constructing a growth fixed income portfolio...the opportunities for fixed income managers with a...
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CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIOMAY 2013
Context
Currently developed market sovereign bonds are not appealing from an investment perspective. they offer negative or low real returns and are exposed to the risk of central bank policy reversal. In addition, nominal bonds are exposed to the risk of rising inflation expectations if unconventional policy continues.
Sovereign bonds continue to have a role to play in controlling asset-liability risk for some investors. Inflation-linked bonds may continue to have some appeal given their inflation protection characteristics.
over the last few years many investors have built allocations to non-government fixed income, as a means of broadening out their growth asset exposure. Such investors have generally focused on investment grade credit and some parts of the securitised markets (such as mortgage securities). others have also invested in newer opportunities such as government debt issued by developing countries (emerging market debt)
the fixed income opportunity set continues to evolve and grow. Investors are getting more comfortable with exposures to non-investment grade multi-asset credit. this paper focuses on the role of fixed income to generate wealth (as opposed to preserve wealth or to hedge liabilities). As such the rest of the paper does not focus on developed market sovereign bonds, nor on investment grade credit (as they are deemed to be part of an investor’s liability hedging portfolio or defensive portfolio).
We note that this paper is written primarily from the perspective of an investor based in the developed world.
ConStRUCtInG A GRoWtH FIxeD InCoMe PoRtFoLIo
tHe oPPoRtUnIty Set
the growth fixed income opportunity consists of the following (sub) asset classes:
Emerging market debt: Investing in the sovereign debt of emerging markets. this can be debt issued in local currency or (typically) in US dollars. the risk premium available to investors is the compensation for being exposed to credit and currency (for debt denominated in local currency) risks. Local currency debt also has realistic prospects of currency appreciation (many of these countries are expected to have capital inflows related to their growth which should result in their currencies appreciating over time) and also some structural real yield advantage (“positive carry” in the jargon).
High yield bonds: Investing in debt issued by companies which are below investment grade (i.e., have a credit rating that is lower than BBB- or equivalent). the risk premium available is compensation for credit and liquidity risk – as these companies have a higher chance of failing and the bonds are therefore subject to more default risk, the risk premium available is higher than for investment grade corporate bonds. the bonds are publicly traded but are likely to be less liquid than investment grade corporate bonds.
Bank loans (also known as secured or leveraged loans): Investing in loans to non-investment grade corporate borrowers. these loans are typically arranged by investment banks. the loans are normally issued by mid to large sized companies to, for example, finance business expansion. they are senior in the capital structure and are typically secured by the borrower’s assets and will tend to have priority rights. Senior loans are floating rate in nature with a coupon return comprised of a nominal spread over LIBoR, for example a coupon of LIBoR + 4%. one of the most important features of senior loans is that they are privately rather than publicly traded. the liquidity is significantly less than investment grade bonds or even high yield bonds. Bank loans secured by underlying assets will tend to have stronger defensive qualities than high yield bonds. Historic recovery values following defaults, which have been higher than for high yield bonds, provide some evidence of this.
Private debt (or private credit): the ability of banks to lend directly has diminished since the financial crisis and this has reduced the supply of private debt in a number of areas. As a result, institutional investors have the opportunity to provide debt capital to borrowers involved in infrastructure projects, real estate and private equity financing (amongst others). the debt can be secured (by the underlying assets) or can have a mix of equity and debt-like characteristics (e.g., mezzanine). the risk premium available to investors is the underlying credit risk and in this case the investment will also be very illiquid so the investor should get compensation for the lack of liquidity.
1
2MAY 2013
Absolute return bond strategies: each of the ideas so far can be considered an asset class with an associated risk premium. Absolute return bond approaches are more about accessing a basket of “alpha” opportunities. the actual characteristics will be very product-specific, but the products are designed to deliver a positive return in all market environments. Investment managers will take advantage of numerous alpha opportunities within the fixed income universe and many of the products will be long and short with limited (if any) directionality. the better approaches should seek to be uncorrelated with growth assets when the latter are doing badly but will have a higher degree of correlation when equities are rising. this is because managers will generally seek to take advantage of the additional spread available in credit markets in positive market environments but look to hold little or no spread assets at times of heightened volatility. on the whole we would expect absolute return bond products to have low sensitivity to the direction of interest rates and credit (they will tend to have low to zero interest and credit duration). this is about accessing manager skill as there is no inherent risk premium available. there is no clear definitional distinction between absolute return bond strategies and fixed income hedge funds. Some absolute return bond strategies that are run at moderate to high risk levels are also marketed as hedge funds, and are sometimes held within hedge fund portfolios.
