These are trying times in the bond market. Gone are the days when falling interest rates acted as a tailwind for fixed income portfolios, and all investors had to do to lock in attractive returns was buy government debt. Today, bond investors face a challenging combination: low (and potentially rising) yields and reduced liquidity. In this environment, the strategies that worked well in the past are likely to fall short—yet bonds remain an essential component of pension asset allocation.
So, what can plan sponsors do? Our research suggests the problem can be tackled by taking a more unconstrained approach; specifically, by implementing a three-part strategy.
First, investors should bench their benchmarks. The problem with nearly all bond indices is that they are issuance-weighted. Companies or governments that issue more debt play a bigger role in the index—and benchmarked investors’ portfolios—leading to potentially unwanted exposures.
Over the past decade, the characteristics of bond indices have changed—and not for the better. Consider Canada’s FTSE TMX Canada Universe Bond Index. Between 2000 and 2013, average yield and coupon fell, duration rose, and overall credit quality worsened—a dreadful combination for bond investors.
The FTSE TMX, like most other traditional bond indices, tends to be heavy on interest rate risk; an unfortunate characteristic at a time when rates seem to have nowhere to go but up. By ditching the benchmark for a “barbell” strategy that creates greater balance between high credit quality, interest rate sensitive assets on one hand and lower-quality, growth-related assets on the other, investors can avoid unwanted risks and focus on absolute returns.
For example, a 50/50 blend of interest rate sensitive U.S. government bonds and growth-sensitive U.S. high-yield debt going back to 1984 would have delivered a higher return than government bonds alone, but with similar volatility and better risk-adjusted returns than either sector in isolation.
Don’t ignore tail risk
Second, don’t neglect to hedge against tail risk. The barbell strategy works in most market environments but would have suffered during the financial crisis of 2008, a tail-risk event that caused diversification to fail and asset-class correlations to rise.
Incorporating tail hedges can provide a buffer against the downside.
It helps to think of a hedge as an umbrella: you want to own one before it starts to rain. The trick is finding the most economical umbrella. Hedges that rely on a single instrument, such as buying puts on an equity index, can be effective, but keeping the hedge on permanently is costly.
Fortunately, asset classes tend to behave similarly during crises, so investors can choose more cost-effective hedges in other assets, such as credit default swaps or currencies. And derivatives, which tend to be more liquid than physical bonds, are also attractive at a time when overall market liquidity is drying up—a by-product of today’s stricter regulatory environment.
Finally, it’s time to change how you think about alpha. The traditional definition is associated with returns over a benchmark. But as we move away from benchmarks, we need a new way to think about alpha.
Based on our research and experience, we think the way to better alpha and risk-adjusted returns lies not just in capturing the upside of an investment opportunity but also in limiting its potential downside. This can be done with derivatives and long-short strategies that capitalize on relative value opportunities. With the right portfolio structure, investors can create an imbalance in their favour, where upside potential is greater than downside risk.
Remember, the prevailing winds in the bond market have changed and new techniques are needed for success. We believe an unconstrained approach should lead to better outcomes in the decade ahead.
Erin Bigley is Senior Portfolio Manager, Fixed Income, AB