Core-Plus Bond Management

Overview: Core-Plus Bond Management Kathryn Dixon Jost, CFA Vice President, Educational Products Core-plus did not gain ...

Author: Daniel J. Fuss | Brian E. Hersey | Jae Park | Ronald Layard-Liesching | Lee R. Thomas III | Scott F. Richard | Barry Coffman | Ismail Dalla | Kenneth Windheim | James Grant

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Overview: Core-Plus Bond Management Kathryn Dixon Jost, CFA Vice President, Educational Products Core-plus did not gain acceptance among mainstream fixed-income managers until relatively recently, perhaps partly because it represents a significant departure from traditional fixed-income management. As conference moderator William Nemerever observed, the quantitative risk management technology used today represents a dramatic change from the reliance in the 1970s on the fixed-income bible Inside the Yield Book,1 with its compilation of price–yield relationships, but despite apparent differences, both techniques share a focus on the term structure of interest rates. Core-plus, however, moves away from term-structure risk and enters the realms of emerging market credit risk, extreme-event risk, and market correlations. Although core-plus is conceptually appealing to many fixed-income managers because it may enable fixed income to gain a greater share of overall fund asset allocations, perspectives do vary. The conference reflected this lack of consensus in a four-speaker panel (not included with the longer formal presentations in this proceedings) that highlighted the benefits and pitfalls of core-plus.2 For example, one member of the panel focused on his firm’s recent success with coreplus management: roughly 250 basis points of alpha and only a 0.3 percent increase in overall portfolio volatility, despite unexpected market volatility during the five-year period 1995–2000. Another speaker, however, expressed concern about core-plus and cautioned that extending beyond a core portfolio to the “plus” sectors often creates a suboptimal result for the client. Also, because the domestic investment-grade index (the core portfolio) is changing and becoming increasingly dominated by callable mortgages and corporate debt with deteriorating creditworthiness, the risk–return characteristics of the core portfolio are not fixed, so venturing beyond the core benchmark to add alpha may be extremely risky indeed. Not only are the overall benefits and liabilities of core-plus open to debate; many of the fundamental characteristics of core-plus remain unresolved: What should the “plus” in core-plus be? What benchmark is appropriate? How should core-plus portfolio risk be measured? Should the “plus” strategy be implemented by a specialist? Part of the core-plus appeal 1 Martin Liebowitz and Sidney Homer, Inside the Yield Book: New Tools for Bond Market Strategy (Englewood Cliffs, NJ: Prentice-Hall, 1972).

may lie in this lack of strict parameters. In many ways, the expansion to a core-plus universe restores managers’ flexibility to exploit possible market inefficiencies and thereby achieve excess returns. The presentations in this proceedings connect the theoretical potential for alpha with the practical challenges of achieving it.

From Sideshow to Core-Plus Daniel Fuss, CFA, summarizes the evolution of fixedincome management over the past several decades, from its mid-20th-century position as “an investment management sideshow” that could not even charge clients a direct fee to its current status as a thriving feebased business. In the past, fixed-income strategy depended almost exclusively on a laddered approach, but today, the essence of fixed-income management is the highly sophisticated, quantitatively driven maximization of total return. This transformation has not been engineered by the investment community but rather has been produced by the combination of globalization, a volatile interest rate environment, and profound technological advances. Brian Hersey shares the results of two recent Watson Wyatt surveys of a significant number of U.S. fixed-income investment organizations. Although the theoretical arguments supporting core-plus are persuasive, the empirical evidence is mixed and sensitive to time-period and manager-universe interpretations. Mr. Hersey attributes the success of core-plus to two factors: first, a bond market with sufficient liquidity and depth to meet the strategic needs of institutional investors and, second, a manager skill set commensurate with the risks associated with extended sectors of the fixed-income markets. If managers cannot demonstrate consistent out-of-index management skills, investors should not pay active-management fees to participate in these sectors on a permanent basis. Mr. Hersey also expects that the next several years will be a critical period for testing the core-plus proposition 2 This discussion is available at www.AIMRDirect.org in an online Webcast that includes the presentations of all four participants: Mark Smith, managing director and senior fixed-income portfolio manager at J.P. Morgan Investment Management; Frank Del Vecchio, portfolio manager at General Motors Investment Management Corporation; Michael O’Leary, Jr., CFA, executive vice president at Callan Associates; and Marc Seidner, CFA, associate director at Standish, Ayer & Wood.

©2001, Association for Investment Management and Research®

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Core-Plus Bond Management under conditions of larger asset commitments and a potentially less-than-favorable investment environment. Even with such daunting challenges, the failure of core-plus would be a big surprise. Jae Park examines core and core-plus strategies and compares the performance of equity and fixedincome active-management strategies, active and passive fixed-income strategies, and various types of active fixed-income strategies for various periods within the past 10 years. Mr. Park concludes that the theoretical rationale for core-plus management is clearly compelling and that in his experience at the IBM Retirement Fund, certain core-plus strategies have indeed delivered impressive results. But a word of caution is still in order: During good times, core-plus will look exceptionally good, but during bad times, the opposite is true. The reason for these extremes is that successful market timing has been a critical factor in the performance of top core-plus managers.

Excess Return and Risk Past sources of alpha are disappearing while simultaneously being replaced by other sources, according to Ronald Layard-Liesching. Technology is the driving force in both evolutions. Mr. Layard-Liesching analyzes the potential for excess return from a global investment based on four elements: scale, sustainability, the information ratio, and the possibility of extreme loss. In this context, credit and currency offer the greatest contribution to excess return. As domestic markets become more efficient, a natural trend toward less efficient markets and sectors is not so gently pushing investors into the global arena. The long-dominant home-country bias is losing steam, and global diversification in fixed-income portfolios is moving ahead with alacrity. Lee Thomas discusses the relatively new topic of portable alpha and its implications for four areas critical to core-plus bond management: benchmarks, guidelines, tracking error, and firm structure. Active management is the attempt to accept active-selection risk only in the markets in which the risk will be rewarded. With a portable-alpha approach, the reward for active management—the excess return— can be “ported” onto equity or bond returns through the use of long derivative positions. Furthermore, tracking error is also portable. If a client’s benchmark is revised substantially, the client has no need to obtain a new manager because the manager’s information ratio (an active portfolio’s excess return divided by its volatility) will theoretically remain unchanged even when the manager’s benchmark is changed. The manager can continue managing the

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portfolio in the same manner and port the alpha to the new benchmark. Systematic risk is of overriding importance because it is the largest source of risk in a portfolio. Scott Richard stresses that compared with core portfolios, core-plus portfolios simply have more, but not different, systematic risk. He focuses on the various types of systematic risk and how each affects coreplus portfolios. Three fundamental tasks facing managers are understanding the systematic risk present in a portfolio, measuring and managing that risk, and writing guidelines that ensure that the risk is controlled. Because modern portfolio theory gives portfolio managers the ability to control any unwanted systematic risk, the primary concern is the accurate assessment of client goals and objectives.

The “Plus” in Core-Plus The proper selection of the “plus” component of a core-plus portfolio is a subject open to debate. Barry Coffman makes the case for high-yield bonds as the most valuable out-of-index sector in terms of marginal risk-adjusted return. High-yield bonds offer the advantages of high absolute returns over time and low correlations with other asset classes, but if the investor is to reap the benefits of this sector, employing a dedicated manager who is proficient in the highyield markets is mandatory. Research capabilities are intrinsic to the success of a high-yield bond strategy. Ismail Dalla makes the case for emerging market debt as the “plus” in a core-plus portfolio. He points out that emerging market debt has provided strong risk-adjusted returns in recent years, even outperforming U.S. large-cap stocks. He also highlights the need for a specialized manager to deal with default, macroeconomic, and political risk. Emerging market debt is less risky than generally characterized and has excellent diversification properties for a fixed-income portfolio. Although plan sponsors continue to make greater allocations to emerging market equity than to emerging market debt, the debt sector compares favorably with the equity sector in terms of performance over the past five years. Kenneth Windheim argues the case for sovereign debt. In particular, he emphasizes the danger of extreme market disturbances. Because all sovereign debt enjoys, to some degree, the benefit of relatively minimal credit risk, in flight-to-quality market conditions, government bonds will outperform other bond sectors. Sovereign debt also has superior diversification benefits, particularly in an equity-heavy portfolio. Mr. Windheim argues that the “plus” decision begins with a thorough analysis of the core portfolio. Then, given the asset allocations of the core portfolio, the “plus” portfolio can be chosen.


Overview

Benchmarks of the Mind

Conclusion

James Grant offers an irreverent view of the “benchmarks of the mind”—commonly held truths that typify the current market cycle. He identifies five benchmarks peculiar to this cycle: the benefits of technology, the definition of an optimal financial structure, the infallibility of the Federal Reserve, the permanence of disinflation, and the preeminence of the U.S. dollar. The investor is trapped in a cycle of learning and then forgetting unpleasant lessons of the past. Recognizing that the benchmarks of the mind are transitory in the long term is important in preventing investing catastrophes.

If the quest for alpha is a unifying theme in this proceedings, a note of caution is the counterpoint. Even some hardy proponents of core-plus acknowledge that changing market conditions could mean difficult times ahead for core-plus managers, and all the authors stress the importance of appropriate risk controls. As Grant notes, because something seems to make sense in current circumstances does not mean the same thing will hold true under different conditions. Given the elastic nature of core-plus, managers must exercise particular vigilance against incurring unnecessary or inappropriate risks as they stretch beyond the benchmark to add value for client portfolios.


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Fixed-Income Management: Past, Present, and Future Daniel J. Fuss, CFA Vice Chairman Loomis, Sayles & Company, L.P. Boston

Fixed-income management has undergone profound evolution in the past several decades, leaving almost no facet of the markets, investments, or the securities business untouched. The only certainty about the future is that it will bring significant and probably unpredictable changes, and managers must learn not only to accept near-term uncertainty and volatility but also how to succeed through flexibility and ingenuity.

ixed-income management has reinvented itself since its inauspicious beginnings. No longer an investment management sideshow, fixed-income management is now in the center ring of investment management. Four decades ago, fixed-income managers focused simply on income, safety, and liquidity, not even charging a direct fee for their services. Today, fixed-income management is a lucrative, feebased business in which highly sophisticated professionals strive to maximize total return. The evolutionary process that produced this transformation was not purely a matter of clever initiative on the part of managers but rather the collision of a volatile interest rate environment, maturing and innovative global markets, and strategy adaptations.

F

Past The changing characteristics of investors, borrowers, and fixed-income managers tell the story of the fixedincome market over the past half century. The amount of change that can occur in the span of a career is remarkable and demonstrates how, in only a few decades, alterations in fundamental factors, such as the shifting identities of major market participants, can lead to a dramatically different future. Investors. In the past, the motivations and concerns of early bond market investors were quite simple. Investors wanted to make sure that they earned the money necessary to cover their liabilities and that they received their principal and interest payments.

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Thus, investors were concerned about call protection and credit analysis. In this respect, the more the world changes, the more it remains the same. Prior to the 1980s, the dominant investors in the bond markets were life insurance companies. The life insurance companies needed income and feared reinvestment risk, which is still true today, but these characteristics were more prevalent in earlier years. Property and casualty insurance companies were also bond market investors, but on a much more cyclical basis. The banks and the savings and loans, also major bond market investors, had a somewhat shorter investment horizon than the insurance companies. The banks focused closely on the stage of the economic cycle before they invested or went to the other extreme and duration-matched assets and liabilities. Employee benefit plans—embryonic at that time—were dominated by defined-benefit plans, which initially were run like the reserves of life insurance companies. Individual investors were not major participants in the bond market, and mutual funds and foreign investors—two major players today— also did not have great involvement. In the 1980s, things started to change. The skills required to manage fixed-income funds evolved to a more sophisticated level, and the number of people needed to manage these funds increased. Borrowers. Until recent years, the dominant borrower in the fixed-income markets was the federal government—both directly and through agencies. So, the dominant borrower in the market was


Fixed-Income Management not in the least bit sensitive to the price of money, because it needed the money to pay the bills and taxing power ensured that the money would be available to repay the lenders. States and municipalities learned from the federal government and followed suit. Corporations, other than those in the top echelon of credit strength, borrowed primarily in the private-placement market, mainly from the life insurance companies. Decades ago, the market had much less liquidity than today. The basic technical skills needed by fixedincome managers were how to initiate and monitor a contract, and these skills were easy to teach—managers simply had to follow the textbook. As the government continued to issue more debt, the size of the bond market grew, as did the size of the secondary market for fixed-income instruments. At this point, investment managers could actually trade. Bond swapping became popular in the late 1960s and the early 1970s. Many people convinced their clients that high turnover was good; every time they sold Bond A and bought Bond B, they were putting a couple of cents in the bank for future years, and this process could compound the value of their portfolios. This view was accurate as long as Bond B made timely interest payments and was not called away from the lender. Most of the fixed-income characteristics that eventually came to be viewed as giving intrinsic value to a bond, such as call protection, were not recognized as valuable until after the fact. Through the 1960s and 1970s, no one, other than the actuaries at the life insurance companies, worried about call protection. Any rational person at that time, looking at the recent history of the market, would have argued that call protection was not a priority because interest rates were going up while bond prices were going down. One of my clients thought I was loony for paying a premium to have good call protection. For quite a few years, the client was right. So, the market evolved from an era once dominated by the expertise of lending money (the 1960s) and, in the early 1970s, entered an era in which public issuance of debt grew rapidly and private placements began to shrink, with secondary trading becoming important in the 1970s. Within this context, a constant theme was present in the minds of fixed-income managers: If interest rates dipped, they would rise again soon. A fixed-income manager dealing with marketable securities that were not locked into liability matching had better be able to sell quickly. This mindset continued until about 1984 or 1985, even though rates peaked at the end of September 1981. Management Style. Forty-two years ago, when I first entered the world of fixed-income manage-

ment, fixed-income managers thought in terms of flow of funds. My early training was at a commercial bank. When the chairman of that bank thought the economy was weakening, rather than making loans, he would invest in the longest Treasuries the bank’s board would accept. When the economy strengthened, the chairman would sell the bonds and make loans to the community. He was cyclically investing by speculating in Treasury bonds, and his approach enjoyed great success. In the past four decades, the fixed-income markets have been in constant flux; the emphasis on income, safety, and liquidity has now been replaced by an emphasis on total return. This change has been a good thing for most managers. Fixed-income management used to be given away to get the equity business and whatever minimal fee was charged for fixed-income management was housed under a fee for balanced funds. When managers began to see that they were earning a 9 percent total return for their clients, compared with the market’s total return of 6 percent, they realized that they could charge a fee for fixed-income management. When fees began to be charged and bonuses earned for fixed-income management, many more portfolio managers were drawn to the fixed-income side of the investment business. The focus on reinvestment uncertainty, or reinvestment risk, moderated in the 1980s but reared its head after the market slide in the spring of 1984. The common thought then was, “Let’s not worry. Interest rates are now going to rise again.” In the early 1980s, as interest rates began to fall, the risk of investing at a lower rate only to have rates rise later was a serious concern for investors. In 1984, when it appeared that rates were in fact reversing course and spiraling higher, managers were actually relieved. As investors, they would rather lend money at 8 percent than 6 percent or at 10 percent rather than 8 percent. Bond managers, by and large, felt much more comfortable with rising rates because they removed the major obstacle of reinvestment risk. The analysis of the specific risk that is associated with the call and credit provisions of a particular security, as well as some other issuer options, did not become important until the late 1970s and early 1980s. In the 1980s, the number of credit analysts grew markedly and specific security risk became paramount for bond investors. This focus was stimulated by the opportunities to capitalize on specific risk and reap the commensurate return rewards. The corporate newissuance calendar expanded, and the high-yield market was born. Private placements, on the other hand, were largely dying off, except at the life insurance companies. The tradition of borrowing shorter term with the bank and longer term with the life insurance

©2001, Association for Investment Management and Research ®

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Core-Plus Bond Management company had been broken. This evolution was a function of changes in the flow of funds in the market. The first big change in the flow of funds was that far more people were involved in the process. Then, after the 1974–84 period—or the 1972–82 period, depending on how it is measured—investors realized that bonds did have positive returns and that in some periods of time, the returns were equal to or greater than those of stocks. This observation provoked a new focus on defining the total return of a bond—not just the current yield or yield to maturity of the portfolio or the yield after expenses, taxes, and potential defaults but the total return. The measurement period for total returns shrank from a year to a quarter to a month, and now, it is measured daily. The people involved in the business, being opportunistic, intelligent, and well educated, quickly started to raise their fees again because they had discovered a demand for performance in bonds. In the 1980s, the types of yield curves familiar today first appeared. The yield curve bounced all over the place. On a daily basis, managers transacting in the market discovered that the yield curve plotted by the research analyst the day before was no longer an accurate guide. In the more volatile interest rate climates, liquidity would exist one moment but abruptly disappear. After a while, a few bright people wondered why the dealers were not always participating in the volatile markets. The dealers explained that they had to pay for the money they used. If their cost to borrow capital exceeded the carry (or interest rate earned) on the bonds, they could not afford to continuously hold large inventory positions. Bond managers, being a bright group of people, saw an opportunity in this situation. Because the managers were agents acting on behalf of clients, they did not have the burden of cost of carry and did not have a need to stay invested in the market. Thus, they agreed to inventory the bonds that the dealers could not afford to inventory. The dealers knew which managers had certain types of bonds, and they bought those bonds from the managers whenever they were in demand. Because the managers were facilitating the needs of the dealers, the managers (or rather the managers’ clients) were paid top dollar to bring the bonds out of the managers’ portfolios. This reciprocity helped dealers and managers successfully bridge the periods of sharply inverted yield curves and interest rate volatility in the 1980s. The saying “reinvestment returns are soaring” used to be quite common. This saying meant that rates were once again on the rise and the value of fixedincome portfolios was shrinking. In an attempt to control the vagaries of the market, managers began to look for the theory behind the numbers rather than

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simply buying a yield curve. A theory developed that still exists today, and I believe it will carry into the future. At first, the theory supported the position that if a corporate bond and a T-bond have identical coupons and maturities and the corporate has a higher yield to maturity and call protection and credit rating are ignored, the corporate will have a shorter duration and a higher yield when calculated to its duration. The better investment appears obvious: Yield products such as corporate or asset-backed securities should always beat Treasuries by a mile. What appears to be obvious, however, is not necessarily true. As time passed, managers realized that the present value of the final principal payment tended to dominate the duration calculation as the bond approached maturity. Consequently, given an illiquid market, the difference in yield spread narrowed as the final maturity approached. So, the theory evolved until a new and different type of bond swap entered the picture. This swap was not apples for apples with a pick-up of one or two points. Instead, time-series swaps emerged. The approach was to buy strong credits with good call protection and then leave them alone. Turnover is bad because it costs money, particularly when capital is scarce in the market, but time is a friend. According to the theory, over longer periods of time, despite temporary yieldcurve inversions, the normal yield curve is positively sloped. Thus, the total return difference between T-bonds and any other type of bond will narrow as the final maturity is approached. Along with the expansion in the role of the fixedincome portfolio manager came the emergence of the marketing department. All of a sudden, marketers and client-service people appeared. Fixed-income management firms found they had a product supported by good performance. Finally, the fixedincome business had historical performance numbers, even if they were fuzzy at best. Naturally, performance is dependent on the reporting time period, and certainly, some amount of business could have been generated from the performance numbers in the early years of the period. Nevertheless, with a supportable theory that not only could be put into practice but could earn excess returns, the marketers had a product they could sell, and sell they did. The basic concern now and in the future deals not with the flow of funds but rather with the nature of bonds. The problem with managing bonds is the absolute-return competition from other asset classes. Recently, the returns in other areas have clearly been a lot better than fixed-income returns, and fixedincome managers cannot do much about these circumstances.


Fixed-Income Management

Today The mechanism that once drove the market (flow of funds) and the borrowers and investors that once dominated the market have faded in importance. The dominant borrower is no longer the federal government. The dominant investor is no longer dealing with structured liabilities. (In my view, however, the federal government, currently a net provider of funds to the market through the significant retirement of public debt, is likely to return to a position of dominance in the future.) The dominant borrowers today are corporations and individuals, who are coming to the market through various channels, such as mortgage-backed or asset-backed securities. The major investors, or buyers, of bonds are far more diverse than in the past. The defined-benefit pension plan is not nearly the force that it used to be and is no longer the net provider of funds to the market. The life insurance companies are not the force they used to be and are no longer monstrously large net providers of funds. Definedcontribution pension plans are important investors, especially the 401(k) and similar tax-protected plans, and of course, individuals participate through individual retirement accounts (IRAs). Foreign entities are net buyers of bonds, particularly in the corporate market, and are emerging as a dominant force. Reinvestment risk remains a major uncertainty in the fixed-income market. Although reinvestment risk certainly has an impact on total return, it is not the dominant factor that it once was. Credit risk has now replaced reinvestment risk as the primary concern among investors. The specific analysis of credit risk, in a period of time when credit risk is rising and much more in the forefront, is important. More credit analysts are hired than traders, and this trend will continue. As technology has advanced, the back office has also changed dramatically. Back-office staff no longer use bond calculators to settle trades; settlement calculations are performed by sophisticated computers.

Future The reality is that, just as in forecasting interest rates, I do not have the foggiest idea, other than a few guidelines drawn from the past, about what is going to happen in the market five years from now. I expect individual investors to become much more of a factor in the bond market, both through greater control over their retirement funds and as direct investors. Foundations, endowments, and similar tax-exempt organizations are clearly an emerging force in the bond market, as they are in the other investment markets. Non-U.S. investors and borrowers are the participants with the potential for the greatest growth. The world’s financial markets have become global, and people

involved in an investing function on a serious basis must be global in their thinking. Gone will be the ability to focus on a pocket within a market as if it were the entire market, whether the pocket is private placements, investment-grade corporate bonds, or highyield bonds. Tax differentials will still be important. Regulatory differentials will be extremely important. Fixed-income managers used to conceptualize the possibilities for return by making a simple table for each type of bond based on the market scenario at a single point in time, as shown in Table 1. I prepared this table in 1993 for an endowment fund because it provided a way not only to communicate with the client but also to focus on a likely return forecast. With this format, I could talk to the client about the market risks involved with specific investments and the risks that were important to them. These two concerns, as well as a security’s expected yield, were critical to bond managers. The table also illustrates whether a bond was a marketable security and what potential capital gain or loss was associated with a particular interest rate forecast. Table 1 highlights how we used to conceptualize portfolio and security risk and the impact of these risks on portfolios. In the future, we will have a different perspective. Currently, fixed-income managers are replacing a time-specific, finite analysis with a fine-tuned balancing act of multidimensional considerations. The emphasis has shifted—and will continue to shift—in the direction of specific security analysis. Managers will focus on the total return a given bond will provide over a certain time period and how these attributes mesh with their clients’ needs. Managers will need to increase their awareness of the nature and psychology of markets. Participants must accept, and accommodate in their investment strategies, the notion that markets will be markets. In other words, they must embrace nearterm uncertainty and volatility, which is a necessary precondition of managing money in a global environment. The world has changed from a time when managers could focus solely on the municipal or highyield market to a time when no sector can be dismissed. To complicate matters, neither managers’ nor clients’ investment guidelines have changed in sync with the world markets. Experience, flexibility, and strong fundamental credit analysis are prerequisites for success in the fixed-income markets of the future.

Conclusion The future of fixed-income management obviously depends on the skills of the people involved, but one other important factor is influencing the markets: world peace. Recently, fixed-income management has evolved during a period when peace has been the


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Core-Plus Bond Management Table 1. Characteristics of Marketable Securities in the Current Market Risks Security

Market

Income

None

High

Yield

Marketability

Capital Gains Potential

Excellent

None

Short term Commercial paper (3-month)

3.14%

Five-year bonds U.S. government

Medium–

Medium

5.15

Very High

Medium–

Agency

Medium–

Medium

5.49

High

Medium–

AA utility

Medium–

Medium

5.55

Medium

Medium–

U. S. government

Medium

Low

6.96

Very High

Medium

Agency

Medium

Low

7.23

High

Medium

Current coupon FHLMC PCs

Medium–

Medium–

6.84

Medium

Medium–

Long-term bonds

New issue levels (SB averages) AA utility

Medium

Low

7.65

High–

Medium

BBB utility

Medium

Low

8.00

Medium

Medium Medium

AA industrial

Medium

Low

7.65

High–

BBB industrial

Medium

Low

8.10

Medium–

Medium

A revenue, municipal

Medium

Low

6.00

Medium+

Medium

Medium

Low

6.60

Medium–

Medium

Convertible debentures Moderate discount, nonvolatile Moderate discount, volatile

Medium

Low

7.80

Low+

Medium

Par, nonvolatile

Medium

Low+

6.90

Medium+

Medium–

Medium+

Low+

7.30

Medium

Medium

Medium

Par, volatile Common stocks Established growth

Medium+

Low

1.25

Very High

High+

Low

0.75

Medium

High

Moderate growth

Medium+

Low+

1.70

High

Medium

Cyclical growth

Medium+

Medium–

4.45

High

Medium

Electric utilities

Medium

Medium–

5.70

High

Medium

Smaller growth

Note: FHLMC PCs = Federal Home Loan Mortgage Corporation participation certificates; SB = Salomon Brothers.

norm throughout the developed markets. Without peace, a completely different social and economic setting and a completely different set of biases would exist—circumstances that would be unfriendly to bonds. In a world without peace, investors would be better off forgetting about investing and simply trading bonds quickly. Perhaps the apparent changes I identify are merely cyclical. On the other hand, if these changes have occurred as a function of peace, not economic cycles, then cyclical effects may be less common in

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the future, as long as peace continues. Of course, just because the river is quiet does not mean the crocodiles are gone. The crocodiles are out there, languorously waiting for the unsuspecting swimmer. As in the past, surprises in the fixed-income markets will occur that will bring stresses as well as opportunities. Clearly, the future will bring a much more globalized market. The barriers between investment categories and asset types will fall. The markets will demand the flexibility to accommodate and exploit these changes.


Fixed-Income Management

Question and Answer Session Daniel J. Fuss, CFA Question: Is core-plus management the predominant mandate of the future? Fuss: A marketing person’s answer would be yes, but I’m not so sure. The current management prospectus and the current search mode for managers—an RFP (request for proposal)—will feature core-plus, but the definition of core-plus is fairly broad. Fixedincome management is evolving as we speak, and at some point, the profession will fly right through what we now know as core-plus. Fixed-income professionals will be dealing with the varying natures and characteristics of a vast array of investments, so what is thought of as core-plus today (80 percent investment grade and 20 percent below investment grade) will be a thing of the past, a historical description. Fixed-income management is moving incontrovertibly toward a totally global arena because the markets are global and many of the managers are already adopting a global approach, and the profession has progressed significantly in this expansion. My sneaking suspicion, however, is that fixed-income managers will start using stocks and real estate and other non-fixed-income asset classes, depending on manager capabilities, because all the asset classes have some overlapping characteristics. Core-plus is the management style of the present, but it is changing and expanding. The life span of core-plus is fairly short—no more than five or six years. Question: How easy will it be to add value to a fixed-income portfolio in the future?

Fuss: My hope is that the fixedincome markets will adopt more of the characteristics of an auction market for fixed-income securities, much like the large buttonwood tree that once clearly identified where people could swap securities, so that the fixed-income markets will resemble the equity markets more closely. We, and others, are working hard right now to make this change happen, and the result will be a much more transparent market in which participants will be much more aware of the last trade that occurred. If greater transparency does not transpire and you want to earn returns that are superior to the bond universe in which you are operating, you’re going to have to make some changes, essentially increasing trading capacity, and those changes cost money. To the degree that the bid–ask spread shrinks because the market adopts the characteristics of an auction market, excess return will be possible, but only if you do your homework. Of course, if excess return will be possible for you, it will be possible for everyone else. Consequently, the market will get more efficient. The bond market is highly inefficient in its present form. In the meantime, the fixedincome markets will go through another phase, in which agents acting for principals take on the advantages and the uncertainties of fulfilling the dealer function. Most of the major fixed-income managers are currently in this phase. How they deal with this inventory depends on their particular management style. Will the dealers ever risk their own principal again? I’m not so sure. Will the dealers’ involvement return in the presence of hedge funds? Defi-


nitely. Their involvement is primarily a function of the yield curve and secondarily a function of the relative position between currencies and yield in one part of the world and yields in another part of the world, which will even out as time goes on and ultimately be based only on credit risk. Question: How have analytics evolved during your career, and what sort of analytics do you use in a core-plus environment to control risk? Fuss: The analytics have evolved, but I don’t claim to be the world’s greatest expert on them. Fortunately, some people at my firm are experts in this field. The nature of risk is evolving. The analytics required to understand risk are getting simpler. Managers should look at the characteristics of an investment and try to determine what the possible cash flows will be in the future. Some of the analytics used today can perform this task. Question: When you began your career, managers had no Treasury curve to spread things off. Do you think the swap market will be a substitute for the Treasury curve as a benchmark in analytics? Fuss: The short answer is no. The swap market will not be a benchmark substitute for the Treasury curve; it will be a supplement. The supposition that there was no Treasury curve when I began my career needs to be corrected. When I started, a beautiful Treasury curve existed. The first long Treasury I bought was a 3.5 percent coupon, and I bought it at par. The last long Treasury I bought had a 4.25 per-

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Core-Plus Bond Management cent coupon at a price of 92. It was issued in August 1962 and last traded around par in 1964 or 1965. I used to measure against Treasuries when I got started on the corporate side, but later, I could benchmark against agencies. Today, managers need an awareness of the swap curve because the dealers benchmark off swap rates. You have to know what the dealers are using as their benchmarks, or you can’t get your trades done. You could benchmark off agencies, but some flaws with this approach have come to the fore this year. You could do what I do, which is not to execute the trade but rather to do the analytics, the guesswork. In the case of investment-grade corporates, I look at all the other investment-grade corporates. I look up and down the sheet and look at the balance between yield and dollar price, noting anything unusual on the call (I don’t believe the wording in call protection anyway). I then contrast that assessment with lower-grade bonds, agencies, Yankees, and so on. In my own case, Treasuries have gone out the window as an effective benchmark. Question: How will the growth of hedge funds affect the bond market, if at all?

