October 2010

FIXED INCOME: a nimble approach

Nimble_dancersOnce bond portfolios were bulky, slow-moving beasts, but low yields and sovereign debt problems have seen fixed income managers and investors overhaul their strategy, finds Nick Fitzpatrick
Retail investors are often accused of investing on the back of momentum rather than value, but their recent behaviour in the UK suggests they understand a thing or two about bond markets and how they are changing. It is necessary to be much more flexible when it comes to allocating money to bonds.

Three of the top five best-selling fund sectors in July categorised by the Investment Management Association were bond funds, with two of those sectors – global bonds and strategic bonds – having mandates to invest in a broad range of fixed income, not just UK government gilts. Global bonds, the number-one seller, saw £361m (€424.4m) of inflows, the highest month on record for this sector.

Could it be that retail investors realise what institutions are also realising, which is that the record low yields on developed-world bonds, coupled with the sovereign debt crises in Europe that have caused certain countries like Greece to fall out of mainstream bond indices, and not forgetting the opportunities for local-currency government debt in emerging markets, mean bond portfolios need to be more actively managed than in the past?

“The big fixed income sales this year in the UK have been global bonds and strategic bonds,” says Simon Surtees, fixed income portfolio specialist at Standish. “These sectors have the ability to move around the markets more freely and the fact that these are popular with investors shows people know that they have to be more nimble now.”

This could mirror the pension fund world, where trustees have historically been slow to act on investment changes owing to the fact they only meet once a quarter to discuss them.

For example, in the world of Eurozone sovereign bonds, Patrick Barbe, head of Eurozone, core fixed income, at BNP Paribas Investment Partners, says there is an increasing demand for active sovereign bond investing by institutions, driven by new decorrelation and liquidity factors.

“There is now less correlation on a daily basis between countries’ sovereign debt, and this is a new factor. Before, people felt a bond issued by Greece was quite similar to a German bund, but many investors now understand that the case for buying sovereigns is different for each country in the Eurozone.”

Lack of liquidity
He adds that although liquidity has improved compared to 2009 for most Eurozone countries, there is still not as much liquidity compared to before the financial crisis. This means large investors are not able to sell without impacting Eurozone debt markets.

“The problem that pension funds have with government debt is liquidity. There is less liquidity on the long end of the duration curve. The Pigs [Portugal, Ireland, Greece and Spain] are not there now and so the market is no longer able to absorb these pension fund trades on the long end, meaning more active management is needed,” says Barbe.

All this has led to a change in pension fund behaviour, he says.

“We see pension funds in Europe behaving in two different ways. First, there are those that want to be in triple-A bonds, close to the benchmark, taking only duration risk. This calls for low active management.

“But the second behaviour is to invest in potentially a wide range of government debt using an active manager, albeit perhaps with some rules attached such as excluding high-yield countries like Greece.

“The objective is to delegate functions to investment managers that they previously did themselves. In the past a lot of investors did not see the need to have a split between different governments, but now that they have realised that not all debt in the Eurozone is of the same quality, there is more incentive to separate them using a greater degree of active management.”

Barbe says the firm is currently pitching for a mandate from a Dutch pension fund. The mandate is passive and the brief is to switch from sovereign bonds to sub-sovereign long-duration bonds.

“We’ve never seen that before,” says Barbe. “This is more popular for higher returns and it involves investing in supranational organisations guaranteed by government.”

Surtees, at Standish, adds there is more demand by institutions to diversify into developing world bonds. Investors “shake their heads” at Greece and other highly indebted European economies like Spain and Ireland, and feel that if they are going to take risk, they may as well be rewarded. “Emerging market local currency government bond funds have enjoyed considerable inflows through 2010 and continue to attract institutional interest.”

He says that BNY Mellon’s Dublin-domiciled emerging market local currency fund, which is managed by Standish, has more than doubled in size this year to US$3.6bn (€2.64bn), driven to a large extent by investment from pension funds and sovereign wealth funds.

Investors also want local currency emerging market debt exposure as part of a long-term asset allocation decision, not just for  opportunistic play, Surtees adds.

James Carver, emerging market debt portfolio manager at Aberdeen Asset Management, indicates investors see little difference between developed and developing world bonds in some cases.

“Investors are divesting from developed government bond markets into the more safe emerging market bonds. This can include corporate bonds but most is government,” he says.

“The difference between developed and emerging market bonds is less distinct. Looking at debt ratings, a number of US pension funds like emerging market debt.”

Yield chasing
In sovereign fixed income, yields are down to near record levels in the developed markets. Chris Iggo, chief investment officer for fixed income at Axa Investment Managers, said in a recent report that not enough is likely to change in the macro environment to cause markets to trade outside of recent ranges. That means yields are not going to deviate much from the 2.5-2.8% range in US Treasuries (10-year), 2.2-2.6% range in bunds and 2.8-3.2% in gilts.

Corporate bond yields are also falling and research by Mercers, a pensions and investment consultancy, shows that accounting measures of the liabilities of defined benefit schemes in most developed economies have seen marked increases in liabilities due to declining corporate yields. Combined with equity market performance experienced over 2010, this is likely to result in larger deficits at company year ends, the firm says.

Back at Standish, Surtees says that inflation in developed economies could remain low or fall even further. This could hold down government bond yields at near record lows and serve to increase pension scheme liabilities, which are discounted by a measure related to AA corporate bond yields that closely track government debt.

The interest in emering market debt reflects the hunt for yield. Although emerging market bonds cannot be used in the discount rate for European schemes (because the bonds must match the same currency that pensions are paid in), they are sought as risk assets by investors seeking to increase asset values, particularly as equities have struggled over 2010.

“Although yields in the developed world are low and could remain so for a period of time, we do eventually expect that yields will rise and this brings with it scope for disappointing performance for fixed income portfolio unless a manager takes action to address this risk through reducing fund duration.” says Surtees.

“Duration can be managed reasonably easily these days through a variety of strategies including highly liquid exchange-traded interest rate futures,” he adds.

Relatively few fixed income managers today have first-hand experience of running money through a period of a sustained rise in yields because rates have been on a downward trend for decades.

For example, US 10-year government bond yields peaked 29 years ago at 15.8% in September 1981 after running up from a level of 6.8% at the beginning of 1977. 

At present US 10-year government bonds yield 2.6%.

Avoiding fat tails
The desire for more active management has been registered at Pimco, the influential fixed income house.

Andrew Balls, Pimco’s head of European portfolio management, says: “Products aimed at protecting your portfolio against fat-tail risk are something we are talking about with clients and we can provide this as part of actively managed portfolios or as overlays.”

Fat tails are unlikely, but hugely damaging, events.

Pimco has also reacted to the concerns of investing in debt-burdened nations by developing a new index that has a lower share of OECD countries and a higher share of emerging markets. This is achieved by weighting index constituents by their ratio of debt to GDP rather than by the market capitalisation of their issued bonds.

This can even benefit passive investors. “If you want more passive strategies then you at least want smarter benchmark,” says Balls.

“Greece was about 3% of European government benchmarks at the start of the year, so something that was more forward looking was needed.”

Crispin Lace, a senior investment consultant at Mercers, notes: “Most investors prefer not to have their portfolios invested against certain benchmarks, and this is understandable because often the biggest issuer in the index is the one with the most debt. You do not necessarily want most of your portfolio in that issuer.”

Whether retail investors have thought their approach to bonds through to this level of detail is doubtful, but certainly those bulky, slow-moving bond portfolios are being dosed up with fuel.

©2010 funds europe

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