Multi-asset credit strategies: one way to think about these funds is that they are the credit only equivalent of balanced funds. they seek to invest in a basket of multi-asset credit opportunities (many set out above) with a view to rotating between the different opportunities. As such they provide access to a wide variety of credit exposures whilst providing some active management of beta exposures (e.g. loans versus high yield). Many also will have the flexibility to move part of the allocation to cash, government bonds or investment grade credit as a way of managing the overall credit exposure (of the investor). the variety of underlying exposures and the level of liquidity will vary by product. the risk premia available are expected to be dominated by those available via investing in the underlying asset classes, as set out above. there may also be smaller contributions to return stemming from active management of the mix between these asset classes and from security selection within these asset classes.
Unconstrained bond strategies: Unconstrained bonds strategies can best be described as an unconstrained approach to traditional fixed income investing. the underlying investment is likely to be developed market sovereign bonds, investment grade credit, and securitised debt (e.g., asset-backed securities). Some products may also stray into high yield and emerging market debt. the risk premium available is compensation for duration and credit risk plus some alpha via beta management between the sectors, interest rate management, security selection and currency positioning. the strategies will tend to have inherent interest rate and credit exposure although the extent of the exposures is expected to vary.
Further details and the characteristics of each of the strategies above are set out in Appendix 1.
DISCUSSIon
Investors’ decisions on which fixed income opportunities to access will depend largely on the following considerations:
• Strategic rationale – what do investors want to achieve from the allocation to growth fixed income and how does this fit in with their existing allocations to the other elements of their growth portfolios? Is the focus on reducing exposure to credit and interest rate exposure (favouring loans or absolute return approaches) or is the focus primarily on return (favouring, say, private debt)?
• Governance – do investors want to add specific strategies (e.g., high yield) to the portfolio once they have an understanding of the opportunity or do they prefer to have access to a basket of opportunities? What capacity do investors have for additional managers and for the additional monitoring burden and complexity which may come from this?
• View on active management – how comfortable is the investor giving their manager(s) wider discretion to manage the beta allocation across a number of opportunities? And what are the additional costs of active management?
• Liquidity – some of the opportunities are less liquid (though not necessarily illiquid); an investor will need to be comfortable with this. It is worth noting that, in our view, some of the more compelling return opportunities are illiquid.
the portfolios we have set out below reflect our current views on the growth fixed income opportunities set. We see opportunities in emerging market debt and private debt as structural opportunities which have a strategic place in investor portfolios. Both of these also add additional drivers of return into a typical investor’s portfolio and therefore provide additional diversification. Some of the other opportunities, such as securitised credit (which, for example, may include investment in mortgaged-backed securities) and bank loans look attractive but are likely to be more cyclical in nature. Also, high yield has performed well recently and has attracted a lot of investor capital, including retail flows, so the asset class is now less appealing.
We are also entering into a macro environment characterised by GDP dispersion – the notion that some countries will emerge from the crisis more quickly and stronger than others. this will increase the opportunities for fixed income managers with a strong global perspective. As such we believe that investors should be considering exposure to a basket of credits and selecting a strategy where the manager is allocating to their “best ideas” across the fixed income spectrum and also has some flexibility to rotate between the different opportunities.
PoRtFoLIo ConStRUCtIon
the paper acknowledges that investors have different needs and preferences. As such, we set out below an “aspirational” portfolio for investors with a focus on growing their assets and who do not have any constraints. We than present some other possible portfolios.
Portfolio 1 – This is our preferred portfolio. The focus is on generating return from multiple sources.
Strategic rationale: the portfolio focus is on return via investing in opportunities which are primarily structural in nature. this is combined with strategies which seek to invest across the credit spectrum and seek to add value via beta management of different multi-asset credit opportunities. the portfolio has a high degree of credit exposure but is a portfolio where the returns are less reliant on the developed markets macro environment. Should the investor wish to add some defensiveness, this can be done by adding absolute return bonds into the mix.
Governance: Challenging, as it could involve appointing many managers and including illiquid opportunities.
Reliance on active management: A mix of beta allocation by the investor and accessing the beta and alpha management capabilities of managers.
Risk/Return: We have modelled the returns of this and other portfolios under three economic scenarios (see appendix 2 for details). this portfolio is expected to have a return of about 8.2% p.a. in a “muddle through” scenario but the return could be higher at closer to 11% p.a. in a “trend growth” scenario but only just above zero at about 1.6% p.a. in a weak growth scenario.