10

Fuss: The hedge funds that deal in bonds are an extension of the Wall Street inventories, and I don’t consider them any different from dealers, except that they don’t have the distribution that dealers have. The dealers are hedge funds. They are hedge funds under a different name. This arrangement is a fatal flaw in volatile markets, as we learned two years ago when the dealers refused to function in the capacity of dealers and backed away from the bid. So, I would welcome the return of the hedge funds. When the yield curve finally does return to a normal slope, the hedge funds—whether they are called leveraged money, hedge funds, or dealers—will be back as major players in the market. Spreads will compress. Liquidity will be great. Potential returns will fall, and we all may as well take a year or two off. Question: Which asset classes do you consider as legitimate investments in bond portfolios? Fuss: Practically all of the asset classes that exist today. The bond portfolios we manage and the asset classes we use, however, are specified in our investment guidelines, and we can’t go outside those guidelines. When clients ask me to write the guidelines for them, I

suggest guidelines that no client would accept. Our marketing person doesn’t come along when I meet with potential clients, and I don’t go with him anymore. I believe the investment guidelines for taxable fixed-income portfolios should be expanded to include many different types of assets. Because clients won’t accept such expansiveness and because I have a large family to feed, I use the guidelines for the Loomis Sayles Bond Fund as a starting point. I tweak these guidelines a little to adjust them for current circumstances so that we can buy all different types of fixed-income instruments, but with limits on currency and credit. (No limit is in place for reinvestment risk or duration in our mutual funds, which is a strange exception to the general Loomis Sayles guidelines.) I then set basic limits and argue for a basket “all-other” clause, which we don’t have in the mutual funds, so that we can do a few other things— normally to correct mistakes, but sometimes to make money—with other types of securities, essentially common stocks. I get the broadest possible mandate that allows me to exploit the changes that have taken place in the past decade as a result of the globalization of financial markets.


Core-Plus: Prospects and Implications Brian E. Hersey, CFA Investment Director Watson Wyatt Investment Consulting Atlanta

Core-plus appeals to fixed-income managers because it enhances the role that fixedincome management can play in an investor’s overall fund asset allocation. Although distinguished by greater credit and liquidity risk than for core portfolios, core-plus portfolios offer greater investment efficiency through the potential for higher returns and an expanded investment universe. Exploiting the advantages of core-plus, however, requires that investment organizations adapt to meet special challenges of resource/skill development and evolving investment processes.

ver the past decade, managers of institutional fixed-income portfolios methodically increased investment allocations to nonbenchmark sectors and securities. This change came in response to the increasing challenge of delivering the level of excess returns investors had become accustomed to receiving during the generous part of the credit cycle. “Extended” sectors, rapidly growing credit-sensitive sectors of an increasingly global and dynamic bond market, offered alluring yield advantages over the U.S. investment-grade markets, but they also systematically increased portfolio exposure to greater levels of credit, liquidity, and prepayment risk; catastrophic event risk arising from security-specific portfolio disasters (credit quality deterioration or default); and the more subtle systematic risk that arises sporadically when a fixed-income portfolio’s expected diversification value vanishes in declining equity market environments.

O

Core-Plus Surveys In a 1998 study, Watson Wyatt Investment Consulting examined the degree to which the investment parameters of traditionally managed fixed-income portfolios were being extended to include nonbenchmark sectors.1 This change coincided with the broad trend of institutional investors committing increased percentages of assets to higher-risk investments, princi1

“Are Today’s Fixed-Income Portfolios Taking On Too Much Risk?”

pally equities and alternative investments, at the expense of historically more stable investments, such as bonds. The study concluded that portfolio risk exposures—including those associated with nonbenchmark “performance-enhancing” investments— were not necessarily inappropriate but needed to be congruent with each investor’s investment time horizon and preferences for risk and liquidity. The risk exposures also needed to make sense for risk budget allocation. Watson Wyatt followed up the 1998 study with a 2000 survey group of more than 91 of the leading U.S. fixed-income investment organizations (a response rate greater than 85 percent), with more than 95 percent of the participants in the 1998 study represented in the 2000 survey group. Collectively, the respondents manage $1.5 trillion in U.S. fixedincome assets, which represents 27 percent of the entire domestic bond market. The analysis in this presentation is based on the data from these two studies and examines the development, characteristics, growth prospects, and investment implications of core-plus fixed-income management.

The Growth of Core-Plus The 1998 study is significant because it captured the evolving profile of institutional fixed-income portfolios during the 1990s and because it ended at the point when the demand for core-plus bond management began in earnest. Sector allocation evidence from the 1998 study supports the assertion that the risk profile


11

Core-Plus Bond Management of fixed-income portfolios increased significantly in the 1990–97 period. Figure 1 shows portfolio sector allocations/averages at year-end 1990, 1994, 1997, and 2000. Several factors underpinned the study’s conclusion that managers were “stretching” increasingly into nonbenchmark sectors to generate higher returns and were generally rewarded for having done so. The major trend of the 1990–97 period was a significant reduction (–15 percent) in government sector exposure in favor of higher allocations to both investment-g rade an d lower-quality creditsensitive sectors offering higher yields. Nondollar exposure, including the emerging market debt asset class, also increased. Overall, at the end of 1997, credit-sensitive exposure (excluding total government debt) represented 74 percent of core portfolio holdings versus 51 percent for the Lehman Brothers U.S. Aggregate Bond Index. In the past three years, the acceptance and credibility of core-plus mandates has been the dominant development in the fixed-income management industry. As a consequence, the investment parameters of core and core-plus bond mandates have been greatly clarified. Investors can now more explicitly express the appropriate role for fixed income in their policy asset allocation, ranging from a traditional, volatility-dampening approach designed for capital preservation to a quasi-equity, return-oriented approach based on nonbenchmark exposures. Furthermore, investment managers can now more precisely position products and define appropriate

management style peer groups. This ability will relieve much of the survival-driven pressure that managers may have felt to systematically “game” traditional benchmark indexes by packing core portfolios with instruments that stretched the definition of what could be called a bond. The role of core-plus in an institutional investor’s overall asset allocation will continue to engender lively debate. What is not debatable, however, is whether core-plus has become a permanent fixture of fixed-income management. Permanence is ensured because of the generally favorable results investors have realized, the expanded investment opportunities offered by today’s nearly US$7 billion bond market, and the infrastructure investment made by organizations in order to function efficiently in a significantly more complex global investment environment.

Defining Characteristics Core-plus is the result of a metamorphosis of traditional active bond management. The point of departure lies in the investment universe from which coreplus portfolios are constructed. A different universe means different characteristics of return and risk and different performance expectations. The primary differentiating characteristics between core and core-plus are credit quality and liquidity. Coreplus portfolios have relatively greater credit and liquidity risk than traditional core portfolios have.

Figure 1. Average Sector Allocations for Fixed-Income Portfolios for Various Years 30 Allocation (%) 45 25 40 20 35 15 30 10 25 5 20 0 15

Government

Mortgage Backed

Asset Backed

10 5

1990 Average

0 Government

Mortgage Backed

1990 Average

Credit High-Yield (InvestmentGrade Corporate)

1994 Average Asset Backed

1997 Average

Credit High-Yield (investmentgrade corporate)

1994 Average

1997 Average

Nondollar

Other

2000 Average Nondollar

Other

2000 Average

Source: Based on data from Watson Wyatt 1998 and 2000 surveys.

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Core-Plus: Prospects and Implications The core portfolio is the traditionally defined mandate, which consists of a portfolio of U.S.-dollardenominated investment-grade fixed-income securities, with a distinct duration target linked to a broad market benchmark, such as the Lehman U.S. Aggregate or Salomon Smith Barney Broad InvestmentGrade (BIG) Bond Index. The core portfolio’s objective is to outperform the defined benchmark while emphasizing preservation of principal, and it is expected to add value through moderate duration adjustments, yield-curve strategies, sector rotation, and security selection. Core-plus mandates include the core investment universe plus tactical, opportunistic (that is, investing when the risk–return prospects are considered attractive) allocations to high-yield, non-U.S.-dollar (hedged or unhedged), emerging market, and convertible debt instruments. The objective is to significantly outperform a broad U.S. fixed-income benchmark. Core and core-plus mandates have distinct parameters, as shown in Table 1. Core-plus portfolios are expected to have an average excess return (before management fees) much greater than the range targeted for core mandates, with a benchmark tracking error only moderately higher. The survey respondents believe these return ranges represent realistic, achievable, full-market-cycle goals and explain why investors are finding core-plus mandates so conceptually appealing. Watson Wyatt’s position is that the survey group’s benchmark tracking-error range is reasonable but that the return estimate range is overly optimistic. In our view, a projected return range of 75–100 basis points is a more realistic risk expectation.

Table 1. Core and Core-Plus Mandates: Distinguishing Characteristics Characteristic

Core

Core-Plus

Benchmark excess return target

35–70 bps

100–125 bps

Tracking error

75–100 bps

125–150 bps

Consensus benchmark

Lehman U.S. Aggregate


Nonbenchmark exposures

0% (5% common)

15–40%

Management-fee differential

—

About a 10% premium over core

Note: bps = basis points. Source: Watson Wyatt 2000 survey.

The essential attractiveness of core-plus is its potential for delivering improved risk-adjusted excess returns. A core-plus portfolio offers three main potential advantages: (1) the ability to realize higher returns from exploiting market inefficiencies outside the traditional domestic investment sectors; (2) increased opportunities for asset class rotation and security selection (i.e., more opportunities to act on insights); and (3) the ability to exploit imperfect correlations between individually risky market sectors and instruments to provide a diversification benefit at the total portfolio level. The catch is that investors need to be willing to withstand periods in which realized correlations are higher than expected. Such circumstances are likely to occur in declining equity markets. For example, in 1998, the Long-Term Capital Management dissolution rippled through the capital markets while the Russian debt crisis sparked a broad-based revaluation of credit risk. So, the downside-risk potential of core-plus needs to be fully appreciated by investors. The Lehman U.S. Aggregate is the survey consensus index of choice for core-plus portfolios, although investors are beginning to give consideration to the Lehman Brothers U.S. Dollar-Denominated Universal Index. By adopting a universal index as a benchmark, an investor would be indicating that the normal policy allocation to nontraditional sectors (high yield, eurodollar, private placements, and commercial mortgage-backed securities) is approximately 16 percent, as opposed to having little or no exposure to these sectors with the Lehman U.S. Aggregate. Thus, the manager would receive a different message about the normal weighting from which tactical deviations are to be made in these sectors. Our survey responses show that managers of discretionary core-plus mandates benchmarked against the Lehman U.S. Aggregate exhibit a broad philosophical approach to setting sector allocation limits for investments in nonbenchmark sectors. Table 2 shows the average June 2000 sector allocations for core and core-plus mandates from the survey group, as well as for the Lehman U.S. Aggregate and Universal indexes. The wide allocation range indicates that investors need to be extremely careful in comparing performance and risk attributes among different managers, even though the classification of a core-plus peer group in the Lehman U.S. Aggregate has become more clearly defined. Interestingly, the average core-plus allocation to the extended sector category nearly matches the benchmark allocations for the Lehman Universal. As this index becomes more widely adopted, the average allocation to the extended sectors should rise.


13

Core-Plus Bond Management Table 2. Average Core and Core-Plus Sector Allocations, June 2000 Sector

Core

Core-Plus


Lehman Universal

Treasury/Agency

22.%

19.%

42.%

35.%

Mortgage backed

37

36

36

30

Asset backed

10

8

1

1

Investment grade

27

21

21

18

High yield

1

7

na

5

Eurodollar

1

5

na

8

Other

2

3

na

3

Corporate

na = not applicable. Source: Based on data from Watson Wyatt 2000 survey and Lehman Brothers.

The fee differential between core and core-plus mandates (after considering the additional resources required to support a core-plus approach) reveals only a marginal financial inducement for investment managers to promote core-plus in a no-growth or negativegrowth market for institutional bond management. Over the 1995–2001 (using estimated data for 2001) period, the average allocation to fixed income by the largest U.S. tax-exempt pension funds is likely to decline from 28.1 percent to 24.1 percent, according to Greenwich Associates.2 The average management-fee differential, however, is inconsequential if the claimed benefits of core-plus are realized. Core-Plus Growth Drivers. Over the past 2 1/2 years, core-plus assets managed by the survey group grew nearly 50 percent, compared with 20 percent for core assets under management, and core-plus assets now exceed US$325 billion in total. This powerful growth trend for core-plus is a consequence of several factors. The primary driver has been investors searching for ways to increase their fixed-income returns (or alpha). Investors have generally been pleased with the risk-adjusted returns but have naturally viewed results in the context of the long equity bull market. In this environment, investors have been willing to pursue fixed-income strategies that offer higher potential return. The “tailwind” reinforcement of having been rewarded for taking additional risk in a favorable investment environment and the confidence in the ability of specific managers to avoid the downside of the riskier sector exposures have combined to make this decision comfortable for many investors. 2

“How Funds Are Coping with ‘Uncertain Markets,’” 1999.

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Another important factor in the growth of coreplus relates to investment governance in an environment in which pension staffs have been downsized and allocations to fixed income have been reduced in favor of other strategies that offer potentially higher returns and greater diversification benefits. Coreplus provides a means for investors to consolidate manager relationships while improving investment efficiency instead of using several extended sector managers with more narrowly defined investment guidelines. Simplifying manager structures (particularly when investment fiduciaries can delegate more decision-making authority to investment experts) and leveraging relationships are major plan sponsor priorities. Finally, the tremendous growth of the bond market supports the demand for core-plus by increasing the universe of sectors and instruments that can become mispriced. This growth also serves the commercial needs of the largest industry participants, whose insatiable appetite for investment products must be fed to satisfy their aspirations for asset growth. Greater Investment Efficiency. Core-plus conceptually improves on the investment efficiency of a core mandate by increasing the scope and breadth of investment opportunities a skillful manager can exploit. If a manager’s insight, or skill, can be acted on more frequently by increasing the number of independent portfolio decisions that can be made, active return will increase. Thus, for any level of active risk, the realized portfolio information ratio (active return alpha divided by active risk) will increase. The efficiency implications favoring core-plus are considerable—if a manager can both improve overall skill and increase investment breadth. In short, the core-plus argument for improved investment efficiency depends on a manager’s ability to (1) take advantage


Core-Plus: Prospects and Implications of asset classes offering higher returns and (2) exploit pricing inefficiencies in an expanded universe of lowcorrelation investments otherwise inaccessible to certain investors. ■ Higher returns. Figure 2 compares the returns (asset-weighted averages) for the survey group’s core and core-plus mandate composites and the Lehman U.S. Aggregate index for various periods ending June 2000. Core-plus average annualized returns have exceeded core returns by margins ranging from 5 basis points for the 3-year time horizon to 66 bps for the 10-year period. The evidence provides support for the argument that core-plus will deliver higher returns to patient investors with reasonable investment time horizons. Over the 5-, 7-, and 10-year periods, the survey group’s core-plus composite average returns exceeded the corresponding core composite average by 56 bps, 34 bps, and 66 bps, respectively. Results over the shorter term, however, are significantly below targeted expectations. For example, the 3-year time frame, with a core-plus excess return of only 5 bps, was adversely affected by the difficult 1998 and 2000 market environments. The longer-term results also require explanation: The average includes the records of less than half of the total survey group, and it is dominated by the strong records of a handful of firms that were the early “pioneers” in managing core-plus mandates. Finally, considering the consensus benchmark target range of 100–125 bps for excess return, only the results for the 10-year period, at 108 bps, fell within expectations.

To further evaluate how well core-plus has delivered on its expected return advantage, a comparison of actual manager composite returns under both coreplus and core mandates is appropriate, as shown in Figure 3 for various periods. The excess returns relative to the aggregate index (5th to 95th percentile range) are displayed. For example, for the five-year time frame, the excess return was 17 bps for the median core mandate and 42 bps for the core-plus median and the highest excess returns (5th percentile) were 79 bps and 156 bps, respectively. Over the three-year period that includes the liquidity and credit crises of 1998, the core-plus and core excess returns are relatively indistinguishable, but the difference modestly favors the core universe. The fact that the results are not more divergent is surprising. The similarity is probably attributable to the amount of nonbenchmark sector exposure that still existed in core portfolios in 1998 and active decisions by managers to increase overall credit quality in core-plus portfolios. ■ Expanded universe. The second argument for core-plus enhancing investment efficiency is that a core-plus mandate expands the investment opportunity set. For the purposes of this presentation, the measure of investment efficiency is the information ratio, which is the ratio of the manager’s active return divided by the volatility of the manager’s active return. Consider the composite information ratio distributions for actual managers. Figure 4 shows a

Figure 2. Comparison of Core, Core-Plus, and Index Returns for Various Periods Ending June 30, 2000 Return (%) 9 8 7 6 5 4 1

2

3

4

5

6

7

8

9

10

Years Core Core-Plus Lehman Brothers U.S. Aggregate Note: Average of Watson Wyatt 2000 survey composite returns (1, 3, 5, 7, and 10 years). Source: Based on data from Watson Wyatt, Plan Sponsor Network, and Lehman Brothers.


15

Core-Plus Bond Management Figure 3. Core and Core-Plus Manager Excess Returns versus Lehman Brothers U.S. Aggregate Bond Index for Various Periods Ending June 30, 2000 Excess Return (bps) 200

150

100

50

0

–50 3 Years

5 Years

7 Years

10 Years

–100 Core

Core

Core-Plus

Core-Plus

Core

Core-Plus

Core

Core-Plus

Percentile 5th–25th

25th–50th

50th–75th

75th–95th

Source: Based on data from Watson Wyatt and Plan Sponsor Network.

comparison of core and core-plus manager information ratios for various time periods, and the data promote several interesting observations. First, the information ratios are generally close, indicating a minimal benefit to investment efficiency from coreplus. The higher average returns generated under core-plus also involved higher active risk. Thus, a more efficient overall portfolio would be possible only if investors could diversify the additional risk linked to the core-plus results. Also, in none of the time periods analyzed did the core-plus median

information ratio achieve even the low end of the target range (0.67 to 0.80); instead, it averaged between 0.40 and 0.50. Comparisons among the upper quartile of information ratios provide the most powerful support for core-plus investment efficiency. For all time frames, the top quartile core-plus information ratio results are significantly superior to the core results, as shown in Figure 5. Thus, with superior manager selection, early investors in core-plus could have realized the claimed benefits. Note, however, that even though

Figure 4. Core and Core-Plus Information Ratio Analysis for Various Periods Ending June 30, 2000 Information Ratio 0.7 0.6

Core-Plus Information Ratio

0.5 0.4 Core Information Ratio

0.3 0.2 0.1 0 3

7

5

10

Years Source: Based on data from Plan Sponsor Network.

16


Core-Plus: Prospects and Implications Figure 5. Information Ratio Analysis of Core and Core-Plus Managers for Various Periods Ending June 30, 2000 Information Ratio 2

1

0

3 Years

–1 Core

Core-Plus

5 Years Core

7 Years

Core-Plus

Core

10 Years

Core-Plus

Core

Core-Plus

Percentile 5th–25th

25th–50th

50th–75th

75th–95th

Source: Based on data from Watson Wyatt 2000 survey and Plan Sponsor Network.

core-plus information ratio results provide ambiguous support for the efficiency argument, the realized results are competitive with those achieved from other public market strategies for unleveraged active management.

Concerns about Core-Plus The counterarguments on the subject of core-plus deserve consideration. A thoughtful and passionate minority of organizations (many of whom lack the requisite resources to effectively compete for coreplus mandates) are vocal in their opposition to the adoption of core-plus by pension plans. One argument challenges the core-plus efficiency assertion, which has been found to be directionally positive but possibly overstated. Investors should carefully assess whether fixed income represents the best use of an investor’s risk budget relative to alternatives offering potentially higher returns. Another argument asserts that the risks associated with core-plus are not fully appreciated by most investors. The skewed return distributions of some extended sectors do not have a long history on which to base evaluations, which understates actual coreplus portfolio risk levels. Furthermore, they claim that core-plus will fail as a fund diversifier in an environment of falling equity prices because a number of the most widely used extended sectors have a

high correlation with the equity market. This concern is credible, especially given that core-plus has not been tested in a prolonged credit and liquidity bear market. In order to explore this last point further, the 2000 survey group was asked to identify the key opportunities and risks associated with each of the major extended sectors represented in core-plus portfolios, as shown in Exhibit 1. The survey group felt that market liquidity trends would have an impact on the ability of core-plus to both achieve its investment objectives and enable managers to increase the total core-plus asset base significantly beyond the current level. In response to the request for a shortterm outlook (i.e., 3–5 years) for market liquidity, the respondents were equally split among the possible fates: improve, worsen, or remain the same. Exhibit 2 shows what underlying conditions are expected for each category. Respondents considered three evolutionary developments to be most critical for the growth of core-plus. First, there must be growth of issuers and issuance. Second, new derivative instruments must be developed to hedge risks and to enable costeffective implementation of active insights. Finally, trading execution systems must be improved to compensate for the contraction in the broker/dealer community and scarcity of committed capital. All three developments are important structural issues that


17

Core-Plus Bond Management Exhibit 1. Opportunities and Risks for High-Yield Bonds, International Corporate Bonds, and Emerging Market Debt High Yield Opportunity

International Corporate Risk

Opportunity

Supply growth

Issuance (marginal credits)

Additional diversification

Declining government Issuance debt issuance

Credit quality at the Weakening economy Ba level

Emerging Market

Risk

Standardized indentures

Regulatory reform

Opportunity

Risk

Currency

Diversifying instruments

Quality divergence as Mexico, Korea, and Brazil become developed

Tax and pension dissimilarities

Supply growth

Worsening liquidity

Leadership and labor reform

Risk stratification

Risk stratification (credit quality across countries)

Worsening liquidity

Declining government debt supply

Appetite of core-plus managers

Leverage

Asset securitization

Attractive valuations

Source: Watson Wyatt 2000 survey.

will greatly influence whether core-plus continues to be the dominant fixed-income portfolio strategy.

Implications for Investment Organizations In managing core-plus portfolios, investment organizations face special challenges in two main areas: resource/skill development and evolution of the investment process. In the area of resource/skill development, experienced credit analysts with an equity research orientation will be vital because of the increasing importance of global security selection. A critical need will also exist for quantitative analysts skilled

in evaluating the expanding array of complex security structures and derivative instruments. Quantitative skills in the area of risk assessment and investment technology will be necessary in order to streamline investment processes and manage information flows. With respect to investment process, effectively executing strategic decisions at the portfolio level will require that management teams do three things: (1) integrate information inputs that are both broad and deep, (2) incorporate complex financial-engineering strategies, and (3) use greater tactical flexibility in executing sector bets and managing changing investment horizons associated with volatile market liquidity conditions. Finally, with an increasing number of

Exhibit 2. Manager Assessments of Short-Term Outlook for Liquidity Improve

Remain the Same

Worsen

Growth of issuers and issuance

Dealer low profile

Illiquid share of U.S. dollar bond market greater than the 30 percent of Fall 2000

Growth of global issues

Focus on bigger-fee, new-issue securities rather than secondary markets

Loss of confidence about trading profits

Development of derivative instruments and synthetic structures

Hinges on no further deterioration in level of risk capital in the system

Loss of effective government security hedging tools

Penetration of electronic trading/auction systems

Shift to swaps/derivatives-based hedging vehicles

Broader access to market makers and improved execution

Consolidation within broker/dealer market and focus on stable sources of income drains secondary market liquidity

Larger management firms will supply liquidity but will require longer investment horizons

More fixed-income assets managed by fewer firms

Greater global efficiency

Absence of hedge fund assets of sufficient size

Source: Watson Wyatt 2000 survey.

18


Core-Plus: Prospects and Implications sector categories requiring highly focused disciplines, compensation programs for investment professionals will need to be adapted to reward insights that contribute to total portfolio performance, as opposed to using incentives that lead individuals to be little more than “cheerleaders” for their own sectors.

Conclusion In summary, core-plus represents a new investment model that expands the role fixed-income management can play in an investor’s overall fund asset allocation. The theoretical arguments supporting core-plus are persuasive, even if the empirical supporting evidence is mixed and sensitive to timeperiod and manager-universe interpretations.

The success of core-plus may depend on two factors: first, a bond market with sufficient liquidity and depth for institutional investors to consider the strategy viable for sizeable asset commitments; and second, the ability of managers to tactically and opportunistically exploit the investment opportunities that the extended sectors periodically offer. If this latter condition cannot be accomplished, investors should not pay active-management fees to gain such exposures on a permanent basis. The next several years will be a critical period for testing the core-plus proposition under conditions of larger asset commitments and perhaps for testing investor faithfulness to the strategy in a less favorable investment environment than has been experienced to date. Even in the event of such challenges, the failure of core-plus would be a surprise.


19

Core-Plus Bond Management

Question and Answer Session Brian E. Hersey, CFA Question: What’s a reasonable investment horizon for core-plus mandates, given their higher volatility? Also, how important is performance attribution, and how developed is the industry in this regard?

sources of return and evidence of skill.

making processes, skill sets, and risk-control procedures.

Question: With core-plus managers, how much of the exposure to extended sectors is the result of a tactical or strategic allocation?

Hersey: Recent evidence has shown that, depending on the starting point, a horizon of at least five years is necessary. Mr. Park’s points on the individual manager results dramatically illustrate that the rewards from a core-plus strategy may not be realized immediately, so patience and long-term horizons are extremely important, as is a willingness to live with sometimes significantly negative short-term results.1 Performance attribution in fixed income has always been a problem, because discrete decisions are extremely rare. Decisions on sectors, duration, and yieldcurve positioning are all intertwined, so the disaggregation of such decisions and attribution to individual components are extremely difficult tasks. Nevertheless, performance attribution can lead to insights about the

Hersey: The exposure is more often strategic than tactical, even though it may be portrayed as tactical. If the appropriate benchmark is the Lehman U.S. Aggregate, the exposure does not need to be tactical. If the index is universal, then the manager is working with a different baseline allocation sector.

Question: How much non-U.S.dollar exposure does the typical core-plus portfolio have, and what is the appropriate range of investment instruments, including structured notes with embedded payoffs, for which core-plus managers should have discretion?

1 See Mr. Park’s presentation in this proceedings.

20

Question: In selecting core-plus managers, what characteristics are evaluated? Hersey: Two considerations are whether a manager’s allocations are strategic or tactical and whether the manager’s decisions indicate a certain level of skill or the relatively simple exploitation of a temporarily favorable environment to beat the benchmark in the short term. Clearly, we look at managers’ resources and capabilities for investing in an extended array of sectors on a global basis, and we evaluate all the issues relevant to the manager’s decision-

Hersey: Few managers are actually taking currency bets within core-plus portfolios. Where such bets are in place, the exposure probably would account for about 1 percent of the portfolio. In my view, anything bondlike is often viewed as fair game for core-plus, although such an approach may not be acceptable to conservative, risk-averse investors. For managers who can demonstrate that they understand the risks and will use appropriate risk controls, the investment instruments should span the spectrum, including certain structured notes. Some structured notes may be undesirable, but in order for the manager to extract value in the most efficient way possible, structured notes should be viewed as a potential security structure for investment.


Core-Plus: Analyzing Past Performance Jae Park Director, Fixed Income Investments IBM Retirement Fund Stamford, Connecticut

Experience indicates that core-plus strategies produce excess returns for fixed-income portfolios. Analysis of performance over various overlapping periods can be useful in identifying risk–return patterns of core-plus managers. Although core-plus managers exhibit a return advantage over longer periods, higher risk is associated with core-plus and a sector specialist in the “plus” sectors is recommended.

he term “core” refers to a style that essentially limits a portfolio to investment-grade securities, which have sector volatility and correlations similar to sectors within the Lehman Brothers U.S Aggregate Bond Index. By this definition, non-U.S., high-yield, and emerging market debt securities would not qualify as core sectors. Core managers have expected tracking errors of less than 150 basis points (bps), with R2s higher than 0.90. Core-plus, on the other hand, refers to a strategy that integrates extended fixed-income sectors within a portfolio. Note that, like core portfolios, core-plus portfolios have a benchmark focus, with tracking errors generally less than 200 bps over 3–5 years and R2s higher than 0.75. A manager with a tracking error and R2 exceeding these limits should not be categorized as core or core-plus. For such a manager, the term “plus-only” would be more applicable.

T

Performance Evaluation The following concepts are frequently applied to evaluate the performance of investment managers and are used throughout this presentation: ■ Information ratio. The information ratio is a relative measure of return and risk. It is the manager’s excess return divided by the tracking error. The tracking error is calculated as the standard deviation of the excess returns. In general, a 0.5 information ratio results in a top-quartile performance ranking. ■ Sharpe ratio. The Sharpe ratio is used as an absolute measure of return and risk. It is calculated by dividing a portfolio’s excess return over T-bills by the standard deviation of the total return. This concept is often useful when the benchmark is not a good mea-

sure of the manager’s performance or when comparing asset classes. A low R2 to the benchmark is an indication that the Sharpe ratio may be a more applicable measure or that the benchmark needs to be modified or “stylized” to better assess manager skill. ■ Alpha. Alpha is the risk-adjusted excess return. Excess return not adjusted for risk is often incorrectly referred to as alpha. A manager with high excess returns but a low or even negative alpha most likely achieved the excess returns by taking more risk than the volatility implied in the market.

