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
The ubiquity of the Bloomberg Barclays Global Aggregate Index is due to its comprehensive reach of investment grade debt securities which cover 24 local currency markets and 84 countries. This has made it a common proxy for the asset class, but its use of debt weighting can create unintended consequences for investors seeking to avoid risk or to maximise value. With few other widely accepted fixed income benchmarks, it has been more common for fixed income fund managers to not use an index to benchmark their performance. In such cases the managers believe the risks and opportunities in an index are too narrow and lack diversification. They also believe that outperforming such a benchmark and measuring the volatility in their portfolio relative to that benchmark will restrict investor outcomes.
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
Source: Bloomberg Barclays Global Aggregate Index, as of 30 April 2018
An unconstrained manager concentrates investments in countries, currencies and sectors where they see the greatest total return opportunity. Figure 2 shows how such value decisions are taken by assessing the real yields (yields minus local inflation) offered by issuers of government debt. The chart shows emerging markets such as Brazil, Russia, South Africa and India are attractive at current levels, given the drop-in inflation in those countries. This contrasts dramatically with the European developed market stalwarts of the UK and Germany, whose real yields are negative as rates remain at record lows.
Figure 2: REAL 10 YEAR BOND YIELDS
Source: Bloomberg. Data as of 30 April 2018 - based on 12 month % change of headline CPI
An additional unintended consequence of investing relative to a government bond index is that a bond’s weighting rises as its currency appreciates. This means indexes can be biased towards markets with overvalued currencies with a greater price risk. Conversely, when currencies are undervalued and have the most potential to appreciate, their index weights are at a minimum. From an investment standpoint this is counterintuitive.
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
Source: Bloomberg Barclays Global Aggregate Index, data as of 30 April 2018
Unconstrained fixed income managers can have portfolios of several hundred securities, while the Barclays Bloomberg Global Aggregate Index currently has approximately 21,000 issues. The trading costs on a smaller portfolio should be cheaper, while an index of so many securities will be difficult to efficiently replicate. Unconstrained managers can also trade in the primary market at any time to obtain new issues at yield premiums. These are typically not available to many passive managers, who trade only at month end. They also have the flexibility to trade in investment grade debt that does not meet the minimum size of issuance to be included in the index ($300m for US issued debt), as well as in securities that are too close to maturity to be included in the index.
Unconstrained managers believe the limitations of debt-weighted indices make it harder to achieve all the outcomes an investor may want from fixed income. And while active management does not ensure gains or protect against market declines, such managers believe searching the entire bond universe makes it easier to construct portfolios to help meet the following client needs.
a) An income that matches a particular liability stream.
b) To protect value/ avoid volatility.
c) Using the widest range of fixed income instruments to produce a unique source of alpha uncorrelated to fixed income or equity benchmarks.