Bond investing has become a lot more complicated. The characteristics of global fixed income markets have changed noticeably over the past 10 years, with duration of major fixed income indices extended. So when rates have hit a secular low, interest-rate risk has hit a secular high.
According to research by State Street Global Advisors (SSGA), interest-rate risk is the dominant risk factor. Taking Barclays US Aggregate Index as an example, close to 90% of the risk comes from interest-rate risk.
The low-yield environment has also made it difficult for investors to generate enough yield to achieve their financial goals. Specifically, since Treasuries, the lowest-yielding sector of the US fixed income market, make up a large portion of the Barclays Aggregate Bond Index, the index’s yield has diminished significantly.
Simultaneously, the duration of the index has lengthened, putting the yield- to-duration ratio near its lowest level since the inception of the index.
SSGA believes that an active core fixed income strategy is appropriate to use in this environment, which requires more than a simple mix of US Treasuries combined with some corporate debt and high-yield bond. But investors will have to venture into broader fixed income sectors such as emerging markets and bank loans in the search of yield and diversification.
In an environment where fixed income as an asset class may struggle to perform, investors are forced to ask the question of how to find value-add without taking too much risk.
Here SSGA and DoubleLine Capital jointly outline their view on the global fixed income market and state the case for actively managed bond ETFs.
Q: What is your view on where interest rates are headed?
A: Investors thought that interest rates might have bottomed out in 2012, but they would be surprised at how slowly they rise. A big driver of financial markets that we have increasingly been focused on is the aging demographics in many countries. The US is better off than most because of higher immigration and fertility rates than other developed markets, but still we have the baby boomers who are retiring en masse, creating tremendous demand for income and tremendous downward pressure on rates.
We think the Federal Reserve wants to raise interest rates in 2015 not for fundamental, but philosophical, reasons. They think zero interest rates are somewhat dangerous because if the economy was to weaken, they would have no ammunition. So, they want to, as they say, “normalise” rates.
So what does this mean for investors?
The bond market has changed a lot over the years. It used to be very simple. People could buy Treasury bonds or municipal bonds and the yields were acceptable. Now firms need large departments of analysts and traders to capture the opportunities in asset-backed securities, in emerging market debt, in currencies ... there are just so many decisions to factor in.
From an asset allocation standpoint, it is important to have active management as part of the portfolio that seeks an attractive combination of yield while managing risk.
But if yields are low, they are low in bond indexing too?
Bond indexing for the core fixed income asset class presents challenges in the current low-yield environment. Since Treasuries are the lowest yielding sector of the US fixed income market and that makes up a larger portion of the index, the yield has diminished to around 2%. Simultaneously the duration of the index has lengthened more than a year to around 5.6 years. This puts the yield-to- duration near its lowest level since the inception of Barclays Aggregate Bond Index.
How does active core fixed income work?
One approach to active core fixed income is constructing portfolios with asset classes and securities that complement each other and work together to manage overall risk.
For example, high-quality government bonds such as US Treasuries and investment-grade debt can be used for a strong portfolio foundation with relatively low risk. Then non-traditional fixed income investments with more credit risk can be added to potentially generate incremental yield.
The overarching strategy combines the various parts to balance interest-rate and credit risk. The marriage of government-guaranteed bonds and credit risk can potentially boost core fixed income exposure and help to limit volatility.
So what is your approach?
We take a barbell approach. There are actually two barbells. One barbell is yield-curve oriented where we have more long-term securities and short-term securities than things in the middle. The other barbell is in credit, which means a significant fraction in government bonds, with mortgage-backed securities as a big part, and a smaller fraction in credit opportunities such as emerging market debt and some high-yield bonds.
Investors may not be aware that high-yield bonds and emerging market debt have cheapened substantially in the last eight months. There are potential opportunities there, and we manage risks by keeping an allocation in government bonds on the other side, although that could change in the future.
What is it that you look for?
We exploit inefficiencies within sub-sectors of the fixed income market, while maintaining active risk management constraints. Portfolio allocation decisions incorporate top-down macroeconomic and market-sector analysis with qualitative evaluation of market trends. Sector weightings are based on fundamentals and relative value. Security selection is a bottom-up process that is stress-tested under a variety of possible scenarios and portfolio shifts are made gradually.
One of the secrets is we run an interest-rate risk lower than the market as measured by the Barclays Aggregate Bond Index. Now, in order to achieve higher returns with lower risk, you need to emphasise mis-pricings in the market.
Is that why you have a bias towards mortgage-backed securities?
Yes, because there are higher chances of finding mis-pricing there than in any other part of the bond market. Biases also exist in other parts of the bond market. For example in emerging market debt, a lot of people use currency risk, but we have a bias in emerging markets to stay dollar-denominated unless there is a very compelling thesis.
For high-yield bonds, a lot of firms use them almost constantly in their portfolios. We believe high-yield bonds are a tactical investment.
What about risk management?
We focus on how investment risks relate to each other across a portfolio, not how their performance compared to their benchmarks drives investment decisions.
To manage principal risk, the team considers security selection within sectors; relative performance of market sectors; the shape of the yield curve; and interest-rate fluctuations. We strive to maintain a shorter duration than Barclays Aggregate Bond Index as a risk management tool that potentially provides return and can help limit volatility.
Why use an ETF structure?
Investors may benefit from the low cost, transparency and tax efficiency of an ETF. Actively managed exposure also grants access to difficult-to-reach fixed income asset classes not covered by existing ETF offerings.
State Street Global Advisors Asia Limited
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State Street Global Advisors Singapore Limited
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Tel: +65 6826 7500
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Investing involves risk including the risk of loss of principal. Past performance is not a guarantee of future results. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Active ETF is actively managed and may underperform its benchmarks. This type of investment is not appropriate for all investors and is not intended to be a complete investment program.