Experience During the early 1990s, I was conducting investment research, focusing on performance analysis to better assess consistent sources of excess return, methods for controlling risk, and performance attribution. I found the most interesting pieces of research to be in fixedincome opportunities outside of the traditional investment-grade arena—in particular, what I defined as “extended fixed income.” My focus was on higher-returning, out-of-benchmark sectors, such as high-yield bonds, emerging market debt, high-risk mortgage derivatives, distressed debt, private placements, and non-U.S. bonds. I also explored nontraditional investment techniques, such as fixed-income arbitrage and convertible arbitrage. So, what I considered to be extended fixed income started out including both techniques and asset classes to add significant value over a broad fixed-income benchmark, such as the Lehman U.S. Aggregate. Some strategies were purely alpha oriented and some were benchmark correlated.


21

Core-Plus Bond Management Table 1. Performance of Core and Core-Plus Fixed-Income Strategies for Various Periods Ending June 30, 2000 Return Index/Statistic

1 Year

3 Years

5 Years

7 Years

10 Years

4.57%

6.04%

6.25%

6.01%

7.82%

First quartile manager

0.50

0.34

0.44

0.53

0.77

Median excess return

–0.04

0.02

0.19

0.15

0.48

Third quartile manager

–0.57

–0.34

–0.14

–0.08

0.10

0.72

1.01

0.94

1.02

1.14

–0.06

0.02

0.20

0.15

0.42

Lehman U.S. Aggregate Excess return

Median tracking error Median information ratio

Note: Performance numbers gross of fees. Data for 141 core managers or products. Source: Based on Frank Russell Company data.

As a result of a large reorganization in 1994, all the internally managed fixed-income assets at IBM Retirement Fund were transferred to external managers. This change led to an extraordinarily large fixedincome manager search and created an opportunity to integrate my research in extended markets. By year-end 1994, the implementation was completed. The observations and conclusions of the 1994 search are interesting. The core-plus style was obviously becoming more popular. The five years from 1989 to 1993 constituted a period of declining interest rates and tightening credit spreads following the junk bond crisis. Despite the declining interest rates, a general movement away from interest rate anticipation and yield-curve management was evident. Managers placed more emphasis on sector rotation and security selection. Today, the fundamental methods and techniques used to successfully add value remain much the same, but advanced analytics and risk-control technology are now widely available. During the 1989–93 period, a large number of managers generated excellent returns, and in the 1994 search, we found a high correlation between excess returns and the breadth and depth of the investment management team. This observation was later supported in a 1998 paper by Ronald Kahn.1 The best breadth was obtained by core or core-plus managers that had a large menu of skills, including interest rate management, yield-curve management, and multiple sector capabilities. Specialists often had the best depth, with much deeper credit research and a better understanding of the complexities within their sectors. Although we found that such specialists were able to add value, the added value came with some additional volatility. The best of the core-plus manag1 “Bond Managers Need to Take More Risk,” Journal of Portfolio Management (Spring 1998):70–76.

22

ers had good depth and breadth and were able to add value with more consistency and lower risk, and this advantage remains true today.

Active versus Passive Strategies A passive strategy, or indexing, is an option available for most pension plans and is often considered appropriate if one lacks insight into active management. Furthermore, active management may provide little or no added value. Table 1 shows data from a survey of core and core-plus fixed-income managers for various periods ending June 2000. Only the rolling 10-year period has a performance advantage net of fees. (Note that these data are probably somewhat inflated because of survivorship bias). For active strategies, the information ratio is used to gauge the level of skill and risk associated with the excess return. In addition to setting objectives for excess return, tracking-error targets must also be established, effectively targeting a particular information ratio. Plan sponsors hire managers with different skill sets and strategies and allocate risk units among them accordingly. This approach results in a diversification of excess returns. At this point, a role for core, core-plus, and various specialists may be established. Grinold and Khan’s fundamental law of active management defined the information ratio as a function of skill and breadth.2 Skill can be measured simply by how well a manager forecasts and how often the manager is correct. Breadth is the sample size. The greater number of bets a manager can take, the greater the number of chances to improve the information ratio. For example, an interest rate forecaster may 2 Richard C. Grinold and Ronald N. Kahn, Active Portfolio Management (Chicago, IL: Probus Publishing, 1995).


Core-Plus: Analyzing Past Performance make only one or two bets a year and is going to need an extremely high level of skill to achieve consistent returns over 3 to 5 years. Unfortunately, if the number of bets is small, even with a skill level well above average, determining whether the skill measured is statistically significant might require a period longer than most people’s lifetimes. Breadth can be increased in many ways. The greatest opportunity is in specific bond selection. With thousands of bonds to choose from, a bond that performs even slightly better than average will provide an edge. Additionally, the use of various sectors and countries, duration strategies, yield-curve management, and volatility management can add breadth. A broad core-plus manager clearly has an advantage because of the greater variety of investment opportunities. Risk Assessment. Consider the same universe of bond managers shown in Table 1 but from the perspective of excess return and tracking error, as shown in Figure 1. Panel A illustrates the information ratios of these managers over a three-year period ending second quarter 2000. To realize a 0.5 information ratio net of fees generally requires an information ratio of 0.75 gross of fees. Few managers were able to deliver this level of information ratio during this three-year period. In fact, many managers underperformed during the period, which included the Asian crisis in 1997 and the Russian default and Long-Term Capital Management crisis in 1998. For the five-year period (Figure 1, Panel B ) and seven-year period (Figure 1, Panel C) ending second quarter 2000, more managers had positive information ratios, improving the odds of building a successful active strategy. Core-plus may not be appropriate for investors who consider risk to be inherent in non-investmentgrade securities (junk bonds) or mortgage derivatives such as IOs (interest-only mortgage strips), POs (principle-only mortgage strips), and inverse floaters, in which the derivative prices fluctuate as a multiple of the underlying security (which in this case would be a mortgage pass-through). In addition, core-plus is probably not suitable for those who would be forced to take action because of negative “headline news,” such as the crises in Orange County, Mexico, or Russia. Achieving long-term objectives often requires riding through some rough spots. Risk-averse investors might be willing to allow core fixed-income managers to invest the bulk of a portfolio in 30-year zerocoupon bonds because they are investment-grade Treasury securities. A portfolio with these zeros, however, will have greater volatility than most portfolios with aggressive allocations made to high-risk mortgage derivatives, even during the weakest of

markets. But the real risk is underperforming the benchmark or exceeding the tracking error on the downside. Although including allocations to highyield bonds, emerging market debt, and non-U.S. debt will add volatility, thoughtful risk-management processes can control this risk. I often hear the argument that risk taking should be limited to equity portfolios while keeping fixedincome portfolios “safe”—for example, invested in a core strategy. I argue that in active fixed-income management, the odds of success are significantly improved by the use of core-plus strategies, but the question still remains whether an active strategy should be pursued in equity and/or fixed-income portfolios. The decision of whether active management is better applied in equities or fixed income should be based on expected performance. Consider the following analysis of the relative success of a universe of pension funds with funds allocated to each asset class. Panel A of Figure 2 shows the performance of 46 of the actively managed equity portions of the funds relative to their respective benchmarks. The combined average risk level (tracking error) of the equity managers is well above 200 bps, and a greater number of funds are below the zero excess return line than above it. Obviously, active management in equities has not experienced great success during this period, and other five-year periods have shown similar results. Using the same approach as Panel A, Panel B shows data for 44 of the actively managed fixedincome portions of the fund universe. The average level of risk of the fixed-income allocations, at 100 bps, is less than half that taken in the equity positions. In stark contrast to the equity funds, most of the fixedincome funds have provided excess returns. The data in Panel B of Figure 2 are not consistent with Table 1, probably because the funds picked good fixed-income managers. Perhaps one of the reasons for this discrepancy can be explained by looking at the components of fixed-income returns, as shown in Table 2. For the period from January 1990 through March 2000, the dominant component of the total return is the yield compounding over time. The Lehman U.S. Aggregate had a return of 116 percent for this roughly 10-year period, and virtually all of this return comes from the yield compounding and little from principal return. Moving down the credit spectrum, a similar pattern emerges. The yield compounding plays a major role in the total return of a bond while the role of principal return, though volatile over short periods, is not significant. Note that the total return numbers include defaults occurring in the index. On the equity side, no return component compensates for the additional risk being taken. The good performance of fixed-income funds


23

Core-Plus Bond Management Figure 1. Information Ratios of Core and Core-Plus Fixed-Income Managers for Various Periods Ending June 30, 2000 ( )

A. Three-Year Period

2

Excess Return (%) Information Ratio = 0.75

2

Information Ratio = 0.75 Information Ratio = 0.50

1 1

Information Ratio = 0.50

0 0 –1 1

0

2

Tracking Error (%)

–1

1

0

2

Tracking Error (%)

B. Five-Year Period Excess Return (%) 2

B. Five-Year Period

Excess Return (%)


2


1 1 0


0 –1 0

1

–1

2

Tracking Error (%)

0

1

2

Error (%) C.Tracking Seven-Year Period Excess Return (%)

C. Seven-Year Period

2

Excess Return (%) Information Ratio = 0.75 2


1


1 0 0 –1 0

1

0

1

–1

2

Tracking Error (%) 2

3

4

3

4

Tracking Error (%) Note: Data for 141 core and core-plus managers or products. Source: Based on data from Frank Russell Company.

24


Core-Plus: Analyzing Past Performance Figure 2. Performance of Selected Pension Fund Active U.S. Equity Managers and Fixed-Income Managers, Five Years Ending June 30, 2000 A. Equity Managers

Excess Return (%) 6.0 4.0 2.0 0

Median Return

–2.0 –4.0 –6.0 Median Risk Level

–8.0 –10.0 0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

4.0

4.5

Standard Deviation of Excess Returns (%)

B. Fixed-Income Managers Excess Return (%) 4.0 3.0 2.0 1.0

Median Return

0 –1.0 –2.0 Median Risk Level –3.0 –4.0 0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Standard Deviation of Excess Returns (%) Note: Forty-six observations for equity managers. Forty-four observations for fixed-income managers.


25

Core-Plus Bond Management Table 2. Components of Fixed-Income Return, January 1990–March 2000 Return Component Index/Sector Lehman U.S. Aggregate

Yield Compounding

Principal Return

112.7%

3.3%

Total Return

Average Default Rateb

116.0%

—

Sector

a

Corporate bonds

124.6

1.6

126.2

0.02%

BBB corporate bonds

130.7

–0.5

130.2

0.06

High-yield bonds

181.1

–7.4

173.7

4.66

Emerging market debta

305.5

105.4

410.9

1.20

Emerging market debt data for April 1990–March 2000. Default rate data for January 1990–December 1999.

b

may be partly explained by the yield compensation received throughout the risk spectrum. A case might be made for strategic, not only opportunistic, allocations to high-yield bonds and emerging market debt. G l o b a l F i x e d I n c o m e . Core-plus often includes opportunistic allocations to non-U.S. bonds, although usually without currency bets. These opportunistic allocations are done to further expand the opportunity set of investable assets. But what kind of consistency of returns can be expected? The answer to that question may lie with the excessreturn and tracking-error data for the universe of global fixed-income managers. Over the three-year, five-year, and seven-year periods ending with the second quarter 2000, these managers had a lot of tracking error but little excess return. During the past decade, significant risks were associated with the non-U.S. debt markets—the seeming dichotomy of the Japanese bond market (strong returns, extremely low interest rate levels), the strong yen in 1994–95, and more recently, the weak euro—that presented substantial challenges, so approach with caution.

Evaluating Active Fixed-Income Managers By analyzing different active-management approaches for fixed-income portfolios, from the lowest level of risk to higher levels, one gains insight into the upside and downside potential of core-plus. To help assess manager performance, we developed an analytic model, which has proven useful over the years. Table 3 is a summary example of our model’s analysis and provides key risk–return statistics for various fixed-income management styles for a seven-year period ending June 2000. Key statistics can often provide insight when comparing many managers and their styles. Passive Strategies. Consider the manager statistics for tight-tracking, or passive/index-plus, strat-

26

egies. Manager 1 is an index fund using a cellular approach3 to replicate the Lehman U.S. Aggregate. All the statistics, from excess return to tracking error, are tight to the index, and every single year is within 5 bps of the index. This fund offers the minimum risk position, so its investors can go home and sleep peacefully. At the next level of risk taking, some small bets are taken against the index in order to exceed the index return. Manager 2 does not have skills in credit research and thus elects to index the corporate sector entirely. This manager is skillful in choosing the most attractive low-risk collateralized mortgage obligations (CMOs) and pass-throughs available in the market. All other risk factors, including sector weights, are kept extremely tight. Manager 3 adds corporate bond research capability and seeks “off the beaten path” bonds that are still investment grade, such as taxable municipal bonds and low-risk CMOs, while maintaining an overall sector contribution to duration. (That is, the product of the percentage allocation to a sector times its duration is the sector contribution to the total duration of the portfolio. In a neutral position, this product will equal that of the index.) No extendedsector securities are used. Manager 4 (core-plus) adds higher-quality highyield bonds, emerging market debt, and nondollar securities while maintaining low tracking-error targets via a risk model similar to the BARRA multifactor risk model. In other words, Manager 4 offers a coreplus manager style in an index-plus strategy. Managers 5 and 6 (core) limit themselves to investment-grade securities but make greater use of market timing in their investment process, including small duration and yield-curve positions. 3 The bond market is divided into cells for each sector and further divided into smaller cells by maturity and coupon. The portfolio is constructed in such a manner that each cell contains bonds that closely replicate the characteristics of the index.


Core-Plus: Analyzing Past Performance Table 3. Annualized Risk–Return Characteristics for Various Fixed-Income Management Styles, January 1993–June 2000 Risk–Return Characteristic Excess Return (%)

Tracking Error (%)

R2

Alpha

Information Ratio

Manager 1

0.03

0.05

1.00

0.03

0.54

Manager 2

0.14

0.13

1.00

0.15

1.15

Manager 3

0.29

0.32

0.99

0.31

0.90

Manager 4

0.36

0.45

0.99

0.41

0.81

Manager 5

0.68

0.39

0.99

0.71

1.75

Manager 6

0.96

0.66

0.98

0.81

1.44

Management Style Passive/Index-Plus

Active Core Manager 1

2.50

8.83

0.84

0.17

0.28

Core Manager 3

0.36

1.44

0.96

–0.02

0.25

Core-Plus Manager 4

1.43

0.99

0.95

1.26

1.45

Core-Plus Manager 5

3.34

4.51

0.45

3.25

0.74

Core-Plus Manager 6

1.71

1.36

0.93

1.44

1.26

Core-Plus Manager 7

0.57

0.85

0.96

0.63

0.67

Core-Plus Manager 8

0.91

1.45

0.88

0.91

0.63

Core-Plus Manager 9

0.56

1.54

0.88

0.49

0.36

Note: Index is Lehman Brothers U.S. Aggregate. Core Manager 2 was dropped because performance reporting ceased. Composite data from consultant databases.

Active Strategies. Consider the active-manager performance summarized in Table 3. Core Manager 1 is the extreme of active management, an unconstrained interest rate forecaster. This manager invests in only investment-grade securities but can invest in all cash or, at the other extreme, all 30-year zeros. Over this period, the excess return is 2.5 percent, but the tracking error, at 8.8 percent, is extremely high. The portfolio alpha for this manager, when adjusted for the volatility, was often negative, but this manager has positive alpha because of the Treasury buyback of 2000. Core Manager 3 attempts to obtain about 60 percent of excess return from interest rate anticipation and usually adopts a plus or minus 25 percent market duration position. The difficulty of interest rate forecasting certainly gives more reason for managers to use a core-plus strategy to seek greater return. Research on interest rate forecasting should be encouraged, but with one or two possible exceptions, managers have not been able to identify and/or integrate the various predictive factors with consistency. Core-Plus Manager 4 uses all leverage available to exceed the benchmark. The success of this manager can be attributed to a well-developed sense of timing in addition to good selection. Duration and yieldcurve plays are only one of many strategies the manager uses. Other generally successful strategies

include opportunistic allocations to hedged European bonds, high-yield bonds, and emerging market debt, as well as over- or underallocating corporate and mortgage sectors and selling or buying volatility with options. For example, in 1996, this manager lost 75 bps in a duration play. The manager’s 1996 performance, however, exceeded the return of the benchmark by 250 bps. By realizing the value of extended sectors during this period, this manager used the “plus” in a big way. Core-Plus Manager 5 is “plus-only” because 35 percent of the portfolio may be below investment grade. This manager focuses intensively on bond picking and value investing. The manager had excess return of 334 bps, tracking error of 451 bps, and an information ratio of 0.74. With an R2 of 0.45, however, this manager should clearly not be considered a “core” manager because of the lack of a benchmark-focused strategy, unless a longer time horizon is acceptable. Analysis of Past Performance. The effects of core-plus on return and risk are evident when we examine the statistics for different time periods. The five-year period ending December 1997 was the most profitable period historically for core-plus. Any managers invested in high-yield bonds and emerging market debt during this period found their information ratios considerably enhanced. One of the greatest dangers for core-plus may be these periods of outstanding performance because they are often followed by a


27

Core-Plus Bond Management crisis, and investors who changed guidelines to integrate core-plus at the end of this period would experience the worst combination of events. Latecomers had no upside to cushion the downside in the period ending first quarter 1999, in which the information ratio of the average plus-only manager fell below that of the average core or core-plus manager. ■ Five-year period. For the five-year period ending in December 1997, Core-Plus Manager 5 (plusonly), the value-oriented bond picker investing in all the extended markets, had an excess return of more than 5 percent, with tracking error of only 2.5 percent. Consequently, this manager had an extremely high information ratio, exceeding all other active managers in this sample. Core-Plus Manager 4, with a multiplevalue-added strategy, had strong performance, but this performance was dwarfed by the high returns of Manager 5. The rest of the managers are interest rate forecasters with high volatility but no excess returns for the period. For a five-year period ending just after the 1998 crisis, one may reach very different conclusions. The plus-only manager (Core-Plus Manager 5) experienced a dramatic drop in information ratio while Core-Plus Manager 4’s information ratio remained solid. The difference between Manager 5 and Manager 4 was dramatically greatest just after the end of the third quarter 1998. ■ Seven-year period. For the seven-year period ending June 2000, interest rate forecasters continued to have the lowest information ratios. (Note that Core Manager 2 stopped reporting numbers during this period and thus does not appear in the table.) CorePlus Manager 4, using multiple-value-added methods, achieved the most consistent performance. This manager is a prime example of core-plus theory being realized. Core-Plus Manager 5 (plus-only) lagged Core-Plus Manager 4 but still maintained a reasonable information ratio. As mentioned earlier, plus-only managers lack benchmark focus. In such situations, style analysis may prove useful. When a more appropriate benchmark composed of 23 percent high-yield bonds, 17 percent emerging market debt, and the balance in long corporates is used, the resulting information ratio improves, which indicates that value is being added in excess of the respective sector benchmarks. To reduce risk, extended sectors need to be included in the benchmark or the allocation to a plusonly manager should be managed by balancing it with an allocation to a core manager. Because one core-plus manager’s success cannot be accepted as universally representing core-plus managers in general, consider a few well-known core-plus managers. Core-Plus Manager 6 performed excellently, adding more return than Core-Plus Man-

28

ager 4 but with a slightly lower information ratio. Core-Plus Managers 4 and 6 shared a better-thanaverage sense of timing during this seven-year period. Tracking these managers over time shows that Core-Plus Manager 6 was completely out of extended-sector credit product just prior to the 1997 Asian crisis. At the same time, choosing the correct duration and yield-curve positions contributed significantly. (The manager had a longer duration than the index as rates declined and had put on a barbell position—with the greater percentage of bonds concentrated in short- and long-term maturities for a given duration—as the yield curve flattened.) Core-Plus Manager 7 has tended to rely more on sector and selection than Core-Plus Managers 4 and 6 and made smaller duration and yield-curve bets. Core-Plus Managers 8 and 9 are well-known, highly recommended core-plus managers, but they underperformed the benchmark significantly during periods of crisis in 1994 and 1998 and through June 2000. Poor performance may result from a manager taking a large position in high-yield bonds or emerging market debt at the wrong time. Alternatively, if a manager reduces allocations to high-yield and emerging market debt just after a crisis, the result may be that the manager’s performance gets whipsawed. This darker side paints a different picture of core-plus. One cannot simply assume that core-plus entails an improvement in the information ratio. A more realistic outlook for core-plus may be that it is likely to add value but clearly with additional risk.

Role of the Specialist Most core-plus and plus-only managers limit their exposure to high-yield bonds and emerging market debt in higher-credit-quality tiers and are not likely to make significant allocations to the lowest creditquality tiers, which often have great downside risk. Russian debt experienced tremendous downside in 1998 and triple-digit upside over the following two years as it regained a B rating. Although plus-only managers tend to be credit specialists with large concentrations in extended market sectors, such as high-yield bonds and emerging market debt, their relative returns may be as much as 10 percent below the investment-grade benchmarks. A core manager can mitigate this sector risk—a phenomenon not applicable to the sector specialists in high-yield and emerging market debt. At the start of my fixed-income program in 1995, the extended fixed-income group of managers was measured against the same core benchmark, the Lehman U.S. Aggregate—plus a return premium. The high-yield premium was set at 200 bps, and the premium for emerging market debt was set at 300 bps.


Core-Plus: Analyzing Past Performance The rationale was that over longer periods, high-yield bonds and emerging market debt would earn a risk premium over an investment-grade benchmark. Furthermore, the high-yield and emerging market benchmarks were arguably not as reliable or comprehensive as the investment-grade indexes. In 1993, this observation was particularly true of emerging market debt indexes, which had only two or three years of history. The Salomon Brady Bond Index contained only Brady bonds, and the broader J.P. Morgan Emerging Market Bond Index Plus (EMBI+) maintained high concentrations in a handful of Latin American countries. These indexes received little respect from savvy managers, who invested in other emerging market debt instruments, including local debt. These managers argued that the index accounted for only 10 percent of the markets in which they invested. In line with this view of benchmarks, sector specialists, depending on their style and focus, are much more likely to hold CCC to D rated bonds in both U.S. high-yield bonds and emerging market debt. They may also invest in instruments with risk–return characteristics that diverge widely from their sector indexes. In such cases, the downside risk relative to their sector benchmarks can be unexpectedly high. In 1998, it was not unusual for a manager to be 10–15 percent below the EMBI+, and in the same year, the EMBI+ was down nearly 15 percent. With a benchmark misfit, an allocation of only 2.5 percent to such a specialist can cause a benchmark-driven fund to be down 100 bps. In 1998, many emerging market debt hedge funds went belly up when Russia defaulted on its GKO (the Russian equivalent of U.S. T-bills) holdings. To add insult to injury, some managers hedged their ruble exposure, giving up the bulk of interest income, only to find their hedges with Russian banks to be worthless. And in U.S. high-yield bonds, problems have occurred as well. For example, in 2000, large numbers of defaults have found their way into some managers’ portfolios. Clearly, with core or any other strategy, any meaningful allocation to specialist managers can lead to risks that are difficult to diversify away. A benchmark misfit with these sectors is not in the sponsor’s best interest, even with a long-term outlook. By assigning the respective sector benchmark to a sector specialist, one can realistically and effectively target the level of risk relative to the benchmark. This approach is an effective means of risk management—

especially today as market volatility rises and benchmarks improve. To accommodate sector specialists, a large fund may include an appropriate allocation to the extended sectors by including a high-yield and emerging market benchmark as part of the fixedincome benchmark. Alternatively, one may adopt a broad macro benchmark. For example, the Lehman Brothers Universal Bond Index was chosen as the benchmark for my fund in May 1999. As a result, tracking error of the fund should have been reduced nearly in half without appreciable reduction in excess return. (After August 1998, the five-year period total return of the Lehman U.S. Aggregate and the Lehman Universal were about the same.) The information ratio improved because it more accurately highlighted the effects of active management within the fund, not the asset allocation effects. Finally, in using specialists, an emphasis on rebalancing can result in highly positive results. A fund can benefit over time by increasing and reducing allocations to extended sectors at opportune times. Increased allocations, especially to emerging market debt, were made in 1995 during the peso crisis and after the Russian crisis in 1998. Reductions were made after the 1996 rally in emerging market debt. Although these examples may appear to involve contrarian market timing, a disciplined rebalancing program to maintain a targeted allocation can have very positive results.

Conclusion The theoretical rationale for core-plus management is clearly compelling: Expanded investment opportunities allow managers to achieve higher returns and effectively manage risk. In our experience at IBM, core-plus is an efficient medium for delivering attractive risk-adjusted returns and certain core-plus strategies have indeed delivered impressive results, thus supporting theory. Other funds, however, have experienced pitfalls that warrant caution. During good times, core-plus will look exceptionally good—but vice versa during a crisis. Successful market timing has been a major factor separating the performance of top managers in general from the performance of average managers. If one accepts that market timing is difficult, taking the middle road implies a relativevalue focus and steady strategic allocations. This middle approach brings higher returns but adds volatility. In general, longer measurement periods are required to assess core-plus manager strategies.


29

Exploiting Opportunities in Global Bond Markets Ronald Layard-Liesching Managing Director and Chief Research Officer Pareto Partners London

Advances in technology are increasing U.S. bond market efficiency to the point of practically eliminating past sources of alpha, but the same advances also are creating new possibilities for excess return in global markets. Investors seeking to exploit the trend toward globalization should evaluate investments based on an analysis of the sources of excess return: scale, sustainability, information ratio, and possibility of extreme loss. Based on these four criteria, the credit and currency markets offer the best strategic long-term opportunities.

he global bond market offers many opportunities for a portfolio manager to add substantial alpha to a domestic portfolio. One overriding influence on current and future opportunities available in the markets is technology. Technology is heightening the efficiency of all markets and is destroying the alpha available within the U.S. bond markets. Similar technological change is occurring in other countries, particularly in the sovereign bond sector. As domestic markets become increasingly efficient, managers have no alternative but to search for alpha by taking a global path. The long-entrenched home-country bias—investing predominantly in securities of one’s own country—is waning. The outcome is clearly increased global diversification for fixed-income portfolios.

T

Past Sources of Alpha Until the mid-1990s, the dominant sources of return in U.S. fixed-income portfolios were sector allocation, prepayment risk, credit risk, and security selection. Technology has begun to compress the returns available from sector allocation and to narrow the returns associated with prepayment risk. Of these four traditional sources of return, only credit risk is likely to continue to provide meaningful and scalable excess returns for institutional fixed-income portfolios. Sector Allocation. In the U.S. market, sector allocation has generally earned investors excess

30

returns. But the advent of sophisticated online valuation models is making any kind of large excess return from the U.S. fixed-income sectors increasingly unlikely. Investors must search globally to find sectors providing incremental return to risk. Prepayment Risk. One sector in the U.S. debt markets that has historically offered an incremental return over government debt is the mortgage sector. The incremental return earned in this sector is a function of the risk inherent in the mortgage borrowers’ option to prepay. Finding alpha in this sector will grow more difficult because technology directly increases efficiency by speeding up the calculation of prepayment paths and option-adjusted spreads. Credit Risk. The corporate and high-yield sectors have provided an incremental return over the return from the government sector. This incremental return comes from assuming the credit, or default, risk of corporate issuers. This sector continues to be an excellent source of alpha, and high-yield strategies are increasingly executed in a global context. Security Selection. Finally, the selection of specific securities has been a source of incremental return in fixed-income portfolios. One problem with this strategy is that the incremental return is limited in scale. This limitation is a serious consideration for large portfolios. As a result, individual security selection is effectively eliminated as a major source of excess return for portfolios of substantial size.


Exploiting Opportunities in Global Bond Markets Over the past decade, managers of U.S. debt portfolios have sought to harvest alpha by shifting allocations strategically and tactically among the major sectors. This approach is based on the managers’ fundamental and technical views. Although bond managers have sometimes been criticized for not adding sufficient value, the fact is that bond managers do add value. But the competitive pressure is rising, primarily because the bond market is incredibly information rich. Panel A of Figure 1 shows that over the past 15 years, bond managers have successfully earned incremental returns for their clients. Panel B indicates that in the past seven years, however, the return per unit of risk has declined. Thus, fixed-income managers must move beyond a domestic arena to find alpha for their clients.

Global Opportunity and Diversification In addition to the widely accepted benefits associated with diversification, five major currents are swiftly sweeping fixed-income investors into a global sea in the search for higher alpha. First, bonds, unlike equities, easily lend themselves to quantitative analysis. Given the exhaustive ability and speed of analytic tools today, the sovereign bond markets, particularly in the United States, are so efficient that there is little mispricing left to exploit. Second, globalization of portfolios is now a worldwide phenomenon. Managers, plan sponsors, and issuers are all realizing that the opportunities are now in the global arena. Third, sophisticated investors are optimizing the use of their finite risk budget. The implication of this change is to spread the risk budget over a global spectrum of investments. Fourth, the technological advances in information dissemination and analytic tools, which were pioneered in the United States, are rapidly spreading throughout the globe. These advances are generating market-moving sector reallocations, notably the shift into corporate credits and the new wave of securitization. U.S. investors and managers who are familiar with these concepts definitely have an exploitable advantage in investing internationally. The fifth current carrying investors into the global markets is the privatization of the world’s fixedincome markets. With the exception of Japan, the major countries are moving toward budget surplus, with consequent reduction in sovereign debt issuance and lower yields. Incremental market growth is already rapid in the private-sector debt arena. These swiftly growing new market sectors lead to inefficiencies in the pricing of risk, which present outstanding opportunities for investors.

