Peter Walsh, a former director of Putnam Investments, says the fixed income sector has “evolved significantly over the past 10 years, as has the complexity of it”.
“Many planners may still view fixed income as traditional sovereign – that is, government bonds – with a few additional sectors such as credit and emerging market debt,” Walsh says.
“This perception may also lead planners to believe that the alpha derived from active fixed income is still around 20 to 50 basis points – which it was, historically. But the evolution of the sector means that alpha of 200 basis points and higher is quite achievable now.”
Walsh says higher returns invariably come with higher risk, but the risk can be managed. And in any case, “although the risk or volatility in fixed income investing has increased, it is still lower than many other asset classes”.
“It’s important to focus on the risk management procedures that managers have in place,” Walsh says.
“Although the alpha is higher, and can be found in many more places, managers must be vigilant to protect those returns and diversify the sources of alpha as much as possible.”
The implications for portfolio construction that arise from the evolution of the sector include a re-thinking of the role played by active management, Walsh says.
“The view was that with only 20 to 50 basis points of alpha available, why should a planner take the active option?” he says.
“This led to many utilising index funds, or even direct fixed income securities for this exposure.
“Constructing a top-down portfolio – with indexed sovereign and government bond exposure as the core, with satellites of good emerging market and/or credit managers added as satellites – has been a popular approach. But it fails to adequately capture all the opportunities, and also fails to adequately manage risk, as each of these sectors can be extremely volatile.
“Now with the additional alpha available, planners should consider using a manager with the broadest tool kit available – the more sectors and securities to choose from, the better placed a manager is to manage risk in aggregate.
“It is important to look at where a manager has derived their returns – if from one sector only, it may be more luck than skill, and may not always be an attractive sector to be in.
“For example, over the past 10 years, emerging market debt has been the best sector as often as it has been the worst. A manager with a permanent overweighting to this sector will look like a hero at times, but could damage a client’s portfolio badly when the sector has a bad year.
“A good manager should be able to provide attribution that breaks down the source of past returns. There are many good managers around but planners should take the time to understand the manager’s skills and risk management before investing.”
If financial planners are going to make greater use of opportunities to invest directly in fixed income, particularly in government securities, then there needs to be some agreement on how to measure the performance of the securities so recommended.
Simon Doyle, head of fixed income and multi-asset sectors at Schroder, says a debate still raging within fixed income circles is the issue of benchmarking.
Doyle says there seems to be no single view on what an appropriate yardstick ought to be for a fixed income investor. In the latest edition of The Fix, Doyle’s regular fixed income update, he suggests as a benchmark “the local sovereign bond, matched to the investor’s time horizon”.
Doyle says the starting point for determining a benchmark should be first to assess the role of the asset class in question. In the case of fixed income, he says, its role is to preserve the real value of capital over a given period of time.
“In constructing an investment portfolio I am simply allocating risk between assets whose role it is to preserve the real value of investor capital – and simply maintain my spending power – and those it is to grow it,” Doyle says.
He says the options for the capital preservation portion of a portfolio are “somewhat limited”. “I need to find assets that will produce a return similar to the real rate of growth in the economy, as a proxy for the preservation of purchasing power, to minimise risk in doing so,” he says.
“For an investor with a medium-term investment horizon, say over a year, only local-market government bonds, matched to my investment horizon, tick both boxes.
“This is because the default risk is effectively zero. So if I hold a portfolio of sovereign bonds that match my investment horizon to maturity, I know with near certainty what my return will be.
“Secondly, the yield on the government bonds broadly proxies the nominal rate of growth in the economy – in effect, my future consumption basket.”
Doyle says treating cash as the risk-free benchmark for investors is potentially damaging, because there’s a risk with cash that the real value of an investor’s capital may be eroded over time.
“If we are going to give the fixed income asset class the attention it deserves, we need to approach the debate from a logical premise, Doyle says. “Let’s not overcomplicate what should be a relatively simple discussion. Sovereign-linked benchmarks, matched to the investor’s investment horizon, make the most sense.”
Stephen Hart, head of planner services for fixed income broker FIIG Securities, says the company will launch within the next couple of months a comprehensive handbook for financial planners wanting to advise on direct bond investments. The handbook will complement an online education course already on offer.
