As with many other asset classes, the landscape for global bonds has significantly evolved over the past 20 years. Sector, sub sector, and security-specific opportunities have replaced traditional country/currency driven strategies as the most important determinants of returns. These new market realities require more sophisticated investment techniques from managers and broader investment guidelines from investors.
Since the mid 1990s, policy is more consistent across the globe and information is readily available (See Figure 1 below). Yields are lower, spreads are lower and volatility is down. At the same time, the market has become much broader in terms of investment liquid sectors and deeper in terms of sub sectors and securities within sectors. Issuance in fixed income markets has migrated from government-backed securities to bonds issued by corporations or securitised by mortgage payments or other cash flows.
As a sophisticated, complex asset class, today’s global fixed income markets are deeper and more efficient than in the past, so it is harder to correctly call top-down decisions based solely on duration or country views. Because the rewards are not as easy to come by, fixed income managers must reach deeper to provide broader sector and security selection. In return, this response provides managers with myriad opportunities to generate excess return for investors. And, unlike the days when outsized wins made it easy to overlook risks, managers must preserve what they make.
The prospects within today’s global bond markets provide wide ranging options, including macro, structured, or credit strategies opportunities. Global term structure or macro strategies still offer alpha-generating possibilities, including variances in currency values, economic growth rates (macro research), and monetary and fiscal policies across Europe, Japan, and US economic blocs.
Structured securities are still an attractive source of incremental excess return. The size of the global securitised debt sector is huge, exceeding $US 5 trillion by some estimates.
The following securities offer the advantages of collateralisation and diversification:
• Mortgage-backed securities (MBS); the largest sub sector
• Asset-backed securities (ABS) and commer- cial mortgage-backed securities (CMBS)
• Structured credit products, such as collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), and collateralised bond obligations (CBOs); the newest frontier.
Credit sectors, especially global corporate high-yield bonds and emerging-market debt are another significant alpha source. Global high-yield corporate bonds have weathered several market cycles and measure nearly $US 1 trillion. As one of the strongest performers over the past 15 years, emerging-market debt has evolved from a tactical allocation to a strategic asset class in the eyes of many investors.
Successful investing in today’s expanding global bond market requires broad and deep expertise. The strategies that advisers should look for their fixed income managers to employ to more effectively capture opportunities, and thus improve returns for investors, are as follows.
Smaller bets, multiple strategies: Instead of relying on big, macro decisions, managers should make a number of smaller calls across diverse strategies. This reduces the dependence on one particular market or economic environment and increases the likelihood of achieving return targets over the long term with the optimal risk/return balance.
Sector specialist teams: To take advantage of the excess return available through security selection, teams of specialists aligned with the various bond sectors — government, securitised, investment-grade credit, high-yield credit, emerging-market debt, bank loans, etc. — can make a big difference. Each team can identify compelling strategies and securities within its area of expertise.
Centralised portfolio construction: A portfolio construction team can select from amongst the strategies recommended by the specialists to systematically build a portfolio of multiple strategies that carefully balances risk and return.
Sophisticated risk management: This is another critical factor in today’s more efficient fixed income market. The portfolio construction team must not only be able to identify risks, but also to quantify its volatilities, correlations, and likely portfolio interactions. Strategies should be balanced so no single factor contributes too much risk to the portfolio.
High Information Ratios(IRS): Look for managers with high IRS or high returns per unit of risk — not just high returns. High IRS are proof statements of well-run processes.
Flexible guidelines: Managers need flexibility to take advantage of the full range of opportunities across multiple sectors. Advisers should ensure that the guidelines of the funds that they are using are aligned with the new market realities.
In today’s global fixed income environment, top-down strategies have become less successful and more risky. The best way to capture excess return is through multiple strategy portfolios that invest across global sectors; through specialised expertise that can uncover and capture the unique opportunities embedded within each sector; and through advanced portfolio construction/risk management techniques. With these factors in place, the best collective ideas of specialists can make their way into a portfolio that achieves the desired return target within the prescribed risk framework.
Peter Walsh is Senior Vice President, Director of Putnam Investments Australia. He is responsible for the management of Putnam’s retail investments including marketing activities, business relationships and product support.