Liquidity: Liquidity is expected to be moderate. Part of the portfolio will be illiquid, but the intention is for this portfolio not to be totally illiquid.
APPRoPRIAte FoR WHAt tyPe oF InveStoR:
It is designed for investors for whom growth fixed income allocations are a significant part of the overall allocation and who therefore are willing to access broad a basket of return sources.
ConStRUCtInG A GRoWtH FIxeD InCoMe PoRtFoLIo3
PoRtFoLIo ALLoCAtIonSBest of Mercer Portfolio
ABS return 11% - 30%Credit oportunities 20% - 40%Local currency eMD 20% - 40%Private debt 20% - 40%
■ Abs return 0% - 30% ■ Credit oportunities 20% - 30%■ Local currency EMD 20% - 40% ■ Private debt 20% - 40%
4MAY 2013
HIGH LeveL InveStMent GUIDeLIneS:
ASSet CLASS StRAteGIC ALLoCAtIon
ConSIDeRAtIonS
Emerging Market Debt - Local Currency
20-40% Permit ability to invest off-benchmark to, for example, EMD corporates– allocation to EMD will depend on whether the multi-asset credit strategy includes EMD as one of its components.
Multi-asset credit 20-40% A basket of multi-asset credit but avoiding strategies which are EMD heavy
Private debt 20-40% Sizing depends on allocation within “Private Equity” to “Debt/Credit” opportunities
Absolute Return 0-30% Higher allocation if the focus is on capital preservation and a investor does not have a dedicated allocation to hedge funds. Consistent with our guidance on building hedge fund portfolios, we would advocate prudence in sizing allocations to any individual strategies within this category that are run at risk levels high enough to allow them to be classified as hedge funds, with no more than 10% being allocated to any such strategy.
Total 100.0%
the portfolio above only makes sense if the allocation to growth fixed income is focused on return and where the investor is tolerant of complexity and illiquidity.
We propose a number of simpler portfolios below – they can be seen as “starter” portfolios which can be built on over time or portfolios which capture investor constraints – e.g. a lack of tolerance to illiquidity. our preferred portfolio is shown, for comparison purposes.
ASSet CLASS PoRtFoLIo 1 “ASPIRAtIonAL”
(BeSt oF MeRCeR)
PoRtFoLIo 2 “ASPIRAtIonAL SIMPLIFIeD”
PoRtFoLIo 3 “SIMPLe AnD LIqUID”
PoRtFoLIo 4 “ LoWeR RISk”
emerging market debt (local)
20%-40% 40%-60% 30%-60% 30%-40%
High yield – – 30%-60%
Bank loans – – – 30%-40%
Private debt 20%-40% – –
Absolute return bonds 0%-30% – – 30%-40%
Multi-asset credit 20-40% 40%-60% – –
Unconstrained bonds 0%-30% –
Total 100% 100% 100% 100%
Some observations:
Portfolio 2: this portfolio is designed to capture a basket of betas whilst maintaining simplicity. the portfolio also reflects the fact that credit markets have done well over the last few years and therefore is an approach which has flexibility to rotate between different betas and critically to reduce overall credit exposure when credit markets are “too rich” and therefore risky.
the exposure to a multi-asset credit strategy provides diversified access to multi-asset credit with some management of overall credit exposure (this will depend on the individual strategy) and beta management of the sub-strategies (high yield versus loans). By adding some floating rate exposure the approach will reduce interest rate sensitivity. For those with existing exposure to emerging market debt, this is simple in that this portfolio requires adding one manager to access a basket of opportunities.
this portfolio is expected to have a return of about 7.3% in a “muddle through” scenario but the return could be higher at about 8.3% in a “trend growth” scenario but only about 2.5% in a “weak growth” scenario. the portfolio is less volatile than Portfolio 1.
ConStRUCtInG A GRoWtH FIxeD InCoMe PoRtFoLIo5
Portfolio 3: A portfolio which is liquid and simple. For those who already have exposure to emerging market debt, strategically the next opportunity which they should consider is high yield. High yield has a strategic role in investor portfolios but currently the asset class is less appealing so investors may need to be on the lookout for better entry points. they may consider “ware-housing” this allocation to absolute return bond strategies or an unconstrained bond strategy whilst waiting for a more opportune entry point. Governance is simple apart from the challenge of managing the entry point.
this portfolio is expected to have a return of about 6.3% in a “muddle through” scenario but the return could be higher at just over 7% in a “trend growth” scenario but only about 2.4% in a “weak growth” scenario. the expected returns are lower than Portfolios 1 and 2 but the
portfolio is less risky.
