Bonds: A bond denominated in U.S. dollars regardless of where the issuer is domiciled. Emerging Market Debt: Bonds issued by less-developed countries. Government Bonds: Bonds issued by the U.S. Treasury and government agencies. Credit: Often called corporate bonds; debt issued by corporations. Asset Backed: Bonds or notes backed by financial assets. Mortgage Related: Bonds secured by a mortgage or a collection of mortgages.
Factors to Consider The BC Aggregate Bond Index omits many segments of the investable fixed income universe High yield bonds, bank loans, emerging market debt, non-agency mortgages, floating-rate bonds, derivatives, and non-dollar-denominated issues are not included in the Index. Active fixed income managers seek to add value by managing the following risk exposures: Duration Yield Curve Sector Allocation Security Selection Plus Sectors
Factors to Consider Duration is a critical concept in understanding how fixed income instruments perform. Duration is an estimate of the sensitivity of a bond s price to changes in the level of interest rates. A bond s price is expected to change by the following expression: (-1) x (Duration) x (Change in interest rates) For example, if a bond has a duration of 5.0 years and interest rates increase by 50 basis points (0.5%), its expected percentage price change is: (-1) x (5.0) x (0.005) = -2.5%. If a bond has a duration of 4.0 years and interest rates decrease by 25 basis points (0.25%), its expected percentage price change is: (-1) x (4.0) x (-0.0025) = +1.0%
Factors to Consider Many factors impact a bond s duration Coupon Payments All else equal, a zero-coupon bond has higher duration than a coupon-bearing instrument Coupon Rate Yield The lower the coupon rate of the bond, the higher the duration The lower the yield of a bond, the higher the duration Maturity The longer until maturity of a bond, the higher the duration
Active versus Passive Benefits of Active Management Potential for Higher Returns Increased Diversification Connected to the Market Utilized by Peers Benefits of Passive Management Broad Diversification Style Reliability Performance Reliability Cost Reduction Minimal Review Liquidity
What is the Right Active/Passive Mix? The right active/passive mix varies greatly by investor. The allocation decision is typically based upon: Theoretical arguments and market efficiency Confidence in active management, which is typically informed by the institution s historical experience Success rates of active management Willingness to allocate time resources for the identification, selection, and evaluation of active investment managers Liquidity needs Desire for exposure to Treasury securities
Index versus Active Managers BC Aggregate Bond Index Universe Rank We observe that the BC Aggregate Bond Index has ranked in either the top or bottom quartile of the Core Plus universe in the last six out of seven years This can be interpreted that active managers have had the opportunity to either outperform or underperform materially 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Trailing 3 Years Trailing 5 Years Trailing 10 Years (1= best, 99= worst ) 33 48 24 94 86 75 88 25 12 99 56 63 81
Core Mandate Defined Core fixed income investing refers to a more conservative investment approach, treating the portfolio as a risk reduction vehicle (a hedging portfolio) that seeks a lower expected excess return than a total return portfolio Non-benchmark positions tend to be small and limited to a specific sector in which the manager demonstrates skill General traits of core mandates: Managers invest primarily in cash bonds Fees are lower relative to core-plus mandates Tend to have more modest sector bets ; lower tracking error
Core Plus Mandate Defined Core plus managers will invest not only in the five bond market segments included in the Aggregate Bond Index, but also in other types of fixed income instruments including high yield bonds, bank loans, non-dollar denominated debt, emerging market debt, and/or other "opportunistic" investments Core plus fixed income managers will likely have portfolios that look significantly different from the Aggregate Bond Index Core plus managers are typically described as having higher return potential than core managers, and increased diversification levels General traits of core plus mandates: More prevalent for managers to invest in derivatives Fees are higher relative to core mandates Tend to have larger sector bets ; higher tracking error
Core versus Core Plus Benefits of Core Managers Low levels of active risk Higher quality bias Benefits of Core Plus Managers Ability to access non-index sectors (current non-index sectors and potential new securities) Higher absolute return expectations Better diversification afforded by low correlations of extended fixed income sectors (but not always the case, as experienced in 2008) Most common industry practice in fixed income management Better potential for excess returns, more diverse sources of alpha