In the past year, the institutional investor preference for domestic securities—the home-country bias—has declined dramatically around the world. This fundamental change in attitude is happening more rapidly in the small markets because the acute lack of diversification and access to all the market sectors is so obvious in small markets. For example, investors in “small countries,” such as Canada or Norway, are questioning the wisdom of concentrating investments in an equity market in which a single stock can be 35 percent of the index. They are looking to rectify this lack of diversification by globalizing. This attitude change is also developing in the larger markets around the world. For example, the October 3, 2000, Financial Times talked of the allocation to European equities for British pension funds increasing to 70 percent. The impact of going global on the diversification of U.S. fixed-income portfolios is evident in the return graphs in Figure 2. Panel A plots the monthly total returns for U.S. Treasuries as compared with the monthly total returns of other U.S. investment-grade debt. Clearly, investing solely in U.S. investmentgrade debt provides little real diversification benefit. Panel B illustrates that diversification and a yield pick-up are attainable within the U.S. debt markets by moving into the high-yield sector. As shown in Panel C, however, much greater diversification is achieved when non-U.S. assets are brought into the portfolio mix. Panel C illustrates true sector, credit, and currency diversification. The ultimate long-term end game of global allocation is this broad scope of real diversification of returns. Although nominal yields appear to be well aligned around the world today, this phenomenon disguises the fact that real yields are exhibiting some large differentials, as Figure 3 shows. Europe, with more than 95 percent correlation among the 11 Euroland nations, is now a closed economy. This development has had a profound effect on the world of investments, particularly European pension funds. In 1995, a typical European pension investment fund had a 95 percent allocation to domestic bonds. Since the arrival of the Euro, the funds have been forced to reallocate, with more than 40 percent and 20 percent allocated to, respectively, equities and non-European securities. This reallocation is the reason the euro fell in the first 18 months in spite of strong economic fundamentals in Europe. For example, one of our clients had a total return of 36 percent on a U.S. equity investment in 1998, half of which was from the currency. If you diversify globally and you make money, you feel good. And when you do something that makes you feel good, you are going to continue to do it. This phenomenon was the secret of the euro’s weakness: European managers’ allocations were


31

Core-Plus Bond Management Figure 1. Historical Risk and Return for Global Bonds CAI Core Bond Plus

A. Fifteen Years Ended December 31, 1999 CAI Core Bond Annualized Return (%) 12 ML High Yield LB Aggregate 14 LB Mortgage Backed CAI Core Bond Plus SB World Govt. 10 12

LB Treasury 20+ Year

LB Corporate

CAI Core Bond LB Aggregate

LB Treasury 20+ Year LB Treasury Long SB World Govt.

ML High Yield

LB Mortgage Backed 8 10

LB Corporate LB Treasury LB Treasury Long

LB Treasury Int. 6 8 90-Day T-Bills LB Treasury 4 60

LB Treasury Int. 4

2

90-Day T-Bills

6

8

10

12

8

10

12

Standard Deviation (%)

4 0

2

4

6

B. Seven years ended December 31, 1999 Standard Deviation (%) Annualized Return (%) 14

B. Seven Years Ended December 31, 1999 12 Annualized Return (%) 14 10

CAI Core Bond Plus

12 LB Aggregate

8 10

Core Bond Plus LB CAI Mortgage Backed

6

6


CAI Core Bond ML High Yield

LB Treasury Long SB World Govt.


LB Treasury LB Aggregate LB Treasury Int. CAI Core Bond

8 4

ML High Yield

90-Day T-Bills LB Mortgage Backed 0 3

LB Treasury Long 6 SB World Govt. 9 LB Treasury LB Treasury Int.Standard Deviation (%)

12

90-Day T-Bills

4 0

3

6

9

12

Standard Deviation (%) Note: CAI Core Bond = Callan Associates core bond manager universe; CAI Core Bond Plus = Callan Associates core-plus bond managers; ML High Yield = Merrill Lynch High-Yield Bond Index; LB Aggregate = Lehman Brothers U.S. Aggregate Bond Index; LB Mortgage Backed = Lehman MortgageBacked Index; LB Corporate = Lehman Corporate Bond Index; LB Treasury Long = LB Treasury Long Index; LB Treasury 20+ Year = Lehman Treasury 20+ Year Index; LB Treasury Int. = Lehman Treasury Intermediate Index; SB World Govt. = Salomon Smith Barney World Government Bond Index. Source: Based on data from Callan Associates Inc.

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Exploiting Opportunities in Global Bond Markets Figure 2. Diversification: Bond Return Matrixes A. U.S. Treasuries versus Other U.S. Investment-Grade Bonds Other U.S. Investment-Grade Bond Return (%) 8

3

–2

–7 –4

–2

0

2

4

6

U.S. Treasury Return (%) U.S. Corporate Bonds U.S. Mortgages U.S. Government-Sponsored Debt

B. U.S. Treasuries versus U.S. High-Yield Bonds U.S. High-Yield Bond Return (%)

Current Sources of Alpha

8

3

–2

–7 –4

–2

0

2

4

6

U.S. Treasury Return (%)

C. U.S. Treasuries versus Non-U.S. Bonds Non-U.S. Bond Return (%) 8

3

–2

–7 –4

–2

0

being directed away from European investments, and they were making money. The reality is that there is now desynchronization between the economy of Europe and the economy of the United States. We used to have a saying in Europe: “If the United States sneezes, we catch a cold.” (In some cases, we got terminal bronchitis.) But the adage is not true anymore. Europe now has a closed economy—in perception if not in absolute reality. If the U.S. economy entered a real recession and U.S. markets were to fall, European market prices would experience a short-run value-at-risk-based impact, but the long-run damage would be mild. Indeed, the world is now divided into three primary economic blocs—North America, Europe, and Japan. This division provides a real economic diversification opportunity for investors. Disequilibrium between real interest rates is likely, and disequilibrium is the basis for adding value. Disequilibrium is a sustainable return source because value is added through an arbitrage of real economic factors.

2

4

U.S. Treasury Return (%) World SGBI (ex-U.S.) in U.S. Dollars World SGBI (ex-U.S.) in Domestic Currency Note: Monthly total returns. SGBI = Salomon Smith Barney Government Bond Index. Source: Based on data from Pareto Partners.

6

The current sources of return for fixed-income portfolios are not (and most likely, future sources will not be) exactly the same as the four sources of the past. For a sector or market to offer a sustainable source of incremental return, some barrier must exist. If no barrier exists, everyone will pursue the opportunity—and thus eliminate it. Knowledge used to be a big barrier, but the growth in technology has destroyed that barrier. Technology is creating a scarcity of mispriced liquid securities. Table 1 lists the sources of excess return. It notes my opinions about their scale and sustainability, the information ratio, and the possibility of “extreme values” that I assign to the source. Scale becomes important once an investor has found a barrier to participation in a market or sector of a market. The issue is whether the investor can take the position to an “interesting size.” An interesting size for most large institutional investors is more than $200 million. If the market limits the size of positions, then the position is not worth the investor spending his or her management time to consider it. Another issue is how likely the strategy is to be a sustainable source of return in the future. The information ratio, which is the ratio of the portfolio’s outperformance divided by its tracking error (or volatility), is indicated by a 1 (Low) to 10 (High) rating. A high information ratio means that the strategy allows greater opportunity for excess return through active management. The column “Extreme Values” in Table 1 refers to how exposed the strategy is to a small chance of a large loss. Any manager who claims to add value by spending the portfolio’s risk budget on a strategy should


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Core-Plus Bond Management Figure 3. Local Market Real Yields Argentina Australia Brazil Canada Denmark Euroland Japan Mexico New Zealand South Africa South Korea Sweden United Kingdom United States U.S. A Corp. a U.S. Mort.b 0

1

2

3

4

5

6

7

8

9

10

Real Yield (%) Note: The vertical line indicates the real yield on the Salomon Smith Barney World Government Bond Index. a

U.S. A rated corporate bonds. U.S. Government National Mortgage Association 30-year mortgages.

b

Table 1. Potential Alpha Sources Information Ratio a

Extreme Values

Very weak

1

Yes

Very weak

3

No

Source

Scale

Duration

High

Yield curve

Low

Sector allocation

High

Strong

6

No

Country allocation

High

Strong

5

No

Security selection

Sustainable

Low

Medium

5

No

Optionality

Medium

Medium

7

Yes

Prepayment

Medium

Medium

6

Yes

Anomaly capture

Low

Weak

7

Yes

Credit risk

High

Strong

8

Yes

Liquidity

Low

Strong

3

Yes

Currency

High

Medium

2

Yes

Note: This list is subjective. Investors must make their own judgment about these criteria. a

1 = low and 10 = high.

be able to explain where and why the decisions are made and the expected return from the strategy. The following sections provide discussion of the pros and cons of fixed-income strategies for pursuing alpha in each risk category. ■ Duration. Generally, duration bets can be made in large size, so I have given duration a “High” rating for “Scale” in Table 1. I believe duration is, however, a very weak source of sustainable excess return to risk within a single market. In a bond performance attribution, many of the other components of return are indirectly duration bets. This assessment depends on the method of nonlinear perfor-

34

mance decomposition. Thus, duration is never eliminated entirely as a source of return, but the potential information ratio for duration-related bets has to be at the bottom of the scale. For a risk budget that is spent across various potential information sources, investors do not want to give a lot to a duration bet. The exception is when the duration bet is spread among the global markets. In that case, diversification is achieved. Betting on duration inevitably exposes investors to extreme values. ■ Yield Curve. Interest rate bets have some degree of forecastability because only four primary yield-curve shapes occur. Yield curves cycle from


Exploiting Opportunities in Global Bond Markets positive to flat, inverted, humpbacked, and back to positive. The short end is driven by monetary policy, and the long end is driven by the economy and longterm inflation. The interaction of these forces leads to a forecastable shape. Even if the yield-curve shape can be perfectly predicted, unless the investor has the ability to short the market, this “knowledge” is of limited value. If derivatives are permitted (to lever the bet) but the manager is still limited by a long-only mandate, again the incremental return will be low, because the positions will all be on the long side. The only strategy available when betting on the yield curve is to move around the yield curve or put on barbell positions. Table 1 shows that, in my estimation, the scalability of yield-curve bets is low within a conventional mandate, and they are typically a weak source of sustainable return. But this strategy rarely threatens the portfolio through extreme-value outcomes. ■ Sector allocation. Sector allocation strategies move the portfolio out of the government sector and into securities that provide a yield pick-up and/or optionality. Large bets can be made in a sector allocation strategy, which obviously makes this category interesting, particularly because it is also a sustainable source of portfolio return. The strategy also has a fair information ratio. It does not risk the extreme values that can be associated with a duration bet because sector allocation, unlike duration, is rarely the single big bet in a portfolio. An exception would be if, for example, the allocation is 100 percent to high-yield bonds. ■ Country allocation. A global bond mandate can be decomposed into three primary sources of return: the country bet, the duration bet, and the currency bet. Credit risk is also a return factor in global portfolios, but compared with the first three bets, the marginal return from credit is close to a rounding error. The vast bulk of the global portfolio’s risk budget is spent on the country allocation. This source of return is similar to sector allocation in scale and sustainability. The information ratio is reasonably good, and the risk of extreme values is low. Unfortunately, the currency and country weightings in a portfolio are all too frequently the same. Many global bond managers do not make their currency selection separate from their country selection, and this practice leads to very poor use of the risk budget. ■ Security selection. In most circumstances, the scalability of a security selection strategy is low, but this judgment is market dependent. For example, large security mispricings are most often found in the less-liquid markets. Similarly, security selection is generally only a moderately sustainable source of

excess return. For example, consider selection within the investment-grade corporate bond market; technology has made such vast improvements in evaluation and analysis that most managers have little opportunity to add value beyond the allocation decision. Usually, if the portfolio is diversified, security selection entails little threat of extreme values. ■ Optionality. Given the risk associated with unexpected investor prepayments and issuer calls, an optionality strategy is currently a good source of excess return. This strategy also can be executed in decent size. Payoff to optionality under future interest rate and volatility scenarios is extremely complicated to measure, even with the latest supercomputers. Thus, this difficulty presents a substantial barrier to some investors. For example, the evaluation of optionality in the mortgage index itself can currently take several hours to calculate (because of all the individual securities with their myriad payoff possibilities under different interest rate scenarios). As technology improves, however, the time to calculate a bond’s optionality will diminish and this barrier will fall. In the meantime, optionality provides a relatively high information ratio, but it is accompanied by the possibility of extreme values. ■ Prepayment. Prepayment risk, a form of optionality, is extremely complicated to calculate. Future prepayment rates are conditional not only on projected interest rates but also on prior prepayment experience and structure (the flow of prepayments to particular tranches of the collateralized mortgage obligation under analysis). These factors contribute to the possibility of a solid information ratio. Prepayment risk is a bet that can be undertaken in moderate size and that generates a moderately sustainable source of return. Extreme values are a concern. ■ Anomaly capture. Several interesting types of anomaly capture are possible, but the contribution of these strategies to overall portfolio return is likely to be small. These bets can be meaningful in a hedge fund on a levered basis because the information ratio attributed to them is high, but they are wasteful if used as the core in other types of portfolios. The risk of extreme events with anomaly capture is high. ■ Credit risk. The world is being privatized and, therefore, so too are the world’s bond markets. The result is explosive growth in new corporate credits to evaluate. The magnitude and difficulty of the evaluation task generates a barrier that few investors can surmount; in other words, credit risk offers an opportunity to earn alpha. Securitization is a particularly exciting international growth area. It is driven by the balance sheet pressure on banks and corporations. Payment flows are being taken off balance sheets and dedicated to


35

Core-Plus Bond Management special purpose vehicles, which then issue debt. To illustrate the new wave of securitization, consider a recent deal in which nonperforming Italian bank loans were securitized. This deal received a AAA rating. It was structured so that the nonperforming loans were taken off the books of the banks at the recovery value. The assets were then fully cash collateralized. As loans are recovered, the cash collateral is freed up. This sector, these types of deals, can provide interesting incremental return opportunities. Within the next decade, such private credits are going to become identified as a new global asset class. This evolution will be incredibly interesting for those institutional investors who have the technology and access to management skills needed to exploit it. An additional opportunity for return in the global market is below-investment-grade corporate bonds, which are frequently shunned by investors. Significant investor restrictions on this market sector—that is, barriers to entry—can create an imbalance of supply and demand that results in serious security mispricings. Figure 4 illustrates the effect on the yield of BBB securities. Obviously, as credit quality decreases, positive spread increases. But the spread increases in a nonlinear fashion. As bond maturities lengthen, the chance of default rises and the probability of loss grows, so spreads widen. Historically, credit risk has been the strategy with the highest information ratio in the major finan-

cial markets. Credit analysts with U.S. experience have a major advantage in sorting through the opportunities around the world, because U.S. analysts have the most developed credit-risk-modeling experience. The strategy also has good scalability and strong sustainability. The strategy’s risk from extreme values, however, can be high. ■ Liquidity. Liquidity is a sustainable but not highly scalable source of excess portfolio return. Liquidity risk arises from the inefficiencies of markets that have insufficient providers of liquidity. Institutions can and do earn a reward for providing liquidity to the market, but the amount of return from this source is limited. The information ratio is low for liquidity-risk bets, primarily because of the fickle nature and duration of market illiquidity. ■ Currency. Betting on currency risk is a highly scalable activity; the currency market is by far the largest market in the world. In the most recent triannual survey conducted by the Bank for International Settlements in April 1998, daily currency turnover was $1.49 trillion. Data from the International Monetary Fund’s publication, International Financial Statistics, indicate that only 1.1 percent of this turnover (as opposed to 25 percent in the mid-1970s) is caused by trade flows. Therefore, 98.9 percent of daily currency turnover is associated with global investment flows. Opportunities exist for adding value through active currency management.

Figure 4. Credit Risk Opportunity: Yields by Investment Grade and Term, Ending March 2000 Spread (basis points) 250

200

10-Year Bond

150

5-Year Bond

3-Year Bond

100

50 AAA

AA

A

BBB

Note: Merrill Lynch & Company Industrial Bullet bid spreads.

36


Exploiting Opportunities in Global Bond Markets Experience shows that currency management as a stand-alone activity not only reduces risk but also adds significant alpha. As the size of the currency markets has exploded in recent years, the market has come to be characterized by time-concentrated periods of return. That is, substantial moves in a currency’s direction often occur in extremely brief time periods. Death can come suddenly in the currency markets. For example, in 1998, the yen strengthened against the U.S. dollar by 14.1 percent over the year. However, 7.5 percent of this move occurred in two hours, between 8:30 and 10:30 a.m (London time) on October 12. Therefore, the risk of extreme values is a valid concern for currency managers and investors, so managing currency risk is crucial. Showing a different pattern, however, the euro declined in a smooth fashion from its inception value. For currency managers, this decline was a great opportunity to add value to clients’ portfolios. Because reacting to changing risks in the currency markets is vital, technology plays a crucial role in carrying out a currency-risk strategy. Therefore, technology represents a barrier to investors in the currency-risk sector, and the sector is, as a result, another good source of return. However, because of the unpredictability of currency movements, the currency bet is associated with a low information ratio.

Conclusion Some of the previous major sources of return in domestic fixed-income portfolios have been lost in recent years. Technological innovation and sophistication have leveled the playing field. But global sources of return are materializing, not surprisingly, from trends originating in the United States and spreading across the globe. Privatization through securitization is primary among the trends sweeping the global markets. Thus, for example, the number of Standard and Poor’s London credit services staff has increased from a dozen to 420 in less than 10 years. Use of the technology of securitization, which developed in the United States, is now exploding in

Europe. U.S. technology enables new securitizations to be executed. It also provides the framework for analyzing the creditworthiness of the resulting hordes of private issuers. As the U.S. market has grown increasingly efficient (because of technological strides), the growth in securitization has occurred at an opportune time for U.S. managers. They have the expertise to apply the technology in the global fixed-income arena. We are also living in a world divided into three distinct economic blocs and three disparate market cycles—North America, Europe, and Japan. If Europe is beginning to wake up to the U.S. style of investing, can Japan be far behind? The technology that has altered the U.S. markets, to the point that alpha is tough to find, is now transforming the Euroland markets. The cult of U.S.-style institutional pension investing is growing. The potential for global economic disequilibrium also encourages large cumulative currency movements because there is no anchor, no market mechanism, to pull currencies back into equilibrium. Professor Charles Goodhart at the London School of Economics, former head of the Monetary Policy Group at the Bank of England, calls currency movements a “random walk with a dragging anchor.” 1 In other words, if a currency moves far enough, the movement so alters the fundamentals of the currency that the movement alone justifies the new currency level. If you are going to go global (and you must if you want superior performance in the fixed-income markets), the strategic long-term opportunities are in the credit markets and the currency markets. This direction is irreversible. Take managed credit-risk and currency-risk positions across markets, and alpha will be materially improved.

1“The Foreign Exchange Market: A Random Walk with a Dragging

Anchor,” Economica, (November 1988):437–460.


37


Question and Answer Session Ronald Layard-Liesching Question: How many big U.S. investors—pension funds, life insurance companies, and so on— are taking currency risk in their portfolios? Layard-Liesching: Our average U.S. institutional client has about 23 percent in developed equity markets and about 4 percent in emerging markets and uses a currency overlay strategy to manage that level of currency risk. The average U.S. large domestic fund has currency exposures equal to roughly 15 percent of its portfolio. Generally, the level of international investments, and thus currency risk, is higher in public-sector funds than in private-sector funds. On the bond side, the story is different. Most U.S. institutional global bond portfolios have a fully hedged benchmark, so the currency exposure will be much lower than for global equity portfolios. The rule of thumb fóor currency risk is that once the exposure reaches 20 percent of the portfolio, this source of risk can have a material impact (positive or negative) on the total fund. A fund should then have a policy on how to address the currency risk in its portfolios. Question: How does Pareto Partners quantify currency risk as a component of total risk? Is track-

38

ing error a useful measure of portfolio risk? Layard-Liesching: I don’t believe in tracking error for the simple reason that tracking error is a product of normal curves. The problem is the possibility of extreme moves, such as the move in the yen in 1998 of 7.5 percent in two hours. Annualizing a move of this type is meaningless. The average volatility of currency—probably 15 percent—is meaningless because 90 percent of the time, the volatility is much lower than the average. But then, it may go berserk. The way we look at currency risk is to estimate the risk of loss. This risk cannot be analyzed within a mean–variance optimizer. Because the portfolio’s downside risk—negative, not positive, volatility—is the concern, we use utility-based optimization. Utilitybased optimization recognizes the difference between positive and negative volatility. Question: Over a three-year time horizon, some currency-overlay products have had difficulty outperforming. Is such performance acceptable for core-plus strategies? Layard-Liesching: Analysts can take two approaches to currency management. One is forecasting. The forecasting model uses economic fundamentals, such as bal-

ance of payments and inflation; market information, such as yields; technical market analysis, such as the continuance or reversal of a trend; and an expert’s judgment. J.P. Morgan Investment Management, State Street Global Advisors, Goldman, Sachs, & Company, and Bridgewater Associates—which are all fine firms—use forecasting to manage currency. In this approach, however, once a fundamental position is taken, it is less frequently altered, because the currency is either way above or way below the value equilibrium. The other approach—our approach—is risk control. The exact method of risk control varies; some firms use dynamic hedging and portfolio insurance programs, whereas other firms use options. These approaches are generally more active in changing the positions and, therefore, less likely to be fixed in an adverse position for an extended period than a value strategy. The bottom line is that the right approach depends on what you’re looking for from currency. Is your goal to bring back to the United States the diversified returns from global bond portfolios? Then you want risk control. Are you more aggressive and looking for further incremental return? Then you want forecasting. We use a combination of approaches for global bond management.


The Effect of Portable Alpha on Fixed-Income Portfolio Management Lee R. Thomas III Managing Director Pacific Investment Management Company Newport Beach, California

A portable-alpha strategy allows a fixed-income manager to reap the benefits of active management by “porting” excess returns from one benchmark to another through the use of long derivative positions. Furthermore, because tracking error is also portable and because the challenge of choosing the active portfolio is the same regardless of the benchmark, a change of benchmark does not alter a manager’s information ratio and what would otherwise be a major shift becomes only a matter of routine accounting. In order to fully exploit portable alpha, however, investment management firms must change not only their organizational structures but their incentive structures as well.

ortable alpha is an investment technology with major implications for fixed-income portfolio management. The significance of portable alpha becomes clear when active management is properly defined. Active management is the attempt to accept active selection risk only in the markets in which the risk will be rewarded. With a portable-alpha strategy, the reward for active management—the excess return—can be “ported” onto equity or bond returns through the use of long derivative positions. This strategy has been practiced very successfully at Pacific Investment Management Company (PIMCO). Not only is alpha portable; tracking error (or variation from the benchmark’s performance) is also portable. As a result, the manager’s information ratio (the active portfolio’s excess return divided by the active portfolio’s volatility) remains unchanged even when the manager’s benchmark is changed. Thus, even if a client’s benchmark is revised substantially, the client has no need to obtain a new manager. The manager can continue as before and port the alpha to the new benchmark.1 This presentation examines the implications of portable alpha for four areas critical to active management: benchmarks, guidelines, tracking error, and firm structure.

P

1 For elaboration on Mr. Thomas’s views on portable alpha, see his following articles: “Active Management,” Journal of Portfolio Management (Winter 2000):25–32; and “Portable Alpha Long,” Risk Budgeting (May 2000):59–63.

Benchmarks In practical terms, the benchmark should be more or less irrelevant to the portfolio manager. Although this statement may sound rather radical, it does not mean the benchmark should be ignored. The difficult part of investment management—choosing the active portfolio—remains the same no matter what benchmark is given to the manager. Too much time is wasted discussing how to choose a benchmark that is fair for both the client and the manager. The definition of “active portfolio” explains why benchmarks are insignificant. Consider a hypothetical portfolio. First, list the assets in the portfolio, and then list the assets in the client’s benchmark. Next, align identical items on both lists. For example, put German bonds next to German bonds, mortgages next to mortgages, and so on. Now, take the difference in allocation between those two columns. The first column is the actual portfolio. The second column is the benchmark. The third column is the active portfolio and simply represents the difference between the portfolio and the benchmark. This concept applies to any portfolio. If a position is not in the benchmark, no problem: The benchmark weight on that asset is zero, and the portfolio has a nonzero weighting. If a benchmark position is not in the portfolio, the active portfolio simply has a negative position in that asset. For example, suppose the manager has a negative view on Japanese bonds and the benchmark weight is 1.5 years duration in Japan. The


39

Core-Plus Bond Management active portfolio would simply account for this difference as a negative 1.5 years duration weight in the active portfolio’s exposure to Japan. When the portfolio optimization is done, the active portfolio turns out to be the same regardless of what the benchmark is. So, optimally, if the manager is managing portfolios correctly, the active portfolio is independent of any benchmark. Porting Alpha to a New Benchmark. With portable alpha, if a client switches from a narrow index to a much broader index, the portfolio manager will need to make only routine adjustments. If the manager has been optimally managing against the J.P. Morgan Government Bond Index (GBI) Global (a narrow index) and now must manage against the Lehman Brothers U.S. Aggregate Bond Index (a broad index), the manager simply creates a new portfolio by adding the new benchmark holdings to the active portfolio. In other words, a little accounting (simply adding the active portfolio to what is in the benchmark) tells the manager what the new portfolio should look like. So, what appears to be a major shift should really be routine for the portfolio manager. Consider a more extreme transformation of the benchmark. The client decides that an absolute return target rather than a relative return target is the ticket. The manager can simply combine the active portfolio with the new benchmark, which is three-month LIBOR. The new portfolio will then be the positions in the active portfolio plus a new position in cash. A more radical notion is that portable alpha also applies to a change from a cash benchmark to an equity index, such as the S&P 500 Index. The manager of a low-duration fixed-income fund can easily adapt to an equity benchmark by following the same management strategy. The manager’s information ratio should remain the same despite the benchmark shift, even if the manager has no skill in stock market timing or stock selection. If the manager can achieve an information ratio of 0.5 for the low-duration fund, the information ratio will remain 0.5 because the manager can benchmark the active cash portfolio against the S&P 500 and have the same active return and the same active risk as before. Portable Alpha in PIMCO’s StocksPLUS. Portable alpha is not merely a theoretical concept. PIMCO has a product called StocksPLUS that uses portable alpha as the portfolio’s primary strategy, with the S&P 500 as the benchmark. Our firm is well known as a bond management firm. We have no timing capability in the stock market, so the portfolio is always fully invested. We have no stock selection ability, so the portfolio always matches the S&P 500 exactly. Despite these handicaps, StocksPLUS is among the

40

top-performing U.S. equity funds of the past five years. Although we have no talent for equity management, we have achieved excellent performance by porting our skill from where we do have talent—in this particular case, managing low duration—into the S&P 500. Our method is straightforward. We buy S&P 500 futures contracts to mimic the index, which results in a portfolio beta of 1. Only a small margin needs to be posted, so the portfolio has a lot of cash. The cash is invested to beat the implied rebate rate embedded in the S&P 500 futures contract, which is roughly equal to three-month LIBOR. If the idle cash earns more than LIBOR, the difference will drop right to the bottom line because the portfolio will achieve the return of the S&P 500 plus the return achieved in managing the cash assets. Managed with this strategy, StocksPLUS has been a highly successful product. So, portable alpha is not simply a theoretical idea; it is an idea we use in practice and that others use as well. C h o o s i n g a B e n c hm a r k . The benchmark should be a straightforward decision for the client and a nonissue for the manager. The benchmark should be selected by the client to optimize the portfolio’s asset allocation and liability structure. The manager can work with any replicable, or investable, benchmark. This discussion is particularly relevant in the area of global bond management because of the wide variety of global benchmarks available to clients. Clients with domestic benchmarks generally limit their choice of benchmark to one or two major fixedincome indexes. At PIMCO, we manage 60 global fixed-income accounts, and we have 39 different benchmarks. The old techniques that worked with only two or three benchmarks are inadequate. Instead, managers need a specific process or system that addresses the wide variation in global benchmarks, and portable alpha provides such a system. With portable alpha, the same active portfolio for all clients can be ported to whatever benchmark the client has chosen. In our case, we can port active portfolios to any one of the 39 benchmarks, so we no longer have to custom manage each and every account. Portable alpha directly addresses the practical aspects of managing global portfolios. Defining a Global Bond Portfolio. Portable alpha requires the reexamination of the accepted definition of a global portfolio. The current notion is that a global portfolio is defined by and replicates the benchmark. For example, if the GBI Global is the benchmark, the account is defined as global. If the Lehman U.S. Aggregate is the benchmark, the account is defined as U.S. domestic. Similarly, if a fund is managed versus three-month Euribor, the


The Effect of Portable Alpha on Fixed-Income Portfolio Management fund is defined as global, and if managed versus three-month U.S. LIBOR, the fund is defined as U.S. domestic. The absurdity of defining the portfolio as global or nonglobal as a function of the benchmark is obvious—the benchmark is irrelevant. The value added by the manager is the composition of the active portfolio. If a manager takes active bets outside the United States and those bets are a significant source of value in the portfolio, the manager is a global manager regardless of the benchmark. Ronald Layard-Liesching and others have argued that the major sources of inefficiency—and thus of excess return—are likely to be found outside the U.S. markets.2 If this argument is right, even though only 5 or 10 percent of the portfolio is invested in global markets, 50 or 75 percent of the portfolio alpha may come from those markets. The portfolio is global because the global markets are where the manager is creating and securing added value. As long as the active portfolio contains non-U.S. positions, regardless of the benchmark, the account is global.

