Andrew Mulliner, fixed income portfolio manager at Janus Henderson Investors, explains why having the freedom to allocate between different areas of fixed income can seek to make the most of the diversity within the asset class.
One might assume that a benchmark like the Bloomberg Barclays Global Aggregate Index, which is invested in different types of fixed income around the world, would offer a high level of diversification. It certainly comprises plenty of holdings – more than 21,000 at 28 February 2018.
More than just a number
Numbers alone, however, do not necessarily equate with diversification. There are a number of common problems with bond indices. The first is that they are biased towards the issuer rather than the investor. Typically, the larger the borrower, the larger its component of the index. Passive tracker funds or benchmark-focused investors that do not want to risk too high a tracking error are obliged to hold some exposure to these large borrowers, irrespective of whether the borrower or bond issue is an appealing investment from a fundamental perspective.
Second, bond indices face compositional drift that reflects the past, rather than what is necessarily relevant for the future. For example, government and government-related debt now comprise more than 60% of the Bloomberg Barclays Global Aggregate Index as shown in Figure 1.
Figure 1: Composition of Bloomberg Barclays Global Aggregate Index, % weight Source: Bloomberg, Bloomberg Barclays Global Aggregate Bond Index (LEGATRUU), US dollars, as at 28 February 2018.
As a result, this widely-followed bond index has a very high correlation to government bonds (see Figure 2). This might be useful if your intention is solely to diversify equity risk but it does mean that investors are getting less exposure to other areas of fixed income than they might desire. It also means that with developed markets comprising a large proportion of this index and developed market government bonds having reached record low yields in recent years, investors are exposing themselves to a high level of duration risk (sensitivity to interest rate changes). This could prove damaging to returns in an environment where the US – the biggest component of the Bloomberg Barclays Global Aggregate Index – is on a clear monetary tightening trajectory, with the market expecting further US interest rate rises during 2018.
Figure 2: Correlation matrix for different asset classes, Dec 1997 to Dec 2017 Source: Thomson Reuters Datastream, 31 December 1997 to 31 December 2017, Global Agg = Bloomberg Barclays Global Aggregate Index, Global Govt = ICE BAML Global Government Bond Index, Global IG = ICE BAML Global Corporate Index, Global HY = ICE BAML Global High Yield Index, Global Equities = MSCI World Index, all total return in USD. Past performance is not a guide to future performance
Sub-asset classes behave differently
Fortunately, fixed income is not a homogeneous asset class. Different parts of fixed income behave in different ways and this can be valuable for unconstrained active investors, who have the freedom to selectively allocate between different areas of the market and individual securities.
In times of economic downturn, government bonds typically do well, while more credit sensitive high yield bonds typically perform better when economies are recovering or expanding and risk appetite is stronger. Longer-dated bonds allow investors to lock in rates when they are afraid that yields may fall but investors worried about rising rates could consider floating rate notes and index-linked bonds where income rises as interest rates rise. Figure 3 demonstrates the dispersion in returns within fixed income over the last 10 years.
Figure 3: Annual returns for different areas of fixed income Source: ICE BAML, Credit Suisse, JPMorgan, Barclays, as at 31 December 2017Note: ICE BAML Indices in USD: ICE BAML US Treasury Master; ICE BAML Global Broad Market Corpoartes hedged to USD; ICE BAML Global High Yield hedged to USD; ICE BAML US 3-month constant maturity Libor; Credit Suisse Western European Leveraged Loans hedged to USD; Barclays pan European 50/50 AAA/AA ABS FRN Composite Index (EUR); Emerging market debt is 50/50 blend of JPM GBI EM local currency index in USD and JPM EMBI Global Diversified Index.Past performance is not a guide to future performance
Another benefit of an unconstrained approach to fixed income is geographical diversity. The US remains the dominant economy and developments in the US often affect the ebb and flow of economies elsewhere. However, its percentage of global gross domestic product has declined from 40% of the global economy in 1960 to 25% in 2016 (source: World Bank, World Development Indicators, current USD). In contrast, emerging markets such as China, India and Brazil have seen their share of the world economy rise, yet they remain under-represented in many bond indices.
Economies are also often at different phases in the economic or credit cycle. Today, some countries like the US are raising interest rates, others are on pause such as Australia and the eurozone, while others are actively cutting rates, such as Brazil. Having the freedom to move at will between different geographies allows an unconstrained investor the opportunity to take advantage of differences in the yield curves between countries. For example, a steeper yield curve might mean we are more disposed towards bonds issued by banks in that country because it makes it easier for them to generate earnings from borrowing short term and lending long term. Figure 4 demonstrates how, in just the short space of two years, yield curves can move in very different directions. Mexico’s yield curve has inverted slightly as short-end yields move slightly above mid-dated yields (signifying expectations of an economic slowdown in the near future). The US yield curve has flattened as the US pursues monetary tightening but still offers a term premium to investors. Meanwhile, the German yield curve has steepened as expectations rise that eurozone inflation will be higher in the future and that European Central Bank unconventional policy measures will be removed beyond the near term.
Figure 4: Sovereign yield curves, same period but different outcome Source: Bloomberg, country sovereign curves, as at 28 February 2018. Yields may vary and are not guaranteed.
Gauging where a country might be in its economic and credit cycle has important implications for where we might want to be invested in terms of accepting or avoiding interest rate risk or credit risk. Within the broad general cycle there are also mini cycles, so there are periods when yields may temporarily rise or fall, or credit spreads widen or narrow, independently of what might be expected of the cycle. Often this is triggered by unexpected economic data, politics (eg, Brexit or Trump protectionism), central banks surprising on policy, or idiosyncrasies associated with an issuer. An active approach allows active managers to tactically exploit situations as they arise.
Taken together, these differences between and within bond markets create opportunities for managers with a flexible fixed income mandate – a flexibility that is all the more important in today’s markets as investors can no longer rely on the supportive tailwind of declining yields to boost capital returns. By building a diverse portfolio and dynamically adjusting exposures an active, unconstrained manager can seek to generate returns and help mitigate risks in a market that is constantly evolving.
The views presented those of the manager at the time of publication. They are for information purposes only and should not be construed as investment advice. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent and may be subject to change.