For years, Canadian investors could count on two certainties: first, fixed income as an asset class did not draw too much attention; second, the relative performance of bond managers from best to worst was fairly close to the return of the index. Consequently, these managers often found it difficult to differentiate themselves from the competition on a performance basis, especially in a lower volatility environment like the one we experienced earlier this decade. Among pension plans needing to meet liabilities, the skill required to manage excess return on equity portfolios was therefore viewed much more favourably than the skill needed to manage fixed income investments.
Then came the credit crisis. Canadian investors now know that fixed income as an asset class is full of surprises and that replicating the return of the benchmark can no longer be taken for granted. In surveying the last two years, there were many traps and issues in the fixed income market. Events such as the Canadian asset-backed commercial paper (ABCP) crisis led the way, followed by failures in the financial sector, while downgrades and defaults of some well-known institutions fuelled the fire. These events have resulted in a deterioration of liquidity that magnified how fixed income investments have a far-reaching impact on the management of all assets.
To make sense of what happened, let’s focus on three fundamental challenges surrounding fixed income instruments: their payout characteristics, differences between bonds, and the trading environment. Thoroughly understanding this asset class will help investors better evaluate the impact of bonds and credit in their portfolios.
Bonds versus equities
There are many differences in the way bonds behave as compared to an equity. Unlike an equity, the upside of a bond is limited. In a scenario where a bond is held to maturity, the investor knows the exact value of the bond and when the bond will mature. The investor receives a coupon twice a year and the par value of the bond at maturity, but not a penny more over the life of the bond. On the other hand, this investor faces the possibility of losing all the money invested in the instrument if the issuer defaults. Since the profile of a bond is asymmetric when held to maturity, investors should make sure their investment approach is tailored for this payout characteristic.
Since stocks behave differently, equity investors do not face the same risk as bond investors. Like a bond holder, a stock holder can see the value of its investment go down to zero. But, the investor can also see his investment reach a multiple of its initial outlay. This is why most equity portfolio managers define their success by picking the winning companies and overweighting their stocks versus the benchmark. Only managers who are allowed to short stocks can make a difference by focusing on picking underperforming stocks.
Using a similar approach for fixed income investment is not optimal. Due to the asymmetric nature of bonds, bond managers focused on finding the underperforming bonds—and are able to avoid them—have a much better chance of surviving a turbulent period as opposed to bond managers who focus only on picking winners. Sidestepping problems in the world of bonds is the key to capital preservation and a good way to avoid large draw downs.
Bonds versus bonds
Bonds also differ from equities in the variety of bonds available to investors. When buying a common share of a company, an investor ranks equally with any other investors holding the same common share; every investor can expect a similar outcome. When we look at bonds available for purchase from a single issuer, the situation can be very different. There are many bonds representing various parts of a capital structure. Each bond will provide investors with a unique coupon and risk/return profile, as well as a certain level of protection given the liquidation scenario. Not only do investors need to be comfortable with the bond’s issuer, but they also need to assess where it ranks on the capital structure of the company.