Guidelines and Active Management Guidelines, not benchmarks, are what should matter. The idea of porting alpha from one account to another or from one benchmark to another works only if the guidelines permit this freedom. If a portfolio with a Lehman U.S. Aggregate benchmark has guidelines that prohibit nondollar bonds, the portfolio is not global. If a portfolio with a Lehman U.S. Aggregate benchmark has guidelines that do permit nondollar bonds, the portfolio has the ability to be global. The global nature of the portfolio will be determined by the manager’s decision to take advantage of the guidelines’ breadth and invest globally—beyond the benchmark—because the nondollar investment decision is the expected source of alpha in the portfolio. The Information Ratio. The law of active management developed by Grinold and Kahn states that a manager’s information ratio can be improved in one of two ways: increasing skill or broadening scope.3 Skill is the correlation between a manager’s investment forecasts and realized excess returns. Scope is the frequency with which a manager can isolate worthy opportunities for taking active risk. The more active investment opportunities that can be found, 2

See Mr. Layard-Liesching’s presentation in this book. Richard C. Grinold, “The Fundamental Law of Active Management,” Journal of Portfolio Management (Winter 1999):53–69; Richard C. Grinold and Ronald N. Kahn, Active Portfolio Management (Chicago, IL: Probus Publishing, 1995); and Ronald N. Kahn, “Bond Managers Need to Take More Risk,” Journal of Portfolio Management (Spring 1998):70–76. 3 See

the greater the chances of improving return and increasing diversification. So, why does increased breadth improve the information ratio? A broadening of scope is the intertemporal equivalent of Markowitz portfolio construction theory. Markowitz showed that, in general, a diversified portfolio will have a higher return-torisk ratio than a portfolio that is not diversified. This construct also holds true intertemporally. That is, if the portfolio’s active bets are diversified over time, the portfolio’s ability to earn excess returns is stronger. Thus, the greater the number of small active positions in a portfolio (the broader the scope), the greater the potential for a more favorable return-torisk ratio (i.e., information ratio). For example, consider a manager who claims to have only one source of alpha (skill)—duration management. The manager either lengthens or shortens the duration of the portfolio based on anticipated interest rate changes. Assume that the portfolio consists of holdings in only one country, and also assume that the manager can produce an interest rate forecast once a quarter and that cyclical movements in interest rates last for about five years plus (a generous assumption). Now, suppose that the portfolio includes four different countries: the United States, the United Kingdom, Europe, and Japan. The manager can make 16 duration bets a year. This requires economic and market cyclical independence, which we all know is not the case. The information ratio increases when the manager can make 16, rather than 4, duration bets a year. If 16 bets can be made every year, each of those bets can be smaller relative to the bets in a portfolio with only 4 possible bets. If the number of possible bets is larger, allowing each individual duration bet to be smaller, diversification—an insurance effect—is achieved. The information ratio ex ante depends on the square root of the number of bets that can be made. The manager who can make more bets will have twice the information ratio of the other manager even if both have equal skill. This effect is an impossible barrier to overcome. If one manager starts off with an ex ante information ratio that is twice that of another manager, the second manager is never going to match the performance (or information ratio) of the first manager, no matter how much the second manager improves in skill. In actual practice, a four-country (global) fixedincome portfolio really has more than 16 bets available because the manager is playing more than one game (duration). The manager can choose from a plethora of slope bets, twist bets, and spread bets in each of the four countries. As soon as the manager


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Core-Plus Bond Management goes global, the number of active bets that can be taken rises dramatically, and the expected information ratio also rises as the square root of the number of independent bets climbs. So, this phenomenon is a strong argument in favor of the broadest possible scope in portfolio construction. The Importance of Guidelines. Guidelines are central to the success of a portfolio manager because a manager with more-liberal guidelines will outperform a manager with more-restrictive guidelines. If the guidelines restrict the manager so severely that only 4, rather than 16, of the possible portfolio bets are achievable a year, the manager’s information ratio will be commensurately lower. The 4-bet manager, however, can produce the same return as the manager with 16 bets. The 4-bet manager simply must be much more aggressive in accepting risk. Each of the bets must necessarily be larger, because the size of each bet is multiplied by only a factor of four. A smaller number of larger bets is much riskier than a larger number of smaller bets. The irony is obvious because clients use restrictions with the intention of reducing risk. Instead, the effect is to grossly amplify the amount of risk that a portfolio manager will take in order to get a certain level of return.

Tracking Error and Active Management Tracking error is important, and the main concern for tracking error in active management is “the coordination problem.” In other words, is it possible to coordinate all the client’s managers to produce optimal performance results and minimize tracking error? In the real world, few managers handle 100 percent of their clients’ assets. The predominant investment management structure today, the modern paradigm, is to use not one manager but a series of specialty managers. Typically, not all of a client’s managers communicate with each other. Optimizing the subportfolios alone, however, will not create an optimal total portfolio. First, the total portfolio must have an optimal asset allocation, so the portfolio must be constructed with knowledge of the assets’ correlations. To accomplish this task, the specialty managers should think of themselves as a team that communicates through the portfolio’s benchmarks, which are assumed to represent the client’s optimal portfolio. For example, one manager benchmark may be the unhedged GBI Global and another manager may have the S&P 500. Now, if the managers do not stray too far from their respective benchmarks, the portfolio should in fact be statistically close to an optimal portfolio. That is, in a statistical sense, the subportfolio should replicate the benchmark, which

42

means tracking error must be moderate and volatility must be approximately the same as that of the benchmark. If such is the case, the correlations between the subportfolios will be close to the benchmark correlations and the overall portfolio will be optimal.

Firm Structure and Active Management The fundamental law of active management dictates that investment management of the future will be a team sport. No guru on earth has the ability to follow every market in the world and unearth the nuggets of inefficiency in each. A global portfolio requires a team of managers, which in turn requires changes in both firm and industry structure. A process must be instituted within the investment management firm that encourages investment ideas to filter up from the specialty markets to the entire team. To encourage ideas in the specialty areas to percolate upwards, incentives must percolate down to the specialty areas. The key is that team members should be rewarded on the entire team’s performance, not the individual member’s performance in his or her area of expertise. This incentive scheme encourages members to make solid micro-forecasts from which the entire team, or entire portfolio, can benefit. Firm Structure. The proposed firm structure can be thought of as a series of boutiques under the umbrella of one large firm. Ideally, the activemanagement decision-making process would involve a representative from each of the boutiques who would present any opportunities available in their markets and would advise the team if no opportunity exists at that point in time. If no opportunity exists, dollars normally allocated to that particular sector would be reallocated to another sector. This approach is a managerial challenge. The sector specialists, the boutique managers, have to be honest and cannot always be cheerleaders for their own sector. Each team member must give an unbiased estimate of the prospects within the area that he or she monitors. Incentive Structure. The new firm structure requires the right incentive structure—one very different from what exists in many investment management firms today, in which the prestige and the bonuses go to the manager who has the most money under management. Instead, the incentive structure should promote the unbiased flow of information, which means that the team members should be compensated based on the performance of the team, not based on their particular sector’s performance. Rather than measure performance based on how much a team member outperformed in an individual


The Effect of Portable Alpha on Fixed-Income Portfolio Management sector—as is typically done now—a better approach is to measure performance based on the team member’s accuracy in predicting the sector’s excess return, including correct predictions of zero excess return. The specialty manager should get the same compensation regardless of the amount of expected excess returns from the sector as long as the forecast is on target. Good news and bad news are equally valuable in constructing a portfolio. Accuracy is what matters, and accuracy is what should determine incentive compensation.

call this strategy an “asset allocation barbell.” Instead of allocating 100 percent of the money to core managers, the same result is accomplished by allocating 90 percent to index managers and 10 percent to hedge fund managers. Not only does the portfolio arrive at the same place, it also pays lower fees. With a core portfolio, the manager charges active-management fees on the entire portfolio even on the portion allocated to indexed instruments. With an asset allocation barbell, active-management fees are paid on only the 10 percent that is truly actively managed.

Investment Strategy. The current separation of functions in the investment industry is artificial. No technological reason compels this structure; it is merely the product of industry evolution. The industry has created specialty firms and specialty managers within firms that are used to enhance the performance of a core manager—the concept of a core manager being neither theoretically well founded nor rooted in practicality. The separation of functions arose in response to the vast differences in client risk preferences and specialty managers’ limits in coverage ability. Hedge funds cater to the aggressive investor; index funds cater to the low-risk investor; and core managers fall somewhere in between. The concept of portable alpha indicates that such a division is not necessary. A hedge fund can be turned into a core product by simply taking part of the hedge fund, calling that the active portfolio, and overlaying it on the client’s benchmark in an amount appropriate to the client’s risk preference. If a higher weighting of the active hedge portfolio is transferred relative to the new benchmark, then the manager has created a relatively aggressive portfolio. If a relatively smaller weighting is transferred, the new portfolio will effectively be an index-plus, or core-plus, portfolio—a more moderate portfolio. Thus, the amount of active portfolio overlaid on the new benchmark determines the risk characteristics of the overall portfolio. If the concept is to taken to a logical extreme— once again thinking of the portable alpha idea of an active portfolio and a passive portfolio—firms should organize their investment mandates to reflect the same structure. Only two types of mandates should be given out: index and alpha. Index fund mandates address a portfolio’s overall asset allocation and should consist of perhaps 90 percent of the total portfolio. Index funds, however, do not produce any alpha. To add alpha, the remaining 10 percent is given to a hedge fund manager who will leverage this 10 percent bet up 10:1, which provides the alpha and the active risk for the entire portfolio. I

Industry Structure. The implication of portable alpha for the industry is that, sadly, large investment management firms are going to beat small investment firms because a large investment management firm can afford to monitor all the different markets and bets, whereas a boutique cannot. This outcome is unfortunate because most investment managers like the feel of a small organization, but the economics of the industry indicate that large firms are going to outperform small firms if they can attain the same level of skill and if they can attract the same talented people as a small firm. The goal is for a large firm to feel like a boutique for the managers who work there. Of course, if a set of boutiques under the same roof is desirable, some may argue that a collection of independent boutique firms would do as well. The answer is in the way a collection of boutiques is going to work. Imagine a collection of boutiques in which one firm has the high-yield/below-investment-grade mandate and another firm has the investmentgrade/corporate mandate. Also, imagine that at a certain point in time, the high-grade manager sees no opportunities in his market—the ex ante information ratio available to him at the moment is zero—but the investment-grade/corporate manager sees a lot of opportunities in her market—the ex ante information ratio available to her is high. The correct decision for the best interest of the client is clear: Take money from the high-yield manager and move it to the investment-grade manager. In practice, the chances of this result happening are nil. The high-grade manager will fight to keep his mandate even with an ex ante information ratio of zero because doing so is in his best interest; he does not get paid to suggest the money be allocated away from his sector. In the current industry structure, the manager is not rewarded for putting the client’s best interests ahead of his own. This fault, however, can be repaired by employing the concept of portable alpha within the context of a large firm of specialty managers operating under an incentive program that rewards team effort.


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Conclusion Giving the manager authority to venture beyond the traditional benchmark to add alpha and then port that alpha to another client-chosen benchmark is what core-plus management is all about. Benchmarks are irrelevant in the sense that the client’s choice of benchmark does not alter the difficulty of managing the portfolio. Tracking error, however, still matters because manager performance is compared with the benchmark, and portable alpha enhances the manager’s ability to outperform any benchmark. Accordingly, managers should concentrate on constructing the active portfolio, determining what to overweight or underweight relative to the benchmark. A manager’s information ratio will determine the potential for alpha, and the greatest increase in the ratio comes from broadening the manager’s scope in general, not focusing on particular pockets of skill. Portable alpha is impossible if a manager does not

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have the necessary latitude to place many different kinds of bets. Thus, guidelines are crucial, because a manager with permissive guidelines has a major advantage over a manager with restrictive guidelines. Managers should either get the necessary authority from clients initially or work to build relationships that will eventually result in more-liberal guidelines. Portable alpha has major implications for investment industry structure. Although investment professionals prefer the feel of working in smaller firms, successful active management requires broad market coverage, which means bigger firms will have a significant advantage over smaller firms. The challenge for large firms is to create a system that rewards the unselfish sharing of information so that investable funds (monies) can be shifted to true opportunities for excess return. Large firms must also create a working environment that will attract the superior talent that might otherwise gravitate to smaller firms.


The Effect of Portable Alpha on Fixed-Income Portfolio Management

Question and Answer Session Lee R. Thomas III Question: Given that clients want “hard assets,” not derivatives or short positions or leverage, is the concept of portable alpha too theoretical? Thomas: No. Portable alpha is more than only theory. At PIMCO, we manage a lot of money in StocksPLUS, which is a pure portable-alpha product. Portable alpha is the key to core-plus management. A great deal of PIMCO’s success has been achieved because we embraced the idea of adding sectors and markets outside the benchmark. For example, PIMCO pioneered the idea of putting bond futures into fixed-income portfolios. At the time, futures were considered the realm of crazy, wildeyed people. PIMCO, however, put futures into pension funds because they were mispriced and could provide excess returns for our clients, and it worked. Question: How can a manager embrace portable alpha if the mandate prohibits the use of leverage, derivatives, futures, or options? Thomas: You can’t. This inability is the reason why it is crucial for the manager to get the authority to use these instruments, and it is also the reason why portfolio guidelines are so important. The client must give the manager authority to use unconventional instruments, and if the client insists on limiting the portfolio only to conventional instruments, the client is the loser. For example, everyone knows an anomaly exists between BBB and BB corporate securities. BB corporate securities have a much higher total return over time than BBB securities. The reason is that portfolio guidelines do not permit most

investment managers to use BB securities. Thus, the lower demand for below-investment-grade securities results in higher risk to the sector, which is compensated by unusually high returns. The same clients who prohibit the purchase of these securities in an effort to control portfolio risk actually end up creating opportunity for clients who do buy this investment class and benefit from the favorable risk–return trade-off. If clients don’t generally approve portfolio guidelines that extend beyond the benchmark at the outset, account managers should be dedicated to the acquisition of broader guideline authority as the client relationship evolves, which is what we do at PIMCO. Question: What is the maximum maturity for the cash position in the portable-alpha portfolio, and how do you earn excess returns on the position? To the extent that you take credit risk, are you accepting more risk than is contained in the asset class you’re trying to beat? Thomas: Typically, we don’t use maturity to define the instruments in which we invest. Instead, we use the concept of duration. What’s the impact of using duration versus maturity? For the large part of the market that does define portfolio guidelines in terms of maturity, a cash portfolio is generally defined as including securities with maturities of one year or less, which means that the portfolio contains a lot of instruments with short duration but with maturities greater than one year. The lack of demand for these securities results in some serious mispricings that create a lot of opportunities to add excess return. We hope that this foolish


mistake continues, because in the financial markets, money is made at the expense of other participants’ misjudgments. Of course, marginal risk is added to the cash portfolio, because return is not free. Active risk has to be taken to earn an excess return, but the risk can be done in a smart way or a not-sosmart way. The smart way is for the manager either to invest in securities that, for a variety of reasons, are not being purchased by others or to achieve a unique insight about the market or a particular security. Yes, credit risk is associated with the cash position, but there is a big difference between the credit risk of a 10-year and a 1-year maturity. Buying a 10-year bond involves much more complicated and speculative credit analysis than does buying a 1-year bond. For a 1-year bond, the primary credit consideration is the amount of the firm’s short-term assets compared with its short-term liabilities. If short-term assets are significantly higher than short-term liabilities, my opinion for the next year will be that the bond is a good credit. This consideration is all I care about, and the evaluation is fairly simple. So, the credit risk is a lot lower than you might think, particularly when compared with the equity position in the portfolio, which has a very long duration in addition to greater credit risk. Ultimately, the amount of credit risk added is disproportionately small relative to the amount of alpha contributed to the portfolio. Question: If tracking error is more important than the benchmark, how do you measure tracking error?

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Core-Plus Bond Management Thomas: Saying the benchmark is not important does not mean the manager should ignore the benchmark. Tracking error matters because the manager must compare performance with the benchmark. The choice of the benchmark, however, doesn’t make managing the portfolio any more or less difficult. If the benchmark is changed from the GBI Global to the Lehman Global Aggregate, the manager’s job should not be more difficult as a result. Such a switch may actually be less difficult when using the concept of portable alpha because of the interaction between guidelines and benchmarks. For example, if the Lehman Global Aggregate is the benchmark, the guidelines must approve the use of mortgages and corporates because both are included in the benchmark. Thus, any change in the guidelines linked to a change of benchmark should be easy to resolve. Moreover, a lot of clients don’t permit outright short positions, but if the guidelines prohibit shorting and if the manager believes corporate spreads are going to widen, the manager cannot express this view any other way. If the benchmark encompasses corporate bonds, the negative view on corporates can be expressed by underweighting the corporate sector. For this reason, I spend most of my time constructing the active portfolio on deciding what should be over- or underweighted versus the benchmark. Such decisions are independent of the benchmark. Question: How much excess return can a global mandate deliver? Thomas: The past three years have not been easy for global managers in general. The difficulties have been compounded by a benchmark that has performed in the top quartile for the period. However, the good news is that the

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past three years have been unusual—a transition period. The fixed-income markets of the future are going to be very different. Several years ago, I would have answered this question by saying that the information ratio for a global portfolio probably could not be improved because, de facto, all of the alpha was likely to come from the United States generated by mortgages and corporate bonds that are unavailable outside of the United States. Times are changing. In the past, alpha came from top-down macroanalysis, but today, bottomup microanalysis produces superior alpha that is more easily achievable. Corporate bond markets are developing in Europe, as are some mortgage markets, such as the Danish mortgage-backed securities market. Structured products are cropping up in Japan as well as in Europe. The fruits of increasingly sophisticated global markets are ripening and being quickly gathered by skillful managers. If a long-term information ratio of, say, 0.5 is available in the U.S. markets alone, the same return should be available in nonU.S. markets but with a likely 30 percent reduction in volatility from increased diversification opportunities. This reduction in volatility would translate into portfolio performance equal to 1.3 times a 0.5 return. Question: Does the success of the portable-alpha strategy hinge on the ability to use derivatives? Thomas: No. Think of the portfolio as being divided into an active portfolio and a passive portfolio. The organization of the portfolio managers should mirror this structure because the skills required in the two areas are quite different. Passive management requires the ability to perform only partial, not full, portfolio replication. A good,

smart quantitative analyst can recreate the characteristics of the benchmark with a relatively small subset of bonds. This task is not enormously difficult and can be accomplished without derivatives, although derivatives certainly facilitate the process. A hedged global portfolio is difficult to manage without derivatives. If you can’t use derivatives when you want to put spread exposure into your portfolio, you actually have to go out and buy corporate bonds. But if you think that swaps are cheap relative to corporate bonds, establishing a long corporate position may not be the best bet. In fact, putting on a swap generally would be less risky (risk being the argument used by clients to keep derivatives out of a portfolio) than going out and buying a corporate bond, particularly to collateralize the swap. The key is how much risk or duration is in the portfolio, not simply whether derivatives are in the portfolio. A portfolio can be wildly risky without using derivatives. Question: Do you endorse the view that bigger is better, and isn’t it harder for bigger firms to scale alpha production? How can the single-strategy firm survive in such an environment? Thomas: For active management to be successful, you need to have breadth of market coverage, which is impossible to achieve without a lot of people. Thus, the challenge is maintaining a management structure within a large organization that creates the feel of a small organization, a structure that will attract talent that would otherwise be drawn to boutique investment shops and that will foster a nondistorted flow of information among all portfolios and portfolio managers. The smaller boutiques will probably be


The Effect of Portable Alpha on Fixed-Income Portfolio Management absorbed by the larger firms and become the specialty teams within the larger organization. The idea is to assemble “pure” information from various sources and direct it along the paths most likely to produce excess return— that is, finding and distributing excess return opportunities for all

portfolios in an unbiased way. An incentive structure that rewards all managers and analysts for the success of the entire portfolio, not only their specialty area, is a prerequisite for this approach to work. With the right incentive structure, bigger is going to beat smaller.


Question: Is a new investment professional being created—not an asset allocator, but an alpha allocator? Thomas: The fund-of-funds manager is the first example of what might be called an alpha allocator.

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Managing Fixed-Income Risk in Core-Plus Portfolios Scott F. Richard Managing Director Morgan Stanley Dean Witter Investment Management West Conshohocken, Pennsylvania

Relative to core portfolios, core-plus portfolios simply have more, not different, systematic risk. Fortunately, the techniques of modern portfolio theory provide managers with the means to control unwanted systematic risk in core-plus portfolios. Perhaps the greatest difficulty for managers, however, is not risk control but accurately gauging and meeting client expectations, and managers can increase the probability of achieving client satisfaction by using explicit, comprehensive portfolio guidelines.

current topic of interest in fixed-income portfolio management is defining the similarities and differences between core and core-plus fixed-income portfolio management. The typical U.S. aggregate fixed-income index provides the performance basis for a standard core portfolio, as shown in Table 1. Clients specifying this index are implicitly indicating their willingness to bear certain types of risk inherent in the index: interest rate risk, prepayment risk, default risk, and liquidity risk. At Morgan Stanley Dean Witter Investment Management, we consider a core-plus assignment to include below-investmentgrade debt, which means emerging market debt, U.S. high-yield bonds, or some combination of both. Also, our client guidelines typically allow mortgage derivatives in a core-plus portfolio. Does the addition of these securities to the investment mix fundamentally change the type of risk that clients bear? That is, does a core-plus portfolio have different risks from a core portfolio, or does it simply have more of the same risks? If core-plus is only a variation of the core management style, the tools already used to measure and manage risk for core portfolios can be applied to core-plus portfolios. Given our definitions of core and core-plus, this presentation focuses on how various types of systematic risk affect core-plus portfolios. In particular, managers face four fundamental tasks: understanding the types of systematic risk present in a fixed-income portfolio, measuring the risk, managing the risk, and writing guidelines to ensure that the risk is indeed

A

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controlled. This analysis focuses on the management of systematic risks because these are typically the largest risks in a portfolio. A manager can also add value through security selection, but the return contributions of security selection usually diminishes as the size of the portfolio grows.

Identifying Fixed-Income Systematic Risks This section focuses on six types of systematic risk found in fixed-income portfolios. Three types of risk (interest rate level, yield-curve slope, and yield-curve twist) are related to interest rates. The other three types of risk (liquidity risk, prepayment risk, and default risk) involve changes in spread relationships. (I am excluding volatility risk, which is beyond the scope of this discussion). Yield-Curve-Related Risks. Three types of systematic risk are inherent in the yield curve: interest rate level, yield-curve slope, and yield-curve twist. Taken together, these three risks account for about 98 percent of the systematic variation in Treasury bond yields. Figure 1, which plots the yields on 2-year, 10-year, and 30-year T-bonds over the past decade, gives an idea of the size of these risks. ■ Interest rate level. The classic measurement of interest rate risk is duration. But if the goal is to manage a portfolio’s total interest rate sensitivity, duration is an inadequate measure of interest rate


Managing Fixed-Income Risk in Core-Plus Portfolios Table 1. Composition of Typical U.S. Aggregate Bond Index (dollars in billions) Treasury

$1,672

Agency

31%

535

10

Corporate

1,217

22

Mortgage

1,947

36

Asset backed

70

Total

1

$5,441

100%

risk because it assumes that all yield-curve movements are parallel shifts. In reality, interest rates of different maturity tend to move generally in the same direction but not by the same amount, so parallel shifts of the yield curve are rare. The reason is that all yields are not equally volatile. In general, about 87 percent of systematic interest rate risk can be explained by changes in the general level of interest rates. For example, the 10-year Treasury bond, which is a good proxy for the general level of interest rates, has an annualized standard deviation (based on monthly changes) of about 100 basis points (bps). Hence, interest rate risk is the biggest consideration in structuring and managing a portfolio. ■ Yield-curve reshaping. The degree of yieldcurve reshaping, or movement, from one date to another can be substantial. A lot of money can be made or lost from both intentional and unintentional yield-curve bets. About 9 percent of a portfolio’s systematic interest rate risk can be attributed to changes in the slope of the yield curve. Although yield-curve slope shifts contribute considerably less to explaining total portfolio risk than do changes in general interest rate levels, yield-curve reshaping can have a huge impact on the risk and return of a portfolio. For exam-

ple, the spread between 2-year and 30-year Treasuries, for the period from May 1989 to May 2000, had an annualized standard deviation of 65 bps, which is a lot of risk. Hence, if a portfolio has one year of interest rate slope duration in a steepening trade and the market moves two standard deviations against the bet, the portfolio will underperform the benchmark by 130 bps. So, investors need to be almost as concerned with having the right yield-curve bet as with having the right interest rate bet. ■ Yield-curve twist. A yield-curve twist is a reshaping of the yield curve in which short bonds rally, intermediates rally more, but long bonds sell off. Approximately 2 percent of systematic portfolio risk can be assigned to a yield-curve twist. Twist risk has a much smaller effect on the overall portfolio than changes in the interest rate level or yield-curve reshaping. Spread-Related Risks. Most of the portfolio risk not attributable to the interest-rate-related systematic risks can be explained by changes in spread relationships. The three large spread risks that affect core-plus portfolios are liquidity risk, prepayment risk, and default risk. Again, the data provide an appreciation for the magnitude of these risks. ■ Liquidity risk. Liquidity risk exists in all markets. Because swap contracts are fully collateralized, swap spreads are a good proxy for liquidity risk. Figure 2 depicts the yield spread for 10-year swap spreads and off-the-run Treasuries (which should correct for any temporary under- or overvaluations in on-the-run Treasuries) for the period from December 1989 to August 2000. Compared with interest-ratelevel risk, liquidity risk has only one-third of the

Figure 1. Different Maturity Yield Changes, 1989–2000 250 Yield Spread (basis points) 400 200 350 150 300 100 250 50 200 0 150 –50 100 –100 5/89 50

5/90

5/91

5/92

5/93

5/94

5/95

5/96

5/97

5/98

5/99

5/00

0 –50 –100 5/89

5/90

5/91

5/92

5/93

5/94

5/95

5/96

5/97

5/98

5/99

5/00

Note: Monthly data from May 31, 1989, through May 31, 2000.


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Core-Plus Bond Management Figure 2. Ten-Year Swap Spread, 1989–2000 140 120 100 80 60 40 20 0 12/89

12/90

12/91

12/92

12/93

12/94

12/95

12/96

12/97

12/98

12/99

12/00

Note: Daily data from December 31, 1989, through August 8, 2000.

volatility, with an annualized standard deviation of 32 bps. In other words, a one-standard-deviation move in liquidity risk equals roughly one-third of a one-standard-deviation move in the 10-year Treasury yield. Nevertheless, liquidity risk can have a significant effect on a portfolio’s performance. For example, if a portfolio is overweight by two years in spread duration (i.e., the price effect of a widening or tightening in spread by 100 bps) and a two-standarddeviation move occurs, the portfolio will underperform the benchmark by 64 bps. Of course, if the market moves in the opposite direction, the portfolio will beat the benchmark by 64 bps. The liquidity bet may not represent as large a bet as the interest rate bet, but liquidity risk remains a significant consideration. Note that the swap spread has recently been at an all-time wide, indicating a very large liquidity premium in the market. This situation is probably the result of two causes: high real short-term interest rates and the market’s perception of the effect of reduced Treasury supply. ■ Prepayment risk. Prepayment risk is the systematic risk associated with the uncertainty of a mortgage security’s cash flow. Specifically, it is the uncertainty that results from the mortgage borrower’s embedded option to prepay the mortgage at any time. A measure of prepayment duration— independent of liquidity, yield curve, and interest rate durations—is essential for correctly gauging portfolio risk. Mortgage option-adjusted spread risk has two components: the liquidity risk portion, which is represented by swap spreads, and the prepayment

50

risk portion. Panel A of Figure 3 shows the optionadjusted spread of the Salomon mortgage index from May 1989 to May 2000. This spread has 36 bps of annualized standard deviation, which is attributable partly to liquidity risk and partly to prepayment risk. ■ Default risk. Default risk is the uncertainty that the corporation issuing the debt will not make timely payments of interest or principal. Panel B of Figure 3 shows the option-adjusted spread for the Salomon A rated corporate index from May 1989 to May 2000. The standard deviation of this spread is 28 bps. Like the mortgage option-adjusted spread, the corporate option-adjusted spread can be attributed to two risk components: liquidity risk and default risk. Note the recent wide spreads in both panels of Figure 3. The mortgage option-adjusted spread is now almost as wide as it was during the prepayment wave caused by the bond market rally in 1993. Furthermore, the corporate option-adjusted spreads are wider than they were in the depths of the recession of 1990–1991. The high liquidity premium, as shown in swap spreads, accounts for much of the widening in mortgage and corporate spreads.

