Fixed income benchmarks can help evaluate active fund managers with conventional investment objectives. But unconstrained managers march to different drummers; for these managers, benchmarks can be more of a hindrance than a help.
A better balance of risks
Debt weighted indexes reflect the full volume of debt issued by investment grade countries, companies or organisations. In a global index, this means an investor will end up with large allocations to the world’s most indebted countries - many of these run budget deficits or have relatively lower discipline in costs versus revenue. An additional problem is that in the low interest rate environment of recent years, developed market governments have been issuing large amounts of debt at very low yields. An investor guided by a world government bond index will have a bigger holding of debt issued by Japan, yielding 0.1%, rather than countries like Australia or New Zealand, yielding 2.5%.
For a broader index like the Global Agg (that covers government and corporate debt), debt weighting results in allocations that are disproportionately made up of government debt, much of it with greater interest rate sensitivity rather than credit risk.
As of 30 April 2018, the Bloomberg Barclays Global Aggregate Index was made up of 54.2% of government debt (see Figure 1). The index offered a total yield of just 1.9%, with many of the underlying securities paying a yield below 1% and a fair share rewarding a negative yield. Such a low yield may offer little protection to shocks that could lie ahead.
Looking at the sector allocation too, a manager who is benchmark driven will be guided by industry weightings in the benchmark. Financial services companies, for instance, make up almost 40% of the corporate sector.
Figure 1: big universe, limited selection
Figure 2: real 10 year bond yields
Non-investment grade bonds
Another drawback of global bond indices is that they don’t cover the entire investment universe. Among the most common bonds that an unconstrained manager will research will be local currency emerging market debt, emerging market corporate debt and global high yield. Most of those sectors are not included in the Global Aggregate index.
Similarly, many EM countries are not included in world government bond indices. Developing economies whose debt capital markets are rapidly evolving and deepening are underrepresented due to those issuers’ low debt market-capitalisation. They can also be underrepresented due to their credit ratings’ lagging an improved creditworthiness for the economy.
These bond sectors and regions have less research carried out on them than those included in the major global bond indices. Partly as highly regulated investors or risk averse investors will either not purchase them or buy them in limited quantities. This gives active managers a greater opportunity to discover bonds whose full value is not priced in.
Managing duration risk
The greater the duration in an index, the greater its sensitivity to changes in interest rate expectations and the likelihood of capital erosion in a rising rate environment. Figure 3 below shows how far duration risk has grown in the Bloomberg Barclays Global Aggregate Index. This means, an index-driven investment strategy implies taking on more interest rate risk in low-yielding countries and less in higher-yielding countries – the opposite of what a rational investor might want.
An unconstrained manager has more flexibility to manage duration risk. So, they can select securities which they think will rise in price and avoid those viewed as the most expensive, based on information about a country’s economic and interest rate outlook.
Figure 3: Yield v Duration - the bloomberg barclays global aggregate index
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