Portfolio 4: A portfolio which is less sensitive to credit and interest rate risk and holds up reasonably well in a rising rate or a rising credit spread environment. the portfolio will be more defensive in nature. the portfolio is likely to be more challenging from a governance perspective as it requires appointing a number of fixed income managers. Also, the absolute return strategies should be adequately diversified – this adds an additional governance challenge.
this portfolio is expected to have a return of about 5.3% in a “muddle through” scenario with the return only marginally higher at about 5.8% in a “trend growth” scenario but will hold up more in a “weak growth” scenario with an expected return of about 3.0%. the return expectations from this portfolio are expected to be the lowest but this is also likely to be the most stable portfolio.
SUMMARy oF RISk AnD RetURnS
the table below sets out the expected returns for the four portfolios in three different scenarios. this dispersion of returns is a better indicator of the risks of the portfolios than the historic risk. the scenarios are described in more detail in Appendix 2. It should be noted that the three scenarios in this table do not encompass the full range of potential outcomes, and that it is possible to construct scenarios in which the returns for all four model portfolios would have been meaningfully negative (as was the case in 2008).
PoRtFoLIo 1 “ASPIRAtIonAL”
(BeSt oF MeRCeR) (%)
PoRtFoLIo 2 “ASPIRAtIonAL SIMPLIFIeD”
(%)
PoRtFoLIo 3 “SIMPLe AnD LIqUID”
(%)
PoRtFoLIo 4 “LoWeR RISk”
(%)
Muddle through 8.2 7.3 6.3 5.3
Weak growth 1.6 2.5 2.4 3.0
Trend growth 11.0 8.3 7.3 5.8
Expected return 7.31 6.5 5.6 4.9
Risk (historic) 6.3 7.6 10.0 6.1
Sharpe ratio 1.22 0.9 0.6 0.8
1 We have estimated the return assuming that the “muddle through” scenario is given a 65% weight, the “prolonged recession” a 20% weight and the “trend growth” 15% weight.
2 Assuming a risk free return of 0%.
6MAY 2013
ConCLUDInG ReMARkS
• Lower-rated credit will likely play a greater role in client portfolios – there are more interesting opportunities available to investors
partly as a result of the reduced role of some of the traditional players in the provision of credit as well as secular changes in the emerging markets.
• Investor comfort and understanding of the opportunities in credit is still evolving – also parts of the credit market tend to be more clearly cyclical than, say, equities. Also some of the emerging opportunities are illiquid in nature.
• We anticipate that investors will approach the opportunity set based on a number of considerations; this includes governance as well as beliefs in e.g. active management.
• We have put forward four possible portfolios – these ranges from Mercer’s preferred portfolio assuming that the client does not have any major constraints (say on liquidity needs) to more simple portfolios for clients seeking to take a “step-by-step” approach.
• the portfolios have differing characteristics – some have more growth potential, others are more defensive in nature.
ConFLICtS oF InteReSt
For Mercer’s conflict of interest disclosures, contact your Mercer representative or see www.mercer.com/conflictsofinterest.
UnIveRSe noteS
Mercer’s universes are intended to provide collective samples of strategies that best allow for robust peer group comparisons over a chosen timeframe. Mercer does not assert that the peer groups are wholly representative of and applicable to all strategies available to investors.
RISk WARnInGS
• the value of Gilts, bonds, and other fixed income investments including unit trusts can go down as well as up and you may not get back the amount you have invested.
• Investments denominated in a foreign currency will fluctuate with the value of the currency.
• Certain investments, such as illiquid, leveraged or high-yield instruments or funds and securities issued by small capitalization and emerging market issuers, carry additional risks that should be considered before choosing an investment manager or making an investment decision.
• For higher volatility investments, losses on realisation may be high because their value may fall suddenly and substantially.
• Where investments are not domiciled and regulated locally, the nature and extent of investor protection will be different to that available in respect of investments domiciled and regulated locally. In particular, the regulatory regimes in some domiciles are considerably lighter than others, and offer substantially less investor protection. Where an investor is considering whether to make a commitment in respect of an investment which is not domiciled and regulated locally, we recommend that legal advice is sought prior to the commitment being made.