Measuring the Systematic Risks Traditionally, portfolio managers have used duration and spread duration to measure the interest rate risk and spread risk, respectively, in their portfolios. At Morgan Stanley Dean Witter, we think that duration and spread duration do not capture adequately all the different kinds of risk in a portfolio, and managers


Managing Fixed-Income Risk in Core-Plus Portfolios Figure 3. Option-Adjusted Yield Spreads, 1989–2000 A. Mortgage Option-Adjusted Yield Spread Option-Adjusted Yield Spread (bps) 140 120 100 80 60 40 20 0 5/89

5/90

5/91

5/92

5/93

5/94

5/95

5/96

5/97

5/98

5/99

5/00

5/98

5/99

5/00

B. A Rated Corporate Option-Adjusted Yield Spread Option-Adjusted Yield Spread (bps) 180 160 140 120 100 80 60 40 20 0 5/89

5/90

5/91

5/92

5/93

5/94

5/95

5/96

5/97

Note: Monthly data from May 31, 1989, through May 31, 2000.

can benefit from applying enhanced risk measures to their portfolios. The following risk measures associated with the six types of systematic risk are suggested as a replacement for the traditional notions of duration and spread duration. Yield-Curve Changes. Because different types of risk affect the yield curve differently at each point on the curve, the typical yield-curve change is not

parallel, as shown in Figure 4. A diversified portfolio with cash flows at many different points on the yield curve will obviously have more than one type of systematic risk. In fact, as was demonstrated by the data in the discussion of systematic risks, managers have to account for three factors. The following discussion focuses on quantifying these factors. The first factor is a change in the yield-curve level and is shown in Panel A of Figure 5. This factor


51

Core-Plus Bond Management Figure 4. Parallel Yield-Curve Moves Are Rare: May 31, 2000, versus June 30, 2000 A. Nonparallel Yield-Curve Moves Yield (%) 7.0 5/31/00 6.5 6/30/00

6.0 5.5 5.0 1

2

3

4

5

6

7

8

9

10

12

15

16

17

18

19

20

25

30

Years

B. Spread between May 31 and June 30 Yield Curves Years 1

2

3

4

5

6

7

8

9

10

12

15

16

17

18

19

20

25

30

0 –5 –10 –15 –20 –25 –30 –35 –40 Yield Change (bps)

accounts for about 87 percent of systematic risk. The second factor is a change in the yield-curve slope, as shown in Panel B. Changes in yield-curve slope account for about 9 percent of the systematic risk in the portfolio. The third factor is the yield-curve twist, as shown in Panel C, which accounts for 2 percent of systematic risk related to the yield curve. To manage yield-curve risk, every night, we apply these three yield-curve shocks to the index and to our portfolio (a total of 8,000 bonds) and then compare the return of the benchmark with the returns of our portfolios to assess our portfolios’ relative performance under each shock. This approach allows us to determine a yield-curve position for our portfolios relative to the index. The position is calculated in terms of how many 2-year, 10-year, and 30-year bonds are needed to hedge all three of the shock-induced movements back to the benchmark. The acceptable risk bets in the portfolio are based on the degree of comfort with being long, short, or neutral at the 2-year, 10-year, and 30-year points on the yield curve, given the interest rates on the yield curve. Currently, we manage our portfolio to be neutral at 30 years, long

52

at 10 years, and short at 2 years. Accordingly, we hope to profit from a slope or twist change but are neutral to level changes. Because of the ability to manage and measure these three systematic risks, the number of bets in the portfolio can be narrowed substantially. We choose to manage our portfolios at the 2-year, 10-year, and 30-year maturities because these maturities have corresponding liquid interest rate futures. Thus, we can make distinct decisions about our risk position at each of these three maturities without having to compromise our risk bets at either of the other two maturities. To understand the usefulness of this approach, reexamine the shift in the yield curve from May 31, 2000, to June 30, 2000. Figure 6 shows the results of applying sequentially each of the yield-curve shifts to explain the total reshaping of the yield curve. Panel A shows the effect of adding the level shift, Panel B shows the cumulative effect of the level and slope shifts, and Panel C shows the total effect of all three shifts. The three factors produce a close fit to the yield curve at the end of June 2000. Despite the accuracy of this method, the reconstructed curve is not a perfect


Managing Fixed-Income Risk in Core-Plus Portfolios Figure 5. Yield-Curve Changes A. Shift in Yield-Curve Level

Yield (bps) 40

Likely Upward Shift

20

0

–20

Likely Downward Shift

–40 0

5

10

15

20

25

30

35

25

30

35

25

30

35

Years

B. Shift in Yield-Curve Slope

Yield (bps) 20

Curve Steepening 0

Curve Flattening

–20 0

5

10

15

20

Years

C. Yield-Curve Twist

Yield (bps) 20

0

–20

0

5

10

15

20

Years


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Core-Plus Bond Management Figure 6. Effectiveness of Various Shifts in Explaining Yield-Curve Changes

fit—particularly at the long end of the curve. Even a minor error of 3 bps, when multiplied by a 30-year duration, can result in significant under- or outperformance for a portfolio. This discrepancy is caused by idiosyncratic market shocks. No methodology currently available can completely hedge idiosyncratic shocks.

A. Level Shift Yield to Maturity (%) 6.8 6.7 6.6 6.5 6.4 6.3 6.2 6.1 6.0 0

5

10

15 Years

20

25

30

25

30

25

30

B. Level and Slope Shifts Yield to Maturity (%) 6.8 6.7 6.6 6.5 6.4 6.3 6.2 6.1 6.0 0

5

10

15 Years

20

C. Level, Slope, and Twist Shifts Yield to Maturity (%) 6.8 6.7 6.6 6.5 6.4 6.3 6.2 6.1 6.0 0

5

10

20

5/31/00

Level and Slope

6/30/00

All Shifts

Level Shift

54

15 Years

Spread Changes. The standard measure for managing spread risk is spread duration. In the same way that we think duration is an inadequate measure of yield-curve risk, we think that spread duration is an inadequate measure of mortgage and corporate sector spread risk. ■ Mortgage debt. We think a better approach to spread-risk analysis for mortgage and corporate debt is to break the spread durations—or the spread sensitivities—into two parts. For mortgage debt, the breakdown consists of the two systematic risks: liquidity risk and prepayment risk. Panel A of Figure 7 shows the contributions of liquidity risk and prepayment risk to the overall spread risk of mortgage securities. The risk components vary as a percentage of total risk based on the market price of the security relative to par. Discount mortgages have little prepayment risk but higher liquidity risk. On the other hand, premium mortgages have high prepayment risk but relatively less liquidity risk. Mortgage prepayments occur at par, thus prepayments on bonds priced higher than par have a higher relative cost of prepayments than prepayments on bonds priced at or less than par. By identifying the type of mortgage risk in the portfolio, the manager can evaluate the weighting relative to the benchmark and hedge away the unacceptable exposure by using a combination of swaps and mortgages. ■ Corporate debt. As with mortgage debt, the spread duration for corporate debt can also be attributed to two sources: liquidity risk and default risk. Panel B of Figure 7 shows the weighting of each risk type for the different corporate rating categories. Again, the two-part analysis is intuitively appealing. Panel B shows a small but gradual pickup in illiquidity from AAA to BBB debt but a large jump in illiquidity for debt below investment grade. Similarly, default risk rises dramatically in lower-rated bonds. In managing a diversified portfolio of corporate bonds, it is important to measure both the portfolio’s liquidity risk and default risk relative to the benchmark index. Spread-Duration Comparisons. Although spread duration is a fairly standard industry measure, it is an inadequate gauge of a portfolio’s exposure to spread changes. Table 2 compares the spread durations of various proxy portfolios defined by four Salomon fixed-income indexes: Broad Investment-


Managing Fixed-Income Risk in Core-Plus Portfolios Figure 7. Risk Weights for Mortgage and Corporate Debt A. Mortgage Risk Weights 1.0 Relative Spread Risk 1.2 0.8 1.0 0.6 0.8 0.4 0.6 0.2 0.4 0 92

94

96

0.2

98

100

102

104

100

102

104

Price of Collateral ($)

0 92

94

96

98

B. Corporate Risk Weights Price of Collateral ($) 3.0

B. Corporate Risk Weights 2.5 Relative Spread Risk 3.0 2.0 2.5 1.5 2.0 1.0 1.5 0.5 1.0 0 AAA/AA 0.5

0

A Non- A Financial A Yankee Financial

BBB

BB

B

CCC

Corporate Rating Liquidity-Risk Weight Payment-Risk Weight AAA/AA A Non- A Financial A Yankee BBB Financial

BB

Default-Risk Weight B CCC

Corporate Rating Liquidity-Risk Weight

Prepayment-Risk Weight

Grade Bond (BIG), mortgage, corporate, and high. The standard spread-duration measure for the total portfolio assumes that spreads widen or tighten for all bonds by the same amount. However, just as interest rate volatility differs along the yield-curve, spread volatility differs by sector. To help adjust for differing spread volatility, a “volatility-adjusted spread duration” can be calcu-

Default-Risk Weight

lated for each portfolio, as shown in Table 2. This risk measure is appropriate for investment-grade portfolios but breaks down for high-yield securities. To see this effect, consider the adjusted spread duration for the BIG, mortgage, and corporate indexes compared with the high-yield index. If the adjusted spread duration is used to calculate a hedge ratio of highgrade corporate bonds to high-yield bonds, the result


55

Core-Plus Bond Management Table 2. Spread-Duration Comparison of Various Indexes

Salomon BIG Mortgage Corporate High yield

Spread Duration

VolatilityAdjusted Spread Duration

Liquidity Spread Duration

Default Spread Duration

3.3 4.2 5.4 4.3

3.6 4.2 6.4 23.5

2.9 3.5 5.0 10.6

0.5 0.0 1.5 5.6

is a hedge ratio of almost four times the high-grade corporate index (that is, volatility-adjusted spread durations of 23.5 for the high-yield index divided by 6.4 for the corporate index). The huge volatility of high-yield spreads is dictating the large hedge ratio. Such a sizable ratio simply does not make a good hedge. Volatility adjustment alone is not sufficient to correctly measure and manage the risks in core-plus portfolios. A further step is required. One solution is to use the duration measures for specific types of spreads—liquidity, default, and prepayment. By identifying which type and amount of risk is present in the portfolio, the manager can choose which bets are appropriate based on client guidelines and current market conditions. When the sources of portfolio risk are determined in this manner, very little disparity exists between core and coreplus portfolios. Core-plus portfolios simply have more of the same type of risks as a core portfolio. For example, assume that the difference between a core and core-plus portfolio is that the core-plus portfolio has an allocation to the high-yield sector. Table 2 shows that the liquidity spread durations of the highyield and corporate indexes are 10.6 and 5.0, respectively, which requires a roughly 2-to-1 hedge to correct for the additional liquidity spread risk in the core-plus portfolio. Consider the spread-duration profiles of two portfolios actually managed by Morgan Stanley Dean Witter. Table 3 provides the spread-duration measures (the same as in Table 2) for each portfolio. The first portfolio is a core-plus assignment, allowing high-yield and emerging market debt to expand value-adding opportunities beyond the benchmark index. The second portfolio shown in Table 3 is a core assignment allowing only investment-grade securities. First, note that spread duration is misleading

Prepayment Spread Total Duration Duration

0.6 2.0 0.0 0.0

4.0 5.5 6.5 16.2

because these two portfolios have identical spread durations but differ significantly in their risks. To better understand their comparative risks, examine the breakdown among the spread durations. In our view, when clients specify a core-plus mandate, they are specifying a higher tolerance for all of the risks in below-investment-grade securities. Thus, they are willing to bear more liquidity and default risk to try to earn higher returns. Prepayment risk is a highgrade risk, so there is no reason that a core and a coreplus portfolio should differ in their exposures. Hence, both portfolios have the same amount of prepayment risk. Default and liquidity risks, however, are higher in core-plus portfolios than in core portfolios. Therefore, the core-plus portfolio’s total liquidity and default spread durations are cumulatively 0.8 years higher than for the core portfolio.

Managing Systematic Risks So, if the major difference between core-plus and core portfolios is that core-plus simply has more of the same types of risk as core, how should the additional risk be managed? The modern derivatives markets are the golden path to providing separate management for separate systematic risks. Cash market bonds bundle all the risks together, both the desired risks and the unacceptable ones. Derivatives allow the manager to segregate the acceptable and unacceptable risks found in the cash market bond by hedging out the unacceptable risks. For example, a 30-year BBB corporate bond has interest rate, yield-curve, and twist risks but also corporate spread risk, which is made up of liquidity and default risks. What method allows for separate management of each type of risk? One way to manage the different risks is to use the derivatives market.

Table 3. Spread-Duration Comparison of Core-Plus versus Core Portfolios

Portfolio Core-plus Core

56

Spread Duration

VolatilityAdjusted Spread Duration

Liquidity Spread Duration

Default Spread Duration

7.6 7.6

9.5 8.0

6.5 6.0

1.3 1.0

Prepayment Spread Total Duration Duration

1.3 1.3

9.1 8.3


Managing Fixed-Income Risk in Core-Plus Portfolios A 30-year interest rate future could be sold to remove the interest rate risk. And suppose the portfolio has a benchmark index with the duration of a five-year bond (such as the Salomon Smith Barney BIG). Duration can be added to the portfolio by buying a fiveyear future. These two transactions—the overlays of the two futures—have shifted the duration of the 30-year BBB corporate to more closely match the duration of the five-year index. If the manager is comfortable with the credit risk of the corporate issuer but uncomfortable with the liquidity risk, the manager can use an interest rate swap to lower the unwanted liquidity risk. If the manager’s mandate does not include the ability to do swaps, the tools to manage liquidity risk—independently of other risks—are severely limited. The manager is also constrained if the mandate does not permit the writing of a fixed-rate swap to hedge unwanted spread risk. Another option to manage liquidity and spread risks is the agency futures market, which is much less liquid than the swap market. So, the key to core-plus portfolio risk management is to set portfolio targets for interest rate sensitivity, yield-curve exposure (both twist and shape), corporate spread duration (both liquidity and default), and mortgage spread duration (both liquidity and prepayment). The next step is to purchase bonds based on their individual merits. Once the appropriate bonds are purchased, use derivative contracts (swaps and futures) to reconfigure the portfolio risks to conform to the bets acceptable within the given market model. Without modern portfolio management tools, the manager’s ability to eliminate unwarranted risks while keeping desired risks is limited, which constrains the success of the core-plus strategy.

Writing Core-Plus Guidelines Portfolio guidelines are generally written for ease in monitoring, rather than for ease in managing, the portfolio. Portfolio guidelines should be written to express the client’s return objectives and risk tolerance. Ideally, the guidelines should include a benchmark chosen to best reflect the risk–return goals most comfortable to the client. Plan sponsors should carefully consider the choice and types of restrictions on portfolio inputs and outputs.

In our experience, portfolio guidelines frequently focus solely on the inputs to the portfolios, such as limits on notional futures, sector allocations, or security type. Unfortunately, these input-oriented guidelines do not always adequately address the risks in the portfolio. When portfolio guidelines limit the amount of corporate bond exposure in the portfolio without limiting the inherent risks of duration, liquidity, or default found in all types of bonds, then the guidelines are incomplete. For example, purchasing a 30-year corporate instead of a 10-year corporate— either of which could be acceptable under inputoriented guidelines (i.e., x percent allocated to corporate bonds in general)—adds substantially greater spread duration, including both liquidity and default spread risks. Thus, relatively higher spread duration in a portfolio introduces additional risks that must be managed but that are not provided for in traditional input-oriented guidelines. Carefully crafted guidelines should focus on output versus input measures. Output-oriented guidelines are harder to monitor, but working together, the client and the portfolio manager should be able to develop output measures that can succinctly capture the risks inherent in a given portfolio structure. Using these output measures, the client can decide if the portfolio structure conforms to his or her risk tolerance level. Taking the time to write explicitly worded, input- and output-focused portfolio guidelines will enhance manager–client communications and increase the probability that client return objectives will be achieved.

Conclusion My answer to the question about the nature of the risks in a core-plus portfolio is that a core-plus portfolio simply has more of the same systematic risks found in core portfolios. Using modern portfolio management tools, managers can effectively hedge away any of the unwanted systematic risks, including liquidity, default, and prepayment risks. In order to meet client objectives, however, managers must clearly understand their clients’ risk–return preferences, and doing so requires written portfolio guidelines that are not only explicit but also comprehensive and that include both input and output measures.


57


Question and Answer Session Scott F. Richard Question: How is the total risk of a core-plus portfolio measured? Is tracking error an appropriate measure? Richard: Tracking error—or at least, most of it—is an effect of the six systematic risks. If these six risks are managed and measured properly, the tracking error of the portfolio will not be surprising. Of course, the risk of an idiosyncratic event remains. For example, if a portfolio has a large corporate bond position of a single issuer that defaults or threatens default, this event will induce additional tracking error. The way to manage such idiosyncratic risk is through diversification. After setting the systematic risk exposures, the next step is creating a covariance matrix for the systematic risks. One problem is that correlations do change over time. So, a portfolio may have 120 basis points (bps) of estimated prospective tracking error based on historical correlations, but over time, the portfolio may turn out to have more or less tracking error than was originally estimated. This complication is unavoidable until better methods are devised for measuring the covariances. Question: Do you see any merit in the value-at-risk (VAR) approach to risk measurement? Richard: VAR is a tool developed for levered institutions. The main concern in the development of the VAR measurement was the ability of a portfolio to survive a market crisis. Because most of the money we manage is not levered, tracking-error risk is more relevant for measuring risk in our portfolios than VAR. However, the portfolio managers of our hedge fund,

58

which is highly levered, are well acquainted with VAR because it is the right tool to measure the risk of such a fund. Most of our clients, however, have little interest in VAR, but they do express a keen interest in tracking error. Question: If you build your own systems for risk measurement, how is attribution handled, and can you recommend available proprietary systems that perform risk measurement and attribution? Richard: If we could find a commercially available system that measures risk as we believe it should be measured, we would certainly buy it instead of designing software ourselves. So, in our opinion, no adequate riskmeasurement systems are commercially available at this time. Our attribution system is tied intimately to our risk-management system and the six systematic risks. The problem is communicating each of these types of risk to the client. Clients are more comfortable focusing on interest rate risk, sector risk, and individual security risk because doing so has been the traditional approach. This difference in approach can present a communication problem at times. Question: When guidelines prevent the portfolio manager from selling swaps, could a note be structured with an embedded spread lock? Richard: Yes, a structured note would be a solution. At Morgan Stanley Dean Witter, however, we follow a philosophy that does not allow a derivatives strategy to be substituted for a similar strategy that is prohibited by the client in a

cash market. We avoid guideline arbitrage, because if it isn’t successful, you’ve lost a client. Question: What is the fundamental source of spread in the swap spread? Richard: This topic is the subject of intense, ongoing research at our shop. Our preliminary research shows that swap spreads are determined by the same fundamental macroeconomic variables as the yield curve: the inflation rate, the real growth rate, and a risk premium reflected in the slope of the yield curve. What is remarkable about this finding is that there is no new risk in swaps beyond the risks in the yield curve. Rather, swaps are a different bundle of the same risks. Question: How does your firm allocate its risk budget, and how does your approach operate within the total expenditures for the portfolio? Richard: We have maximum targets for interest rate risk and spread-duration risk measures, so we know what our risk exposures will be when our value signals are at a maximum. We also have value signals for each one of the specific types of interest rate risk and spread-duration risk bets, which allows us to determine where we want to be relative to the maximum targets. The maximum targets are set in part by a model based on all of these spreads exhibiting mean reversion and in part according to our business-risk tolerance and our clients’ portfolio-risk tolerance.


Managing Fixed-Income Risk in Core-Plus Portfolios Question: What is the tolerable maximum shortfall in a core-plus environment on an annual and quarterly basis? Richard: The answer depends on your client. For example, if a client

has a core-plus portfolio with 125– 150 bps of tracking error, in a very bad market environment, the client should expect between 200–300 bps of shortfall relative to the index in one year, which should be the maximum tolerable level of under-


performance. In a core portfolio with 75–100 bps of tracking error, the maximum tolerable underperformance would be expected to fall within a range of 150–200 bps relative to the index.

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Choosing the “Plus” in Core-Plus: The Cases for High-Yield Bonds, Emerging Market Debt, and Sovereign Debt Barry Coffman Portfolio Manager, Fidelity Management and Research Company, Boston Ismail Dalla, CFA President, Washington Asset Management, Inc., Washington, DC Kenneth Windheim President, Strategic Fixed Income, L.L.C., Arlington, Virginia

Deciding in favor of a core-plus strategy opens the door to another decision: how to allocate the “plus” portion of the portfolio. Three authors make the respective cases for allocating the “plus” to each of three sectors: high-yield bonds, emerging market debt, and sovereign debt.

High-Yield Bonds

become an important and large asset class and for that reason alone should not be ignored in the asset allocation decision. The sector is now a prominent component of the overall capital markets. The high-yield market offers instruments encompassing a broad spectrum of credits and structures—a unique feature of this sector—that provide additional diversification benefits above and beyond the sector itself.

by Barry Coffman High-yield bonds offer high absolute returns over the long term, and their low correlation with other asset classes enhances portfolio efficiency, which makes them an excellent choice for core-plus portfolios. Exploiting these attributes, however, is a complex task and requires a dedicated manager with expertise in the high-yield market and the ability to perform intensive research.

wo points about the high-yield bond market stand out. First, high-yield bonds are an independent asset class with unique characteristics that should always be considered in any asset allocation decision, such as allocating the “plus” in a core-plus portfolio. Second, the peculiar qualities of the high-yield sector require the specialization of a dedicated manager to achieve the added value that the high-yield sector brings to the investment management process.

T

The Advantages of High-Yield Bonds First and foremost, high-yield bonds offer high absolute returns and low correlation with other asset classes. As a result, the sector offers significant diversification benefits that can increase the efficiency of a fixed-income portfolio. High-yield bonds have

60

High Absolute Returns. Over the long term, returns for the high-yield market compare favorably with other bond markets. Table 1 compares the annualized returns for the high-yield market with those of the Lehman Brothers U.S. Aggregate Bond Index and Lehman Brothers U.S. Corporae Bond indexes and the 10-year U.S. Treasury bond for the 10-year period ending July 2000. The one-year comparison is not flattering, but the 10-year performance comparison is highly favorable. This specific 10-year time frame is particularly representative of the sector’s relative performance because the period captures various economic and monetary events that negatively influenced the fixed-income markets. The period began in recession and encompassed two cycles of rate tightening by the U.S. Federal Reserve, one in 1994 and one in 1999. Thus, this 10-year period offers a realistic perspective on high-yield bond performance over an interest rate cycle.


Choosing the “Plus” in Core-Plus Table 1. Comparison of Annualized Returns for Various Bond Markets, 1990–2000 1 Year a

3 Years

–0.57%

5 Years

10 Years 10.62%

3.04%

6.87%


5.97

5.42

6.49

7.77

Lehman U.S. Corporate

4.83

4.51

6.33

8.18

10-Year Treasury

4.09

4.54

5.76

7.36

High-yield bonds

Note: 2000 data through July 31. a

Merrill Lynch High Yield Master II Index.

The power of the coupon is worthy of emphasis; the high coupon earned by high-yield bonds mitigates much of the sector’s principal losses when they occur. The 10-year annualized return for high-yield bonds in Table 1 is approximately equal to the average coupon for the sector for the period. This fact indicates that most of the principal losses during the period were actually offset by the interest earned from the coupon and some minor principal gain, as well as the compounding of the coupon. Another point related to the high coupon is that it also mitigates significant negative returns in any given time period, such as a single calendar year within a longer time period. The highyield market experienced negative returns in 1990 and in 1994, but because of the high coupon earned on these bonds, the negative return in each year was minimal, as shown in Figure 1. Enhancing Efficiency. In addition to relatively high absolute returns, the high-yield market can also enhance the efficiency of a portfolio. Figure 2 plots an efficient frontier using a variety of combinations of high-yield bonds (Merrill Lynch High Yield Master II Index) and the Lehman U.S. Aggregate. Based on the annualized return and annualized standard deviation of the past 10 years, a fixed-income portfolio that combined the Lehman U.S. Aggregate and the High Yield Master II indexes would have reached optimality with a 20 percent allocation to the highyield sector.

No standard index exists for the high-yield market. The Merrill Lynch Master II Index is probably the index that is most similar to high-yield bond managers’ portfolios because it includes securities that default and some zero-coupon and pay-in-kind coupon bonds, whereas the Merrill Lynch Corporate Bond indexes and the Merrill Lynch High Yield Master indexes do not. Most major brokerage firms calculate a proprietary index, and over time, these indexes generally produce differing results, which only adds to the mystery of the high-yield market. A Significant and Growing Asset Class. Over the past 20 years, the high-yield market has grown in size to about $650 billion, as shown in Figure 3. The high-yield market is equivalent in size to roughly one-third of the total corporate bond market. If an investor is allocating part of a fixed-income portfolio to investment-grade corporate bonds with no allocation to the high-yield sector, this action is not dissimilar to excluding a significant sector of the stock market in an equity portfolio. The decision to ignore a major part of the fixed-income market is a statement—a bet—and as a result, the investor may not participate in potentially outsized returns. ■ Primary market. High-yield bonds can be created in one of two ways. The first way is by original issuance. This method originated in the mid-1980s with Michael Milken and Drexel Burnham Lambert,

Figure 1. Annual Returns for Merrill Lynch High Yield Master II Index, 1987–99 Annual Return (%) 40 30 20 10 0 –10 87

88

89

90

91

92

93


94

95

96

97

98

99

61

Core-Plus Bond Management Figure 2. Efficient Frontier for Fixed-Income Portfolio Including High-Yield Bonds 10.0 Annualized Return (%) 9.5 11.0 9.0 10.5

80% LA/20% HY

30% LA/70% HY

8.5 10.0 8.0 9.5

100% HY

100% LG

7.5 9.0

80% LA/20% HY

7.0 8.5 6.5 8.0 3.0

4.0100% LA

3.5

7.5

4.5

5.0

5.5

6.0

6.5

5.5

6.0

6.5

Annualized Standard Deviation (%)

7.0 6.5 3.0

4.0

3.5

4.5

5.0

Annualized Standard Deviation (%) Note: LA = Lehman U.S. Aggregate Index; HY = Merrill Lynch High Yield Master II Index.

Figure 3. Growth of High-Yield Market, 1977–2000 New Issuance (US$ billions)

Market Size (US$ billions)

180 700

160

600

140

500

120 100

400

80 300

High-Yield Market (left axis)

60

200

40 New Issuance (right axis)

100 0

20 0

77

79

81

83

85

87

89

91

93

95

97

99 00

Source: Based on data from CSI Research.

and the issuers were typically smaller mid-market companies. By the late 1980s, new issuance was dominated by more mature companies undergoing some form of financial reengineering, most often a leveraged buyout. Some start-up or capital-intensive growth companies, primarily in the cable and wireless industries, were issuing new debt during the late 1980s, but they were by far a small proportion of the entire new issuance market. The complexion of the new-issuance market has changed in the past 10

62

years, however, and leveraged buyouts play less of a role in today’s new issuance than they have in the past. A much larger segment of new issuance is now generated by emerging, capital-intensive growth companies, primarily concentrated in the telecommunications sector, such as competitive local exchange companies, long-distance communications companies, and wireless companies. The second type of high-yield bond creation involves fallen angels (or the “big uglies”). A sizable


Choosing the “Plus” in Core-Plus increase has occurred in these types of companies, and each company or bond’s story has the potential to create significant opportunities—driven by inefficiencies in information flow and valuation—for excess return. Chrysler is a great example of a company that entered the high-yield market twice, once in the early 1980s and again in the early 1990s. Both times, the bonds earned significant excess returns for investors. Today, the fallen angels include a number of prominent retailers that are trading like junk, such as J.C. Penney Company, Saks Fifth Avenue, and Dillard’s. A variety of finance companies, such as Conseco Services and The FINOVA Group are also entering the market, and even companies such as Xerox Corporation and Waste Management have entered the market under less-than-pleasant financial circumstances. ■ Secondary market. New issuance in the highyield market within any short-term time frame is greatly influenced by technical factors of supply and demand. A period of significant new issuance is generally followed by a period of underperformance. The period leading up to 1990 (a negative return year, as shown Figure 1) contained three years of high newissuance levels relative to the immediately preceding new-issuance levels, and a significant correction occurred in 1990. The same situation occurred in the period leading up to 1994, followed by another year of negative returns. In 1997 and 1998, the market again saw high levels of new issuance relative to the immediately preceding years, which is part of the reason high-yield bonds have performed so poorly this year. When demand declines within the market, the supply chain does not quickly shut off, and as a result, interest rates back up, causing the entire market to be repriced. So, within any short-term time period, these technical supply and demand factors have an important effect on near-term returns. ■ Bank debt. The market for bank debt, a structure growing in popularity and becoming very insti-

tutionalized, has increased substantially over the past few years. Although bank debt is not a security by legal standards, it is treated like a security in many ways. With the growth in prime rate funds and collateralized debt obligations, many mutual fund managers are increasing their exposure to bank debt. Depending on the shape of the yield curve, bank debt can offer a competitive yield along with the benefits of seniority and security. Obviously, the call protection of bank debt is not as strong as that of a bond, but the volatility is substantially lower. Diversification. High-yield bonds have a low correlation with both equities and investment-grade bonds, as shown in Table 2. For the 10-year period ending July 31, 2000, the high-yield market had a 0.40 and 0.41 correlation with the S&P 500 Index and the Lehman U.S. Aggregate, respectively. Because the high-yield market is made up of many individual securities, the sector is perhaps better characterized as a market of bonds. Most of these bonds have specific and unique credit characteristics and thus are not highly correlated with each other, so the sector offers an additional layer of diversification benefits. The high-yield market is diversified not only in security characteristics but also in industry representation. The industry concentrations in the high-yield market are distinct from those of the investment-grade fixed-income market. The largest segment in the highyield market is the telecommunications industry, with 20 percent of total market value. Telecom also makes up a significant segment of the investment-grade market but is only half the size of its representation in the high-yield market. The banking and finance industries are the two largest issuers in the investmentgrade market, but they do not issue much debt in the high-yield market for obvious reasons. The second largest segment of the high-yield market, at nearly 15 percent, is the cable television industry.

Table 2. Correlation of High-Yield Bonds with Various Asset Classes, 1990–2000 High Yielda



S&P 500

High Yielda

1.00


0.52

1.00


0.41

0.98

1.00

S&P 500

0.40

0.42

0.36

1.00

Nasdaq Composite

0.39

0.27

0.20

0.69

Nasdaq Composite

1.00

Note: 2000 data through July 31. a

Merrill Lynch High Yield Master II Index.


63


The Need for a Specialized Manager The high-yield market is a unique asset class that demands familiarity and experience. When I hear people speak of the high-yield market as a place to dabble and pick up extra yield, I think of the familiar warning of TV commentators: “Do not try this at home. Leave it to the professionals.” The main reason this warning is appropriate for the high-yield market is that relationships are so important. High-yield bonds are an extremely illiquid asset class. The bid– ask spreads are extremely wide, and participants need an extended period of time to truly understand the dynamics of the market. This market is also extremely labor intensive despite all the technological advancements that have occurred in other areas of the financial markets. The sell side of the market has broadened substantially since the demise of Drexel Burham Lambert, and significantly more sell-side firms are now involved. For example, most major commercial banks have gotten involved in the past 10 years. Many new buy-side firms have also come on the scene. In spite of this increased participation, the high-yield market is still an old-fashioned, down-and-dirty, over-thecounter market in which established relationships carry a fair amount of weight. Intensive Credit Research. High-yield is a credit-driven marketplace requiring a significant amount of dedicated research. The market has a universe of securities with an asymmetric payoff, significantly more downside than upside, and a relatively illiquid secondary market. High-yield bonds, unlike other debt instruments, are not highly correlated with interest rate movements. Someone once said that the high-yield market is nothing more than equity in drag, and this characterization has some merit. At Fidelity Management and Research Company, the high-yield bond department has never been part of the fixed-income group and is actually physically located with the equity group. Accordingly, we use a bottom-up, fundamental approach to high-yield securities analysis. In fact, the method we use is similar to equity analysis. The major difference is that we have a greater focus on cash flow, as opposed to earnings, because most high-yield companies do not have earnings and many have little hope for earnings. In most cases, credit analysis for high-yield bonds is done at the point of issuance, which is when the bond is priced at par and is generally the time of greatest credit risk. Usually, the new issue is triggered by some corporate event—a takeover or a leveraged buyout—at a crucial financial period for the issuer. For this reason, credit analysis of high-yield securities requires intensive credit research.

