Fortify your bond portfolio

The current market environment is providing bond investors with a cold headwind: nominal and real interest rates are low or even negative in many countries, while Treasury bonds, traditionally regarded as the ultimate ‘safe’ investment, are now subject to credit concerns — so much so, in fact, that some people now joke that Treasuries no longer provide risk-free returns but return-free risk. Achieving the two main traditional objectives associated with bonds, risk reduction and return generation, has undoubtedly become more difficult. So how can bond investors inject some energy into their portfolios?

The answer to this question will depend largely on whether the investor is focused on relative or absolute returns. Relative return investors typically have long-duration liabilities. For them, risk reduction means holding a portfolio of matching assets that mitigates the duration gap (that is, risk due to changes in the interest rate). An optimal portfolio for relative return investors will usually comprise a strategic allocation to government bonds, with additional returns generated by deviating opportunistically from this strategic weight.

Absolute return investors, by contrast, might not require a strategic weight in bonds at all. For them, cash or even gold may be the safe haven asset class. Positions in fixed income assets are taken opportunistically, when valuations are attractive. Their portfolios might be much more diversified across various sub‑categories of fixed income investments and less concentrated in long-duration Treasuries.

Boosting relative return

Government bonds typically entail only two major risk factors: term risk, the compensation for postponing consumption by lending one’s capital; and inflation risk, the compensation for bearing the risk that the purchasing power of one’s capital will have declined when returned at maturity. The shape (that is, risk and return characteristics) of a bond portfolio might be enhanced by adding a number of ‘vitamins’. These could include: vitamin C (corporate bonds, which adds credit risk to the portfolio); vitamin H (high-yield bonds, which adds a dose of illiquidity risk); and vitamin E (emerging market debt, adding some political or macro risk to the portfolio).

For bearing these risk factors, investors typically ask for compensation via higher yields. Diversifying a bond portfolio within its asset class might provide higher returns; however, for these potentially higher returns, investors must give up some of the safe-haven attributes typically associated with Treasuries.

High-yield corporates and emerging market debt were discussed extensively in the January issue of Currents (Loosening the Bonds, January 2012 Currents, pages 26-30), so let’s consider the choices facing investors who are free to incorporate absolute return strategies. There are various facets of active management (which we may call vitamin A), which could be employed to enhance the risk reduction and return generation attributed to a bond portfolio.

Taking opportunistic advantage of attractively priced sub-asset classes and individual securities in the fixed income universe can help to enhance returns. However, translating opportunities into returns requires skill, experience and insight. In particular, the manager will need to be able to:

Assess the appropriate risk premium for different risk assets. Research into the aggregate financial health of corporate borrowers, the macroeconomic outlook, the demand for products at different phases of the cycle, and the availability and cost of funding in markets: these all inform a view of the right time to be invested in specific sectors in a tactical asset allocation context.

Choose the issuers and securities to best express those asset class views based on a combination of factors. These include: deep examination of individual company fundamentals, an analysis of the specific covenants or investor protections in a particular bond, quantitative assessment of valuation or market sentiment regarding an issuer, or some combination of these.

The appropriate techniques for going active on this part of a portfolio will depend on clients’ individual risk objectives and investment constraints. A traditional active approach, for example, would have an active opportunity set that is largely defined by the benchmark — namely, an active high-yield portfolio would generate the large majority of its alpha over its benchmark from high-yield bond selection aiming to identify attractive sectors and issuers.

Thinking outside the box

Today’s low yield environment is also characterised by high volatility and dislocations in the global fixed income markets. Although this is generally bad news for a long-only investor, it creates opportunities for investors who are willing to think and invest outside their traditional fixed income instrument set. The ability to select the best issuers and securities across the corporate and sovereign universe is a very useful skill, but it still leaves traditional investors vulnerable to shocks due to the directional nature of long-only investing.

But if the skill of choosing and buying attractively priced assets is combined with the skill of identifying and selling unattractively priced assets, fixed income investors can create less directional, market-neutral returns. As a result, they can achieve a superior position on the risk/return spectrum. This effect is amplified if the investor is able to screen the global rates and credit markets for opportunities globally.

Clearly, not all fixed income investors have the skills or experience to enhance their risk/return position in this way. For such investors, allocating to hedge fund managers who do have these attributes is often a preferred option. The highly challenging market environment in the last few years provided the toughest of tests for hedge fund managers, and those who successfully weathered the storm can be seen as efficient all-weather additions to a fixed income portfolio.

Investors in fixed income hedge funds need to determine how to incorporate their hedge fund exposure within their overall fixed income allocation. This can be achieved by using derivatives to replicate the market exposure of parts of their fixed income benchmark synthetically (such as government bond futures for a global treasury index, credit default swaps or total return swaps for corporate indices), which can free up cash to be invested in a hedge fund. Alternatively, a security lending programme can be applied to an indexed portfolio to efficiently raise cash for investment in a hedge fund. Both methods allow investors to maintain their chosen beta exposure while adding significant alpha potential.

These are just a few of the options. Adding active management, credit, high-yield and emerging market debt or fixed income hedge funds can help to diversify a portfolio in a way that enables it to weather the current cold headwinds of bond markets more effectively. In addition to boosting a bond portfolio with vitamins, investors could also think outside the box and consider more exotic bond exposures, such as insurance-linked securities or mezzanine real estate debt.

Furthermore, non-bond assets that are related to bonds, such as equity income strategies or infrastructure assets, could further boost a bond portfolio’s resistance against weather conditions even worse than those at present — however, the relatively illiquid nature of these assets would have to be considered before any such investment was made. 

(The writer is a director of the BlackRock Global Markets Strategies Group based in Dubai)