AP
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ConStRUCtInG A GRoWtH FIxeD InCoMe PoRtFoLIo7
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ConStRUCtInG A GRoWtH FIxeD InCoMe PoRtFoLIo9
SoURCeS oF RetURn
the table below summarises the different sources of return (from an investor’s perspective) available from opportunities in fixed income – we have shown how the building blocks above access the different opportunities.
tRADItIonAL eMeRGInG
Cre
dit
bet
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lph
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gin
g m
arke
t so
vere
ign
cre
dit
(har
d)
Emer
gin
g m
arke
t so
vere
ign
cre
dit
(loc
al)
Emer
gin
g m
arke
t cur
ren
cy
Emer
ging
mar
ket c
orpo
rate
Dis
tres
sed
Loan
s
Hig
h Y
ield
Lon
g &
sh
ort a
lph
a
Con
vert
ible
s
Priv
ate
deb
t
Investment grade credit
a (a) a
Absolute return (a) (a) (a) (a) (a) (a) a
Unconstrained bonds
a a a a a a a (a)
EMD local (a) a a (a)
EMD hard a (a)
High yield (a) a
Mult-asset credit
a a (a) (a) (a) a a (a)
Private debt a a
the table above makes a distinction between investing in “traditional” opportunities, opportunities with which the investors is likely to be familiar and “emerging” opportunities, i.e. areas in which investors are only just building their understanding and comfort.
APPENDIX 2 – SCENARIO ANALYSIS the tables below summarise the returns for each of the sub-asset classes followed by the returns of each of the proposed portfolios: Summary Returns table
InveStMent MUDDLe tHRoUGH (%) WeAk GRoWtH (%) tRenD GRoWtH (%)
Emerging Market Debt – Local Currency 7.5 3.5 8.5
High Yield 5.5 1.0 6.5
Senior Loans 5.0 2.0 5.5
Private debt 10.0 0.0 16.0
Absolute return 3.5 3.5 3.5
Multi-asset credit 7.0 1.5 8.0
Unconstrained bonds 4.5 2.5 5.5
Below we describe the three possible scenarios with accompanying assumptions for credit spread changes, rates rises (government bond curve) and currency appreciation or depreciation.
10MAY 2013
MUDDLe-tHRoUGH SCenARIo (65%)
our base case scenario assumes a "muddle through" economic environment. this scenario assumes there will not be another financial crisis nor will there be a disorganised default of any significant developed country. We assume modest rates rises with modest spread tightening in investment grade credit with greater contraction in high yield. We believe local currency emerging market debt will continue to benefit from positive growth dynamics relative to developed markets and this should see currency appreciation, albeit with a high level of volatility. It will also see rates fall slightly as inflation concerns become less of a problem.
WeAk GRoWtH (20%)
We attach a small though not insignificant probability to this occurrence. Under this scenario, we assume moderate credit spread changes in investment grade credit with larger moves in high yield. We would expect absolute return strategies to achieve their objectives with unconstrained bonds strategies returning below target due to their utilisation of credit. We expect local currency eMD to suffer some currency depreciation and significant volatility.
tRenD GRoWtH (15%)
though we regard this as unlikely, it may be possible. Under this scenario, we believe investment grade credit would actually perform more poorly than in a muddle-through scenario because the market would price in greater rates rises than would be offset by contracting spreads. this would not be true in high yield, which therefore should do marginally better. We expect that an unconstrained bonds strategy should do better in this environment, owing to its LIBoR floor + target combined with contracting spreads. Local currency eMD should also benefit from marginally higher currency appreciation.
APPENDIX 3 - SOME HISTORY
HIStoRIC RISk AnD RetURnS
the table below summarises what the risk and returns have been from the major fixed income sub-asset classes over the period 2003 to 2012:
ASSet CLASS RetURn (%) RISk (%) RetURn/RISk InDex/SoURCe
Emerging market debt - local currency
12.3 11.9 1.0 JPM GbI-EM GD Index
Global High Yield 11.0 11.4 1.0 boA ML Global High Yield Index
Senior Loans 6.1 7.0 0.9 Median Manager Return – Mercer US Leveraged Loan Universe
Private debt 10.1 5.9 1.7 Median Manager Return – Mercer Distressed Debt (Net of fees) Universe
Absolute Return 4.8 2.9 1.7 Median Manager Return – Mercer International Fixed Absolute Return Universe
Multi-asset credit 10.0 5.1 2.0 Median Manager Return – Mercer Multi-asset credit (Net of fees) Universe
Unconstrained bonds 7.1 5.9 1.2 Median Manager Return – Mercer International Fixed Unconstrained bond Universe
Global Credit 6.2 7.0 0.9 barclays Capital Global Aggregate Credit Index
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