64

Importance of Security Selection. Security selection is the key to success within the high-yield sector. Table 3 shows the yield dispersion within the different rating categories in the high-yield market. This phenomenon is not surprising. Some of these yields, however, are meaningless and should be called “yields to nothing”—rather than “yields to maturity”—because the bonds may have no maturity or a highly uncertain maturity. Table 3 highlights the higher yields available in the lower credit tiers of the high-yield market and the breadth of these yields. These large dispersions illustrate the higher level of risk in the bottom credit tiers and, by definition, the potential value residing there as well. These qualities are what make the asset class so attractive: frequent, significant inefficiencies that can be translated with hard work into opportunities for excess return in a fixed-income portfolio.

Table 3. Spread Dispersion by Rating Category, as of July 2000 Spread Rating Category

High

Average

Low

AAA

245.bps

100.bps

43.bps

AA

273

129

50 56

A

346

154

BBB

1,000

209

88

BB

2,363

330

102

B

3,193

526

114

CCC

7,470

1,536

365

Performance Is Widely Dispersed. Choosing a specialist high-yield manager is also important because such a wide dispersion of returns exists among high-yield managers, as shown in Table 4. The dispersion does lessen with time. Notice that the median annualized returns for the Lipper high-yield mutual fund universe for the 3-, 5-, and 10-year periods underperformed the annualized returns of the high-yield index shown in Table 1. Part of the reason for this underperformance is that the high-yield index is positioned much more conservatively than most mutual fund managers. The average mutual fund in the Lipper universe has a 20 percent allocation to BB bonds, compared with an average allocation in the high-yield index of about 40 percent. As a result, in periods of economic crisis or rising interest rates, the bottom credit tier of the high-yield market (B and lower) underperforms relative to the entire highyield market—spreads widen as default and interest rate risks increase. Most high-yield managers will underperform the index because they have a greater allocation to this credit tier than does the index.


Choosing the “Plus” in Core-Plus Table 4. Dispersion of Returns among Managers in the Lipper High-Yield Mutual Fund Universe, 1990–2000 3 Years

5 Years

10 Years

Maximum

8.07%

13.22%

12.68%

5th Percentile

5.38

8.76

11.81

25th Percentile

3.34

7.38

9.99

Median

2.05

6.22

9.53

75th Percentile

0.53

5.05

8.79

95th Percentile

–4.02

2.27

7.33

Minimum

–8.05

0.51

6.80

Investors might decide simply to buy a representative index portfolio, but doing so is not easy. Although derivatives are available that offer exposure to the index, replicating the index itself is extremely difficult. Many of the bonds in the index are not freely available, whether they are locked up in another investor’s portfolio or are simply not widely traded. To get these bonds, investors would be forced to pay a higher price than what they are valued at in the index. Another consideration is that investors have a great deal of competition from other investors to buy the higher-quality securities in the index. High demand for a finite pool of bonds markedly raises the prices of the bonds. Thus, to duplicate the index, investors must pay up to secure the bonds they need. Doing so, however, is self-defeating.

Emerging Market Debt by Ismail Dalla, CFA In recent years, emerging market debt has provided strong risk-adjusted performance, outperforming even U.S. large-capitalization stocks. Obtaining the benefits of emerging market debt requires intensive analysis of default, macroeconomic, and political risk and the ability to implement a strategy dependent on timing of entry and issuer analysis. To succeed, investors need managers with highly specialized knowledge and lengthy experience in the market.

merging market debt is less risky than generally characterized, and because of its favorable diversification properties, it is an excellent addition to a core fixed-income portfolio. Over the past five years, emerging market debt has proved to be a strongerperforming , less risky asset than U.S. largecapitalization stocks (particularly in light of the recent behavior of several large-cap stocks, such as Intel Cor-

E

Need for Dedicated Resources. In addition to the labor intensity demanded for proper credit analysis, the high-yield market is also labor intensive from a trading and legal support perspective. The high-yield market is an inefficient asset class with wide bid–ask spreads. Most large managers have trading desks dedicated to this market. Trading and executing in the high-yield market is rather like going down to the Lower East Side every single day and haggling with a variety of vendors over the same piece of merchandise. This process has not changed much over the past 10–15 years, so having good traders who have good relationships with the Street is critical. Also, having a good legal department is vital, not only to analyze indentures at the time of purchase but to deal with the inevitable workouts that will arise.

Conclusion The high-yield market is a significant asset class that has generated strong long-term performance. Because of their low correlation with other asset classes, particularly with the U.S. equity market, high-yield bonds offer material diversification benefits and can increase the efficiency of most portfolios. These qualities make the high-yield sector a valuable addition to any fixed-income portfolio, and a core-plus portfolio can benefit markedly by an allocation to high-yield bonds. And given the somewhat quirky nature of the sector, high yield is best managed by a dedicated management team.

poration and Eastman Kodak) and Internet stocks. In addition, emerging market debt has compared favorably with emerging market equity in the past five years. Most plan sponsors allocate a larger percentage of assets to emerging market equity than to emerging market debt, but the debt sector has been by far the better performer in terms of risk-adjusted returns.

Recent History The market for emerging market debt has been experiencing structural changes since the 1997 currency crisis. This sector originated in the 1970s when the oil crisis caused many import-dependent developing nations (primarily the Latin American nations) to default on their external debt obligations. The remedy was the first Brady bond market, which led to the securitization of these countries’ outstanding external debts. The emerging debt market has grown rapidly since its inception; as of December 31, 1999, the total size of the emerging external debt market was US$2.5


65

Core-Plus Bond Management trillion. The largest part (46 percent) is private-sector debt, the bulk of which was initially short-term debt (owned by the commercial banks). As a result of this debt being securitized over time, the majority of emerging market debt risk has now shifted from the banks to the private sector and to bilateral (21 percent) and multilateral (14 percent) creditors. Not all of the US$2.5 trillion in emerging market debt is tradable. Sovereign tradable debt is US$1.4 trillion in size, and total tradable emerging market debt is much larger than the entire market for U.S. high-yield debt ($650 billion). Table 1 shows that from 1994 through 1999, dramatic growth occurred in the domestic sector of total sovereign emerging market debt. Most of this growth occurred in Asia (an increase from 16 percent in 1994 to 33 percent in 1999), a region with a traditionally high savings rate. Until recently, Asian issuers were forced to seek financing externally because the countries in the region lacked a developed internal debt market. The international banking community intermediated this gap between the Asian nations’ internal savings and internal investment. When the Asian crisis hit, this arrangement unraveled. Since then, Hong Kong, South Korea, Thailand, and Malaysia have made tremendous efforts to build their domestic debt markets.

Table 1. Growth in Emerging Market Tradable Sovereign Debt (US$ billions) Debt Domestic External

1994

1997

1999

US$304

US$927

US$966

340

316

419

Source: Merrill Lynch & Company.

By the end of 1999, local currency debt had expanded, as shown in Figure 1, to two-thirds of tradable emerging market debt. From 1994 to December 1999, Brady bond debt shrunk to 8.7 percent of total tradable debt. Most of the outstanding Brady bonds are being restructured, so further decline in this sector’s market representation is expected in years to come.

Risks Emerging market debt, although less risky than some other assets, remains a risky asset. The market has dealt with crises in Mexico, Asia, Russia, and Ecuador, but the damage, in hindsight, has been relatively modest and recoverable, with the notable exception of the Russian default. Russia was the first major

66

Figure 1. Emerging Market Tradable Sovereign Debt Universe, 1994–99 U.S. Dollar (billions) 1,400 1,200 1,000 800 600 400 200 0 1994

1997

1999

Brady Bonds Euro/Global Bonds Tradable Loans Local Currency Bonds Hard Currency Bonds Source: Based on data from Merrill Lynch.

nation that actually defaulted on its domestic debt; a few communist countries have similarly succumbed, but their default was not in the same league as Russia. No Asian country has defaulted on its domestic debt, and during the Asian crisis, all the Asian governments stayed current with their debt service. The price of Asian debt fluctuated widely during this period, but no default occurred. Default Risk. The risk of default in the emerging markets is high, but it has been exaggerated because investors are overly influenced by limited, not overly serious, regional crises. Most of the emerging market countries have improving fundamentals, so the risk of default is increasingly less worrisome. The economies are growing, so each nation’s hard assets and real investments are multiplying. In fact, the underlying assets for many of the issuers of emerging market debt are actually more valuable than those of some of the start-up companies in the U.S. high-yield market. Unfortunately, for the issuers of emerging market debt, the assets happen to belong to corporations, for which the credit rating cannot be higher than that of the sovereign. The emerging market companies frequently have strengths that are overridden by the rating of the sovereign (the ultimate creditor). So, the risk level of a corporate issue rated CCC may really be BB or CCC+ in a country such as Thailand and not truly equivalent to the CCC rating risk analysts would see in the United States.


Choosing the “Plus” in Core-Plus Macroeconomic Risk. The most important, yet generally ignored, risk in the emerging markets is macroeconomic risk. Most analysts and investors failed miserably by forgetting that a country such as Russia has no experience collecting taxes from its citizens, has no tax basis, and is basically dependent on a single commodity (i.e., energy). Despite this poor financial infrastructure, investors lent a lot of money to Russia before its economic and financial collapse. Investors simply neglected the fundamentals. To control macroeconomic risk exposure, investors must search for strong macroeconomic fundamentals that indicate low default risk; in general, this characteristic implies an export-oriented economy with a high savings rate. Political Risk. Another crucial factor is political risk. Even the best macroeconomic characteristics can be negated by swiftly moving political events. Consider the example of Thailand: In 1997, Thailand had an excellent macroeconomic system, but within three months after a change in the nation’s leadership, the central bank, the securities and exchange commission, and the stock exchange were destroyed through political intervention. Careful scrutiny of the political system and political trends is an integral part of a thorough analysis of an emerging market debt issuer. Strong fundamentals can be wiped out instantaneously by politics.

Returns The risks in emerging market debt are adequately rewarded. This sector consistently provides above-

average returns. Table 2 clearly shows that these markets present an opportunity for active managers to add excess returns to domestic fixed-income portfolios. Over the past five years (mid-1995 to mid2000), the J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) and Emerging Markets Bond Index Global (EMBI Global) have provided U.S.-equity-like returns. Both emerging market debt indexes have a reasonable Sharpe ratio and have significantly outperformed emerging market equity. The Sharpe ratio for emerging market equities is miserable, but investors have nonetheless increased allocations to this sector. In their allocations to the emerging markets as part of a core-plus mandate, investors would reap higher returns by shifting that equity allocation, in whole or in part, to emerging market debt.

A Core-Plus Strategy with Emerging Market Debt Emerging market debt has a low correlation with any U.S. domestic debt portfolio. As Table 3 clearly shows, correlations with major U.S. fixed-income subclasses, as well as with U.S. fixed-income core as a whole (represented by the Lehman Brothers U.S. Aggregate Bond Index), are low. Thus, choosing emerging market debt as the “plus” investment in a core-plus strategy clearly adds value through diversification as well as through a favorable risk-adjusted return.

Table 2. Risk–Return Profiles, June 1995–June 2000 Index Lehman U.S. Aggregate Bond

Annual Returns 6.25%

Annual Volatility 5.87%

Modified Sharpe Ratio a 1.06

U.S. Long Treasury

7.40

10.12

U.S. Government

6.20

6.31

0.98

3.12

8.65

0.36

MSCI World Salomon Brothers High Yield

0.73

7.22

8.68

0.83

J.P. Morgan EMBI+ b

16.31

16.92

0.96

J.P. Morgan EMBI Globalb

15.66

16.40

0.96

Latin America

16.57

16.27

1.02

Mexico

15.29

13.73

1.11

Asia

8.02

12.90

0.62

Korea

6.79

14.62

0.46

1.88

19.18

0.10

21.71

14.99

1.45

MSCI Emerging Market (equity) S&P 500 a

The modified Sharpe ratio is annual return divided by standard deviation of returns (that is, return per unit of risk). b The EMBI+ includes Brady bonds and other sovereign emerging market debt. The EMBI Global is an expansion of the EMBI+ through the addition of emerging market countries. Sources: Based on data from Washington Asset Management, Bloomberg Data Services, and Lehman Brothers.


67


68

Table 3. Correlations of Various Asset Classes, June 1995–June 2000 Long-Term T-Bonds Long-Term T-Bonds

U.S. Government Agencies

U.S. Corporate Bonds

U.S. MortgageBacked Securities

U.S. AssetBacked Securities


MSCI World

U.S. High Yield

EMBI Global

1.00


Government Agencies

0.98

1.00

Corporate Bonds

0.90

0.91

1.00

U.S. Mortgage-Backed Securities

0.82

0.87

0.90

1.00

U.S. Asset-Backed Securities

0.88

0.93

0.94

0.91


0.95

0.98

0.96

0.94

0.96

1.00

MSCI World

0.40

0.48

0.37

0.37

0.41

0.45

1.00

U.S. High Yield

0.17

0.16

0.48

0.35

0.34

0.30

–0.06

–0.03

–0.01

0.26

0.20

0.08

0.11

–0.06

0.64

1.00

0.17

0.18

0.37

0.31

0.20

0.27

0.13

0.53

0.69

EMBI Global S&P 500

S&P 500

1.00

Sources: Based on data from Washington Asset Management, Bloomberg Data Services, and Lehman Brothers.

1.00 1.00

Choosing the “Plus” in Core-Plus By adding global emerging market debt to a U.S. domestic fixed-income portfolio, investors can earn additional return without generatin g much additional volatility. Figure 2 shows the three risk– return frontiers for portfolios created by combining the EMBI Global with the Lehman U.S. Aggregate, the MSCI World Index, and U.S. long T-bonds in various proportions. Most interesting is the combination of the EMBI Global and long T-bonds. The return per unit of risk for this combination is the highest of the three portfolios. A variation of this strategy would be to limit the emerging market debt to BB quality or better; this combination of relatively higher-quality emerging market debt with the T-bond portfolio would provide a pick-up in yield of 400–500 basis points (bps) over a Treasuries-only portfolio. If the core-plus portfolio is based on adding the EMBI Global to the whole Lehman U.S. Aggregate portfolio, the optimal level of emerging market debt is 10 percent. Table 4 shows that for the five years ended June 2000, this 90 percent/10 percent allocation would have produced an annual return of 7.33 percent, an annual volatility of 6.27 percent, and a modified Sharpe ratio of 1.17. Timing of Entry. The timing of entry and exit from the emerging debt markets is governed by the spreads between emerging market debt and other debt sectors. The spreads between emerging market debt and T-bonds and between emerging market and U.S. high-yield debt are shown in Figure 3. In 1998, the entry point for new investors in the emerging debt markets in spread terms was 1,200 bps over T-bonds. A spread this generous mitigates the various risks associated with the investment. If spreads narrow to 200 bps over T-bonds, which was the case in late 2000 for the sovereign debt of Thailand, Malaysia, Korea, and Mexico, investors are not being paid to accept the risks of emerging market debt. If the spread is less than 400–500 bps, the timing is not propitious for initiating a new position in emerging market debt. In the near term, the position will probably earn a poor absolute return because the small spread does not sufficiently capture the political risk of the sovereign issuer. A spread of 200–300 bps over T-bonds signals that the time is right to exit emerging market sovereign issues and swap into lower-rated (BB, B) emerging market corporate issues, for which the yield pickup is 600–700 bps over T-bonds. Such a switch entails no major increase in credit or default risk. Evaluating the Issuer. Three factors are intrinsic to evaluating issuers and sovereign debt in the emerging markets: country selection, credit, and liquidity.

■ Country selection. The number one factor in choosing emerging market debt issues is the country. Country selection, in turn, has two component risks— macroeconomic and political. Investors should not buy debt in any country if the chances are good that the macroeconomic or political situation is going to deteriorate or if there is any uncertainty about the developing trend. On the economic side, investors should look for countries that are export oriented and can service their debt. The country should have a high savings rate and the ability to survive a debt-service stress test. For example, Malaysia is a politically controversial country, but it would not need to borrow a penny to survive an economic crisis because it has a 37–38 percent domestic savings rate. Malaysia also has a large employee provident fund (a type of retirement-savings scheme), so it could conceivably afford to close the country and initiate selective capital control. Thailand, however, has a high savings rate but no domestic long-term resource mobilization, and it is extremely dependent on foreign capital flows, which is the main reason Thailand has taken much longer than Malaysia to recover from the Asian crisis. In short, investors must be confident that the country’s financial structure is sound enough for the nation to rebound rapidly from the repercussions of an economic or market crisis, and the country’s securities should be able to quickly adjust to international revaluation and realignment. Vulnerability to U.S. interest rates is a crucial decision-making factor in country selection. Investors need to closely monitor the amount of short-term funding used by the country. If the level is high relative to total debt obligations, rising U.S. interest rates may have a negative impact on the country’s balance of payments and undermine the survival of the country’s domestic banks. On the political side, investors should be wary of any country that is moving from a dictatorship to a democracy, as Indonesia is today. Only a high premium would justify the inordinate risks of investing in a country experiencing such a drastic change in government. The many compelling and immediate claims on a government in this situation will inevitably lead to large fiscal deficits. Such a situation is exactly what unfolded in the Philippines after Ferdinand Marcos was succeeded by Corazon Aquino. ■ Credit. The second most important factor in choosing emerging market debt is the issuer’s ability to repay the debt and make timely interest payments. Credit analysis for emerging market debt is more complicated than a similar endeavor in the U.S. highyield market. Emerging market analysts must consider the differing accounting standards of each


69

Core-Plus Bond Management Figure 2. Adding Emerging Market Debt to U.S. Core Portfolios, June 1995– June 2000 Annual Return (%) 16

14 100 Percent EMBI Global

12

10

8

100 Percent Long-Term U.S. T-Bonds

6

100 Percent U.S. Aggregate

4

100 Percent MSCI World

2 5

7

9

11

13

17

15

Volatility (%) Lehman U.S. Aggregate + EMBI Global MSCI World + EMBI Global Long-Term U.S. T-Bonds + EMBI Global Sources: Based on data from Washington Asset Management, Bloomberg Data Services, Lehman Brothers, and Chase Manhattan Corporation.

Table 4. Benefits of Adding Emerging Market Debt to a U.S. Core Portfolio, June 1995–June 2000 Annual Return

Index

Annual Volatility

Modified Sharpe Ratio


6.25%

5.87%

1.06

95% Lehman U.S. Aggregate + 5% EMBI Global

6.79

5.93

1.15

90% Lehman U.S. Aggregate + 10% EMBI Global

7.33

6.27

1.17

15.66

16.40

0.96

EMBI Global

Sources: Based on data from Washington Asset Management, Bloomberg Data Services, and Lehman Brothers.

country, all of which vary from U.S. generally accepted accounting principles. Also, the emerging market countries require less transparency in corporate governance. ■ Liquidity. The third factor to be considered in pinpointing investments in the emerging debt

70

markets is liquidity. The most obvious choice is to buy the sovereign debt with the most liquidity, but this strategy may not produce the greatest excess returns. Secondary issues will probably provide more excess return but less liquidity. Compared with the U.S. high-yield bond market, finding


Choosing the “Plus” in Core-Plus Figure 3. When to Enter/Exit Emerging Debt Markets 1,000 Spread (bps) 1,400 800

LB–EM Spread

1,200 600 1,000 400 800 200

LBEM Spread

LB–EM/High-Yield Spread

6000 400

6/95

12/95

6/96

12/96

6/97

12/97

200

6/98

12/98

6/99

12/99

6/00

LBEM/High-Yield Spread

0 6/95

12/95

6/96

12/96

6/97

12/97

6/98

12/98

6/99

12/99

6/00

Note: LBEM = Lehman Brothers Emerging Markets Debt Index. LBEM/High-Yield = the spread between the LBEM and the Lehman U.S. High-Yield Index. Source: Based on Lehman Brothers data.

liquidity in emerging market debt is easy, with plenty of sovereign issues greater than $500 million in size. For relatively conservative investors, the returns in liquid emerging market debt should be sufficient to boost the return of a diversified fixedincome portfolio, even after paying a liquidity premium, but a much higher yield can be obtained by investing in high-quality (but less liquid) emerging market corporate bonds. For example, Thai subordinated debt will yield 400 bps over the sovereign issue.

Conclusion

Sovereign Debt

in core-plus is a strategic decision that should complement the core portfolio. Before deciding which investments should compose the “plus” portion of the portfolio, an examination of the core investments is mandatory. Currently, many, if not most, client portfolios are near the top of, if not beyond, their stated equity allocations. Plans that used to have a 50 percent equity exposure now have a 65–80 percent exposure and are drawing on private equities to raise the exposure even further. So, given the specific asset allocations of the core portfolio, managers should focus on how the “plus” part of the fixed-income portfolio should be structured. Because greater diversification always benefits a portfolio, international bonds are an attractive investment: The sector’s low correlation with the U.S. stock market offers a clear advantage as the “plus” in a core portfolio that already has a high allocation to equities.

by Kenneth Windheim Sovereign debt offers certain unique strategic advantages that make it particularly attractive as the centerpiece of core-plus portfolios. In the event of a major market disturbance that provokes a flight to quality, government bonds will outperform other bond sectors. Sovereign debt provides superior diversification benefits, particularly in equity-heavy portfolios. Managers should exercise caution in the selection of sovereigns, however, and use appropriate risk-control measures, such as value at risk.

he question is not whether we should bother with core-plus but whether we know why we are bothering with core-plus. Choosing the “plus”

T

Investing in emerging market debt requires broadbased investment and analytical experience. Managers running emerging market debt portfolios should have extensive knowledge of the emerging market countries’ economic and political situations. And they need to have been around for a while so they can differentiate between Korea and Kazakhstan. Solid analysis of the credit issues and economic issues specific to each emerging market country is what the emerging market portfolio manager is paid to do.


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Sovereign Debt: The “Plus” With a large proportion of the average portfolio devoted to U.S. equity investments, managers should counterbalance the risks associated with the vulnerabilities of U.S. equity investments. More often, however, core fixed-income portfolios are increasingly invested in sectors that share the vulnerabilities of the U.S. equity market. For this reason, noncore fixedincome investments should be primarily, if not solely, invested in international securities and, in particular, sovereign debt. Flight-to-Quality Attributes. The current global environment makes the decision to place noncore fixed-income investments in sovereign debt particularly easy. If a catastrophic event or recession spurs a global flight to quality, government bonds will outperform the other sectors of the bond market—and the equity market. During most of the 1990s, U.S. Treasuries composed approximately 45–50 percent of the U.S. benchmarks. This proportion has fallen to the low 20 percent range, and if the U.S. Treasury continues to pay off outstanding debt, the share will drop to the low teens by 2003. As the percentage of outstanding Treasuries has slipped, mortgage securities have filled the void. The U.S. fixed-income benchmarks have about 30 percent allocated to the mortgage sector. The problem is that mortgages have negative convexity. So, if the core fixed-income portfolio replicates the index, which has a minor position in government debt, it lacks protection if a flight to quality occurs. The debt of other developed nations benefits, although to a lesser extent, from the same flight-toquality attributes as U.S. Treasury instruments. High-yield and emerging market debt do have a place in core-plus portfolios—but only when plan sponsors limit the equity allocation to 50 percent rather than the current 75 or 80 percent. All nongovernment investments are, in effect, spread products. All spread products are highly correlated with the U.S. equity market, which means that all nongovernment debt is going to get hammered in a global crisis or economic downturn. In such a situation, not only will equity investments perform badly but so will mortgage, corporate, high-yield, and emerging market debt instruments. The only safe haven from spread widening is government securities. Sector Diversification. Consider the correlation coefficients of various fixed-income sectors with the S&P 500 Index for the 1990–2000 period: U.S. high-yield bonds 0.61 Emerging market debt 0.50 International hedged 0.36 U.S. corporate bonds 0.31 International unhedged –0.03

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Because unhedged international bonds have a negative correlation with the U.S. equity market, they are the place to be when the S&P 500 and investments correlated with the S&P 500 perform poorly. U.S. high-yield bonds have a stronger correlation with the U.S. equity market than the other fixed-income sectors and almost twice that of hedged international bonds. Because of this diversification benefit, international bonds are a complement to a portfolio heavily concentrated in U.S. equities. Currency Diversification. The volatility associated with international investments is mainly attributable to currencies. This association, however, can be a positive factor during periods in which diversification from the base currency is needed. Currently, the dollar is very strong, but the dollar’s strength will not last forever. Non-U.S. investors have been flocking to the U.S. market in unprecedented numbers. About three years ago, non-U.S. investors accounted for about 15 percent of the U.S. fixed-income market. Since then, the percentage has increased to 30 percent, and these investors keep buying—agencies and mortgages and corporates. Non-U.S. investors have actually been big sellers of U.S. Treasuries—net sellers of government bonds—because non-U.S. investors, especially Europeans, have adopted the characteristics of U.S. managers and are constantly stretching for yield. It is irrelevant to the non-U.S. investors that agency spreads have widened to 110 basis points from 25 bps over the Treasury curve. At a wider spread, agencies are relatively more attractive—as long as the dollar stays strong—but how long dollar strength will continue is uncertain. Not only are non-U.S. investors buying spread products in the fixed-income market; they are also buying equities in unprecedented amounts. In 1996, non-U.S. investors had net purchases of about US$8.7 billion in U.S. equities. By 1999, net purchases by nonU.S. investors had escalated to US$72.3 billion, and these numbers exclude mergers and acquisitions. In the first quarter of 2000, non-U.S. investors bought US$62.5 billion of U.S. stocks, and for the year as of September 2000, they had bought US$137.7 billion (or more in total than they bought in both 1998 and 1999). The result of this nearly insatiable demand for U.S. investments is a U.S. current account deficit equal to 4 percent of GDP—a larger percentage than in 1985 when the dollar collapsed—as shown in Figure 1. The dollar has not yet collapsed because of the strong participation of non-U.S. investors in the U.S. markets. If this participation falters, however, the dollar will come under pressure, and if non-U.S. investors ever decide to reallocate assets away from U.S. markets and repatriate funds, such a movement will have grave consequences for the U.S. dollar and U.S. asset prices.


Choosing the “Plus” in Core-Plus Figure 1. U.S. Dollar Valuation and Current Account Deficit, 1980–2000 U.S. Current Account Deficit (% GDP)

U.S. Dollar Valuation 1.30

0.0030

1.24

–0.0012

1.18

–0.0054

U.S. Dollar (left axis)

1.12

–0.0096

1.06

–0.0138

1.00

–0.0180

0.94

–0.0222

0.88

–0.0264

0.82

–0.0306 U.S. Account Deficit (right axis)

0.76

–0.0348

0.70

–0.0390 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00

Note: Ending data as of first quarter 2000.

The dollar is as overvalued now as it was when the dollar fell dramatically in 1985. The returns for international bonds over the two-year period from 1985 to 1987 illustrate the effect of the dollar’s fall on international bonds, as shown in Table 1. Returns were not bad for the Salomon Smith Barney Broad Investment-Grade (BIG) Bond Index, but returns were substantially better for the nondollar market (i.e., the Salomon Brothers Non-U.S.-Government Index) over the period before the central banks intervened with the Louvre Accord at the end of 1987 to stop the dollar from falling. For the entire two-year period, the nondollar markets outperformed the U.S. markets by about 6 percent.

Controlling Risk Although the diversification benefits of nondollar international bonds make them attractive noncore fixed-income investments, controlling their inherent risks is essential. Using value-at-risk measures can help guard against extreme market events. Because

Table 1. Comparison of U.S. Dollar and Non-U.S.Dollar Bond Portfolios, 1985–87 Quarterly Returns

Quarter/Year 3rd/1985 4th/1985 1st/1986 2nd/1986 3rd/1986 4th/1986 1st/1987 2nd/1987 3rd/1987 4th/1987 Average

Salomon Non-U.S. Government

Salomon BIG

15.0% 8.3 15.3 7.1 3.7 2.9 13.4 –0.1 –3.8 23.9 8.6%

2.0% 7.7 7.8 1.1 2.5 3.3 1.3 –1.5 –2.6 5.8 2.7%

Difference 13.0% 0.6 7.5 6.0 1.2 –0.4 12.1 1.4 1.2 18.1 6.1%

market movements of nondollar international bonds are driven mainly by macroeconomic effects, managers should avoid evaluating investment opportunities solely on the basis of incremental yield.


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Core-Plus Bond Management Value at Risk. At Strategic Fixed Income, we measure risk in an international portfolio the same way we measure risk in a domestic portfolio. We use value at risk (VAR) because investment reactions to market events do not produce a perfectly distributed bell-shaped curve. For example, as a matter of probability, the Long-Term Capital Management debacle should not have happened in the entire 4-billion-year history of planet earth. But it did, and that is why we use VAR. In the past two decades, we have had the 1987 stock market meltdown, the Mexican crisis, and the Asian crisis. Investors were probably not using VAR to measure the possibility of these events, because they basically had just one trade: a 100 percent credit play. The trades at that time were a combination of off-the-run versus on-the-run Treasuries, mortgages against Treasuries, and corporates against Treasuries. There were probably 60,000 separate trades around the globe, and each one was in reality a spread trade (selling governments and buying credit). VAR in an international bond portfolio can be divided into two components: the foreign exchange risk and the interest rate risk. The currency-risk component is much greater than the interest-rate-risk component, as shown in Figure 2. If the currency risk is hedged away, only interest rate risk remains. When the interest-rate-risk components of U.S. bonds and hedged international nondollar bonds are compared, international bonds have substantially less total volatility than U.S bonds, as shown in Figure 3. If the currency volatility of unhedged nondollar bonds is unpalatable, the investment can be hedged. When U.S. short-term interest rates are higher than short-term international interest rates, hedged international bond positions can actually provide a yield “pick up” versus U.S. dollar bonds. For example, as

of fall 2000, 10-year German bonds can be hedged back into dollars with a yield “pick up” of approximately 120 bps, roughly equivalent to the spread differential between AAA U.S. government agencies and Treasuries. Figure 4 shows that when the cost of carry favors U.S. investors, as it does today, a AAA non-U.S. government can be bought and hedged to generate a spread of more than 100 bps over U.S. Treasuries. Also, the different interest rate cycle is obviously a good diversifier. If a crisis eventually triggers a flight to quality, this trade will provide a safe haven, with a good yield in the meantime. Usually investors and analysts speak only of spread, of stretching the envelope, of doing whatever it takes to earn a higher excess return, but sometimes a defensive strategy is appropriate and available with a sacrifice in yield that is historically minimal. Ma c r oe c ono mi c s . Nondollar international bond managers may have a small advantage over a firm that does everything from corporates to high yield. Most international bond managers focus almost exclusively on a top-down, macroeconomic approach because the dynamics of nondollar bond markets are driven almost 100 percent by macroeconomics. The style of most domestic managers, however, is typically to add incremental yield without a macroeconomic view. The difficulties with this strategy in the international arena can be illustrated by the example of the Japanese market. The Japanese market has been the best-performing bond market in the past few years, even with nominal yields of only 2 percent, because the yen has been strong, the Japanese people have a high savings rate, and the nation has had a current account surplus—all solid macroeconomic variables. These factors are not the things that the

Figure 2. VAR Components: Currency Risk and Interest Rate Risk, March 1999– August 2000 Value at Risk (%) 4.0 3.5 3.0

Total VAR

2.5 2.0

Foreign Exchange VAR

1.5 1.0

Interest Rate VAR

0.5 0 3/99

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5/99

7/99

9/99

11/99

1/00

3/00

5/00

7/00 8/00


Choosing the “Plus” in Core-Plus Figure 3. Comparative Interest Rate VAR: Hedged International versus U.S. Bonds, March 1999–August 2000 Value at Risk (%) 3.0 U.S. Interest Rate VAR

2.5 2.0 1.5

International Interest Rate VAR

1.0 0.5 0 3/99

5/99

7/99

9/99

11/99

1/00

3/00

5/00

7/00 8/00

Figure 4. Benefit of Positive Cost of Carry for Hedged International Bond Portfolios Salomon Non-U.S. Hedged Spread 0.508 versus Salomon BIG (%)

U.S. Three-Month T-Bill Spread versus 0.2 Three-Month Spread (%) World 2.0

0.530

–0.7

0.497

1.1

0.519

–1.6

0.486

T-Bill Spread

0.2

0.508 Salomon Spread

–2.5

0.475

–0.7

0.497

–3.4

0.464

–1.6

0.486

T-Bill Spread

–4.3

0.453 Salomon Spread

–2.5

0.475

–5.2

0.442

–3.4

0.464

–6.1

0.431

–4.3

0.453

–7.0 –5.2

0.420 90

91

92

93

94

95

96

97

98

99

00

–6.1

0.442

0.431

–7.0

0.420 90

91

92

93

94

95

96

97

98

99

00

Note: Ending data as of July 2000.


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Core-Plus Bond Management typical domestic manager analyzes. Anyone concerned only with finding incremental return would not find the Japanese bond market attractive, despite its excellent performance in recent years.

Conclusion The Fed bailed investors out of the Mexican crisis. Investors were bailed out of the Asian crisis in 1997. Long-Term Capital Management was bailed out in 1998. These past bailouts can all be attributed to Alan Greenspan, but he will not always be calling the shots. Investors should consider the possible impact of the next crisis, for which no bailout may be provided.

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With most plans currently running extremely high exposures to U.S. equities, managers deciding how to allocate noncore fixed-income investments should carefully weigh the diversification benefits of investments not highly correlated with the U.S. equity market. In this context, nondollar international bonds are attractive because they have historically had a low or negative correlation with the U.S. equity or bond market. In choosing international bonds as the “plus” in core-plus portfolios, managers are acknowledging the prudence of buying the flightto-quality trait of sovereign issues, the shortcomings of an exclusive focus on incremental return, and the benefit of controlling exposure to extreme events.


Choosing the “Plus” in Core-Plus

Question and Answer Session Barry Coffman Ismail Dalla, CFA Kenneth Windheim Question: Can one successfully manage global bonds or emerging market debt without a local presence or local sources of information? Dalla: Yes. Five years ago, you would have had to travel to get local information, but now the information flow is good because of Internet information services, such as Bloomberg. As long as you have access to multilateral data through some type of information network, investing in most of the emerging markets is entirely feasible without going directly to the local market. Even with the ease and availability of information flow, however, the manager investing overseas must have a good understanding of the markets in which the investments are to be made. Information alone is not a substitute for an understanding of and experience in the overseas markets. Windheim: I second that. I would also say that, at least in the international fixed-income markets, the prime driver of return is the dollar. A key component of what moves the dollar is U.S. economic numbers—U.S. retail sales or unemployment. In London, the entire market holds its breath until the U.S. numbers are released. Then, the major currency and bond markets trade off of the U.S. economic numbers. Sometimes, French bonds move more on U.S. numbers than do U.S. bonds. French and German economic numbers simply are not perceived to be of equal importance to the U.S. economic numbers. The global markets are looking more

and more to the U.S. economy for direction. So, this dollar-driven phenomenon is one advantage that U.S. investors have in the global markets and one reason a local presence in those markets is not that important. Question: Are bonds rated B and lower fundamentally flawed, given that many of these issuers have no plans to graduate to investment grade and most will not survive a recession? Coffman: No, these bonds are not fundamentally flawed. These bonds are generally issued at their highest point of credit risk, and the goal is to ultimately refinance the capital structure at a cheaper rate. The refinancing can be accomplished in several ways: A company can issue equity to pay down outstanding debt, opportunistically sell the company to pay off the debt, or refinance at a lower cost as a result of either a shift in market rates or a perception of credit improvement. Even though most of the lower-grade issuers rarely improve enough to move up to investment grade, bonds rated B and lower can gain ground over time, and these issuers are obviously highly motivated to do so. Question: Should investors in emerging market debt expect future bailouts of defaulting nations? Dalla: Bailouts occurred for Mexico, Russia, and Korea, but no bailouts occurred for Thailand and Indonesia. The reason was that no U.S. economic interests were threatened by the defaults in


Thailand and Indonesia. Investors will benefit from keeping abreast of where U.S. interests lie. For example, the United States will never allow Korea to go under because of the serious negative impact such a disaster would have on all major U.S. financial institutions. So, when an economy in which the United States has a direct interest becomes a systemic problem, a bailout is likely. Money can usually be made in this type of situation. Question: What tools are needed to analyze European corporates from a macro perspective, and can such analysis be done adequately from the United States? Windheim: I am not even sure investing in European corporates is worth doing at this point. Today, U.S. corporates are trading in Europe at lower spreads than in the United States. For example, Ford Motor Credit single-A assetbacked securities trade 180 bps over Treasuries in the United States but only 90 bps over U.S. Treasuries in Europe. Since the creation of the European Union, investors obviously have found little benefit in going from Germany to France or from Italy to Belgium, and from the perspective of relative value, there seems even less reason to venture into this sector. Right now, investing in this sector simply doesn’t make sense. At some point, however, yields in that sector will reach equilibrium with those of comparable credits in the United States, and that event will mark the right time to get involved in the sector. Instead of buying corporate credit in Europe, we have used a

77

Core-Plus Bond Management strategy of buying sovereign debt of the EU convergence candidates—Hungary, the Czech Republic, and Poland. Since June 1998, according to the Lehman Brothers Euro-Aggregate Index, the government sector has outperformed all the corporate credit sectors. The European sovereigns have returned about 8 percent annualized for the past two years, with the corporate credit sector falling behind by about 50 bps. Poland, the Czech Republic, and Hungary produced a total return for the past two years of about 30 percent annualized. Poland’s twoyear note yields 18 percent in local currency terms. Poland is a A/BBB split credit and yields about 1,200 bps over the curve for German government bonds. Of course, there’s always the single-A Ford Motor asset-backed securities at 90 bps over U.S. Treasuries. You pick. Question: Is all the bad news currently priced into the high-yield market, or is more bad news on the horizon going to spur more spread widening? Coffman: Yes, all the bad news is priced in the market, but if you had asked me that question a year ago, I would have said the same thing. It’s hard to say what will be the catalyst to get the high-yield sector going again. The spread to governments is as wide as it was in 1990— about 650 bps—which is the widest it has been since 1990. The average bond is trading at about 88 cents on the dollar. So, whether we’re at the bottom of the cycle is hard to say, but we’re certainly closer to the bottom than we are to the top. The outperformance of the stock market over the past five years has affected the quality of the companies that have issued highyield debt. The high-yield investor has been the victim of “adverse selection.” Over the past few years, most quality companies that are

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leaders in attractive industries have benefited from a higher valuation—a cheaper source of capital—by raising capital in the equity markets. The high-yield sector has been left with much smaller, lower-quality issuers. Emerging growth companies with significant capital needs have been dominating the high-yield sector, but this trend is beginning to change. Larger leveraged buyouts of mature industrial companies are beginning to reenter the high-yield sector. Returns in the equity market at the end of this year (2000) will spur investors to rethink portfolio asset allocations and move more funds into fixed-income securities. The high-yield market should be a beneficiary of this shift. The recent decline in issuance should help high-yield valuations; new issuance this year is about half of last year’s amount. Obviously, at some point, these conditions will work to the advantage of highyield bonds. Question: How do you evaluate a country for both macroeconomic development and geopolitical risk? Dalla: We largely depend on the International Monetary Fund rating (which is updated annually) for the developmental stage of a market we are evaluating. As for geopolitical risk, we look at the impact of the geopolitical situation on the macroeconomic variables and on the local political system. If we determine that the risk is high, we simply stay out of that country. Question: How much value is added from global bond management, and what volatility accompanies the pursuit of this kind of added value? Windheim: The added value from going global can be substantial but also sporadic, and periods

of underperformance will occur. For example, during the past five years, nondollar markets underperformed U.S. markets by about 3 percent on an annualized basis. Investors may have to suffer through several quarters of poor returns before being rewarded for staying in the game, but more often than not, the reward arrives quickly. If the nondollar bond position is unhedged, volatility is probably twice that of U.S. Treasuries. When the nondollar sector is compared with the corporate and high-yield sectors, however, the volatility comparison is more favorable. If the nondollar bond position is hedged, volatility is probably about 25 percent less than that of U.S. Treasuries. Question: What definition of risk is appropriate for the highyield market? Coffman: The focus should be on absolute risk rather than benchmark risk. The typical benchmark has 500 to 1,100 issues, and replicating the benchmark is a real challenge. The average portfolio has only about 100 issues. Industry allocations can be replicated in the average portfolio, but finding the right individual securities—obviously a more important determinant of portfolio return—is a very difficult task. Question: How many high-yield managers use convertibles and common stocks, and is this approach an appropriate extension of the high-yield mandate? Coffman: Yes, both convertibles and common stocks are an appropriate extension of the high-yield mandate. A lot of high-yield (below-investment-grade) convertibles are available. At my firm, the focus tends to be on busted convertibles, which really trade much more


Choosing the “Plus” in Core-Plus like bonds than stocks, and the portfolios with high-yield mandates have an average 2–3 percent allocation to equities. The rationale for putting equities in high-yield portfolios is that the basic fundamental analysis for equities and high-yield bonds is virtually identical. In practice, however, emerging market corporate bonds are used more often in high-yield portfolios to add diversification and incremental return than are convertibles or equities, yet using emerging market corporates is probably less appropriate than using equities or convertible debt. Although the fundamental assessments of the securities are not particularly different, the performance of the securities does differ. The performance of an emerging market corporate bond is much more closely aligned with the performance of the emerging market sovereign than with the fundamental performance of the corporate issuer. When used judiciously, these securities are more appropriate for high-yield mandates than emerging market debt, but emerging market corporate debt is more commonly used in high-yield portfolios than equities and convertibles. Question: Does bank debt have a place in a high-yield portfolio?

Coffman: Yes, bank debt is becoming a more significant part of the high-yield market. Bank debt trades in a unique fashion. It’s not a security; it’s an arduous legal transaction. Generally, most firms handle bank debt on a different desk from high-yield bonds. Unfortunately, this difference means establishing a new set of relationships to get access to bank debt and trade it. We launched a public retail bank-debt fund recently, and even though Fidelity is one of the largest high-yield players in the marketplace, we’re finding it tough to buy securities because we’re not a big player in the bank-debt market. Putting bank debt in high-yield portfolios makes sense, particularly because many of the credits are the same. Over a 10-year period, the returns for bank debt will probably look very similar to high yield, but the volatility would be significantly less. Question: Would each of you comment on the analytical tools you use to manage risk in your portfolios, and are there any alternatives to developing in-house programs? Windheim: We use value at risk as an analytical tool and J.P. Morgan’s Riskmetrics system to calculate it. The value-at-risk function on Bloomberg is almost


comparable to Riskmetrics, although it doesn’t do currencies well. Obviously, assumptions have to be made for the models, but the models use the assumed volatilities and correlations to run different yield curves. The model also does cross-market correlations. VAR is a more important and more effective risk measure than the tracking-error risk of a portfolio, especially for a nondollar bond portfolio. In both an absolute and a relative sense, VAR has worked very well for us. Dalla: We use VAR and stress tests. One of the things we try to avoid at all costs is a default. We will not invest in any bond for which we see a chance of default. Coffman: We’re really in the business of pricing risk. We try to understand what risks exist within companies and industries and try to determine the appropriate price for the risk. Our performance is measured relative to benchmarks, principally the Merrill Lynch High Yield Master II Index, so we’re constantly looking at our portfolios relative to the index in terms of industry weightings and also individual company concentrations. The assessment of risk is much less scientific for high-yield bonds than for the more highly correlated instruments.

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The Benchmarks of the Mind James Grant Editor Grant’s Interest Rate Observer New York City

The received wisdom of financial markets plays an intangible yet significant role in shaping investor perceptions and, hence, markets. Today, five “benchmarks of the mind”—the beneficence of technology, the definition of an optimal financial structure, the infallibility of the Federal Reserve, the permanence of disinflation, and the preeminence of the U.S. dollar—hold particular sway. Investors should beware, however, that nothing in financial markets is immune to change, including “truths” that seem selfevident and unquestionable.

ither financial progress is cumulative or it is cyclical. Either we stand on the shoulders of giants, learning and never forgetting, or we don’t. I believe that we don’t. I can’t help but notice that investors do forget. In fact, they recycle their mistakes like soda cans. We collectively learn, and then—in response to underwriting fees, syndication fees, yield pickup, and other emoluments—we forget. In every market cycle, certain ideas are held to be self-evident. We can call these revealed truths “benchmarks of the mind.”

E

Benchmarks of the Mind At the millennium, by my count, there are five such benchmarks, or articles of faith. Technology is the first. The idea of an optimal capital structure is the second. The Federal Reserve Board is third, from which follow the fourth and fifth benchmarks: disinflation and the U.S. dollar. Technology. Technology sets us free and makes us rich. This idea is almost universally embraced, and not without reason: It has been true for more than a century. But the burden of fixed charges for the industries in the technology vanguard is not necessarily light or even manageable. The September 29, 2000, Financial Times reported that European bank regulators are probing $171 billion in new loans made to European telecommunications companies because the regulators fear that the banks are overextended to the sector. Some people had thought that the banking difficulties of the 1980s were behind us, at least for a generation, but the Office of the Comp-

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troller of the Currency has shown otherwise. Its proof is simple and elegant—just compare the return on equity (ROE) of U.S. commercial banks with the riskfree rate (specifically, the 10-year Treasury yield). Not only does this spread relationship capture the risk portion of the ROE of the banking business, but it also stands at, or near, a record high. As always, banks are making money by taking risk, not by being good citizens. Telecommunications companies today are struggling under the exorbitant costs of so-called third generation licenses. More than a century ago, when the railroads (another liberating and capital-intensive new technology) sought government assistance, the price tag was cheaper. The Indians had the land, and the government gave it to the railroads. Now, the government auctions licenses that actually belong to television companies. The railroads changed the way people lived and worked, just as the Internet-enabled cell phone has done and continues to do. The service that railroads provided, however, was a largely undifferentiated commodity, and in this respect, the railroads anticipated the telephone. Furthermore, railroads usually earned less than their promoters expected. In 1916, at the peak of the railroad industry’s fortunes, the combined ROE was 7 percent. The long-suffering stockholders, not to mention debt holders, had barely finished counting their newfound wealth when the United States entered World War I and the government nationalized the railroads—an eventuality that probably was not mentioned during the promotional phase of the cycle.


The Benchmarks of the Mind Optimal Capital Structure. The second received truth of the present day is a belief in an optimal capital structure. The credit quality of the Lehman Brothers corporate bond index from 1973 to the present is an obvious and vivid testament to the steady deterioration of American corporate credit quality as a whole. What is notable about this slippage is that so much of it is premeditated. Corporate managements—answerable first and last to the stockholders with whom they have so conscientiously aligned their own interests—are running up debt in order to buy back shares and make acquisitions and thus make the stock price climb. The assistant treasurer of capital markets at A-1 rated Pepsi Company recently made some extremely frank and eye-opening comments (quoted in the May/June 2000 issue of Treasury and Risk Management magazine) about this idea of the optimal capital structure, which is not necessarily optimal for the creditors. “We’ve talked with academics,” he begins unpromisingly, “and investment banks,” he proceeds ominously, “and they say that the ideal place to be, the ideal space in terms of cost of capital, is double-B. The reason every company in America is not there is that if you have a problem and drop one notch, you’re threatened with illiquidity, so you go a notch higher to triple-B. But if you make one acquisition, you’re near the edge. That’s why a lot of companies opt for the A rating.” He may be right, but it is not as if the socalled metrics by which credit quality is measured were permanent and settled truths either. The currently accepted idea of what constitutes cash flow would shock a bond buyer of even one generation ago—it shocks me still. In June 2000, Moody’s Investors Service performed a public service by issuing a study entitled “Putting EBITDA in Perspective: Ten Critical Failings of EBITDA as the Principal Determinant of Cash Flow”—EBITDA, of course, being earnings before interest, taxes, depreciation, and amortization. Contrary to almost universal belief, observed Pamela M. Stumpp, lead analyst on the project, EBITDA is not functionally identical to cash flow. Before EBITDA came along, a company’s interest expense was conservatively measured by EBIT (earnings before interest and taxes). The subtraction of depreciation and amortization occurred not by accident but rather out of necessity. “With the advent of LBO [leveraged buyout] mania in the 80s,” according to the Moody’s study, “EBITDA became widely used as a tool to measure a company’s cash flow and consequently its ability to service debt.” In other words, EBITDA was necessary to derive the financial numbers that drove the transactions (LBOs) that generated the fees. EBITDA is an extremely generous reckoning of cash flow, and it is highly flattering to the corporation reporting the numbers. It can be seriously misleading.

Markets believe what they want to believe. Perception of financial phenomena is often selective. In a bad market, people choose to see the worst. In a good market, they home in on the best. Word for word, the ancient adage “markets make opinions” is about the wisest on Wall Street. Consider the example of Cisco Systems, which discloses its quarterly results in two different ways. The first is earnings according to U.S. generally accepted accounting principles (GAAP); the other is the earnings according to the Cisco method. Cisco seems to find GAAP inexpressive or otherwise deficient for the richness of its own experience, and accordingly, it uses something that may be called the “Cisco standards.” Earnings according to Cisco standards consist of GAAP excluding in-process R&D, payroll tax on stock options exercised, acquisitionsrelated costs, intangible assets, gains realized, and so on. Not surprisingly, over the years, GAAP earnings have underperformed Cisco-standards earnings. In fact, the premium of Cisco to GAAP earnings over the past two years has been 23 percent. The problem is not necessarily that people see the higher non-GAAP Cisco number and then buy the stock. Rather, they choose to believe the highest number because that is the prevailing zeitgeist. Markets make opinions. Federal Reserve Board. The third benchmark of the mind is a belief in the competence, even omniscience, of the U.S. Federal Reserve Board. Imagine how the Fed would be valued if it were a stock. In the public market today, under the leadership of Alan Greenspan, the central bank would trade for about 10 times book and 40 times a very generously reckoned 2003 earnings estimate; it would yield about nothing. Compare this valuation with the much less enthusiastic one that can be imagined for the Fed when Paul Volcker took over in the late 1970s—before he implemented the October 6, 1979, monetary reform that broke the back of inflation. Why has the Fed gained so much stature in both American finance and American public life? Consider what the Fed does. It sets an interest rate. It is the all-important rate, one that can supposedly maximize every facet of the economy’s performance. It can make the GDP grow, the stock market rise, the dollar exchange rate stabilize, and so forth. If such a rate existed, who would believe that a committee of public servants could find it? Five days a week, hundreds of people on the floor of the Chicago Mercantile Exchange are screaming at the top of their lungs just to discover the right interest rate. Why, then, is the task of price discovery for the fulcrum money market interest rate given to a committee of federal employees?


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Core-Plus Bond Management The question is not asked because almost nobody is dissatisfied with the results of Fed policy: The economy has grown and the stock market has soared. Yes, as the French might reflect, it’s all very well in practice. But what about the theory? I knew Alan Greenspan when he was only another civilian trying to guess the next quarter’s GDP. Sometimes he was right, and sometimes he was not. The amount of faith and trust lodged in the central bank is extraordinary, and it is highly revealing of the mindset of investors during the great bull market. Disinflation. The belief in the permanence of disinflation is connected to the belief in the Fed’s infallibility. It is instructive to look at the Treasury inflationindexed securities market and calculate the implicit inflation forecast embedded in their price. This calculation can be made by comparing the yield on Treasury inflation-protected securities (TIPS) with yields on comparable unindexed Treasuries. Currently, the break-even inflation rate for 7–10 years is about 2 percentage points. That is, over the course of the better part of a decade, if the inflation rate were greater than 2 percent, Treasury inflation-indexed securities would do better than the conventional kind. In the past 12 months, the inflation rate has been almost 3 1/2 percent and the so-called core rate, which is the great consolation of creditors and central bankers, has gone from approximately 1.9 percent in December 1999 to about 2 1/2 percent at present. So, inflation cannot be said to be decelerating, at least not yet. In fact, the U.S. Bureau of Labor Statistics (BLS) recently revised the inflation rate up by 10 basis points. Nonetheless, the Treasury inflation-indexed securities market is priced for something very close to perfection. Furthermore, consider that Treasury securities are priced at less than the rate of the year-over-year growth in nominal GDP. Yields are rarely below this level. The September 29, 2000, issue of Grant’s Interest Rate Observer features a critical analysis of the U.S. Consumer Price Index. In this exercise, we conclude that the CPI has been over bred—it has come to resemble a German Shepherd that, after laborious efforts to improve the breed, winds up looking like a Dachshund. Immense effort goes into the calculation of the CPI. Thousands and thousands of observations are taken for prices, and teams of brilliant econometricians adjust the prices for seasonal influences and for change in product and service quality. The closer you look at the CPI, however, the more you are inclined to wonder whether all this effort isn’t being bent toward understating the rate of inflation, rather than just reporting it. Even before the Boskin Commission (which worked backward from the conviction that inflation was overstated by about one percent) came on the

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scene in 1996, the BLS was in the business of adjusting product quality for perceived improvements and making the indicated adjustments—almost always to lower the reported rate. One of the most revealing moments in the history of the CPI came in 1997 when Barry Bosworth of the Brookings Institution went before the U.S. Senate Finance Committee and reported that in 1995, the total (unadjusted) price increase in a subsample of the CPI covering about 70 percent of the total index amounted to 4.7 percent. According to Bosworth, the BLS determined that 2.6 percentage points of this amount, or slightly over half of the increase, represented improvements in quality. So, how many creditors that day knew that more than half of the CPI was whisked away by hedonic adjustments—that is, by adjustments to compensate for perceived improvements in product quality? We also asked the BLS how much of the CPI was assumed away in years after 1995. The BLS said they did not know and could not tell us but they would check. As scrupulous as the government has been in adjusting for improvements in computer processing speed, the safety of automobiles, or the power of air conditioners, it has been less thorough in adjusting for the disimprovements attendant upon the stretching of the service economy. Nothing in the CPI compensates the air traveler for delays or the computer consumer for time spent waiting for help or the ordinary mortal for trying to navigate the voice mail of a company that, presumably because of the labor shortage, has sacked all the receptionists. Such negative effects are not reflected in the CPI. The CPI represents a single-minded concentration on improvements in product quality. The U.S. Dollar. The U.S. dollar is the fifth received “truth,” and it relates to the preceding two mental benchmarks concerning the Federal Reserve and disinflation. Not long ago, the U.S. dollar was the doormat of the world monetary system. In the late 1970s, Italian hotel clerks turned up their noses at dollar-denominated travelers’ checks. Then came the Reagan years and the great dollar bull market that peaked in May of 1985. Under the influence of former Treasury Secretary Robert Rubin—a strong dollar is in the U.S. interest, he said over and over—the greenback became virtually the Coca-Cola of world monetary brands. The International Monetary Fund reports that the U.S. dollar as a percent of world foreign exchange reserves has gone from about 51 percent in 1990 to about 66 percent in 1999. When the euro debuted, I expected it to be a serious competitor for shelf space in the world monetary market, but the opposite has been true. A calculation performed by J.P. Morgan & Company shows that the German and French real trade-weighted indexes are lower now


The Benchmarks of the Mind than they were at the peak of the Reagan dollar bull market in 1985. So, the dollar is well and truly almighty. In finance, as in all things, the knee bone is connected to the thigh bone, and the dollar exchange rate is connected to the perceptions of the Fed, convictions about disinflation, and the world’s view of the American economy.

Conclusion In the mid-1980s, two ideas purported to explain the looming secular shift toward disinflation. One was that a tribe of “bond market vigilantes” would brook no rise in the inflation rate. On seeing such a move, the vigilantes would sell Treasuries, thereby nipping any new inflation in the bud. The second idea was that the GDP was being physically lightened. Because the economy had entered a post-industrial age, the mix of national income contained much less stuff and many more ideas. Less physical bulk meant less stuff to finance and thus less inventory to move. Moreover, people thought that fewer railcar loadings per dollar of GDP would lead to a lower demand for working capital. The Information Age would make the economy more efficient, and interest rates would secularly fall. In fact, the bond market did not go up each and every day, but by 1993, anyone who believed in these two ideas was looking very good indeed. Today, what is the empirical evidence concerning the potency of the bond market vigilantes and the lightening of the GDP? To take the latter first, I propose to you that the telecommunications sector represents a new railroad industry. As for the bond

market vigilantes, the pricing of U.S. Treasuries suggests that these worthies have retired to play golf. A common point of view is that the Treasury market is going to go away because the government is now running massive surpluses. A look at the table of federal indebtedness at the back of any issue of Barron’s, however, indicates that the federal debt is not decreasing but increasing. The increase has come in so-called nonmarketable debt. This debt cannot be traded, but it exists on the books—and in the past two years, it has grown considerably more than the marketable debt has shrunk. In finance, few ideas are intrinsically right or wrong. Rather, ideas are right or wrong at a price. I used to be the scourge of the junk bond market. Now, I see that I should have been the scourge of the junk bond market at par. The debate over junk bonds involved rather more moralizing and rather less analysis than was appropriate, given the fact that the issue was not moral but financial. The idea that the dollar will always be the one and only currency is an idea that soon will become unprofitable. The idea that disinflation will be perpetual (because the bond market vigilantes will ride herd on the Fed and the politicians) will similarly disappoint. The idea that the Fed somehow can improve the future is patently untenable. Everything under the financial sun is cyclical, including the benchmarks of the mind. We should all be alert to how these ideas change, and we should be open to the fact that they might be changing even now.


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Question and Answer Session James Grant Question: Since your publication is for “bears,” have you found that your constituency is shrinking because of your unbridled excess? Grant: The question is whether I am going broke by being bearish. Why, no. I have often thought that individuals are born with a characteristic turn of mind. Some people wake up in the morning, and for them, it’s the first day of spring. Some people wake up saying, “Yes, but. . . .” That’s me. It takes all kinds. But perpetual prosperity isn’t possible, no matter what the ruling turn of mind. The optimists among us claim that we are living in an age of unique productivity growth. But there is a trade-off between productivity growth and corporate creditworthiness. If capital investment exceeds internally generated funds, creditworthiness will tend to deteriorate. Excessive borrowing to finance the acquisition of productivity-enhancing capital goods is fine until the next down-

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turn, at which point it may translate into higher defaults and more bankruptcies. So, gains in productivity growth are not unrelated to losses in creditworthiness. Question: If you strip out hedonic pricing from business investment, do you believe the consumption deflator is GDP and productivity growth? Grant: If you strip out hedonic adjustment, where are the major indicators of economic health? I don’t know. In 1995, half of the inflation rate was adjusted away. The reason I’m not sure that inflation is actually running at 4 1/2 percent or 5 percent is that we have so many different checkpoints on inflation. In other words, the CPI is not the only thing that indicates where the price level is going. A variety of other measures, such as the Chicago Purchasing Managers Survey, come into play, and these measures are not hedonically adjusted. The inflation rate is

understated but not drastically so. The true inflation rate is probably closer to 4 1/2 percent than to the 3 1/2 percent reported by the BLS. At Grant’s, we are continuing to work on this subject (some people at Harvard have done all the difficult econometrics on hedonics for me). Hedonic adjustments— adjustments for improvement in product quality—go all the way through the national income accounts. The Bundesbank recently said that if Germany had implemented hedonic adjustments to its own capital investment account, the rate of increase in reported German investment would have been much higher. If so, people might have held a better opinion about Germany and about the euro. The misapplication of this complex econometric procedure is not responsible for the bullish appearance and substance of the American experience in recent years. But it has played an important role at the margin.


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