Bringing skill to the fore

Modern portfolio theory starts off with the premise that all investors are rational profit maximisers and therefore all investment opportunities can be analysed on the basis of their expected returns, risks and correlations with the rest of the market. But the real world is more complex with many players who are not driven by trade-offs between total returns and risks and the global market for bond investments is a case where game theory rather than the behaviour of crowds is more relevant.

As Emanuele Ravano, co-head of the European Strategy team at Pimco, says: “Active management is not about guessing the movement of rates, but about finding other investors with a different perspective- people who are not total return driven - and we can capitalise on that.”

This also applies to issuers, and given the key role that Asian central banks are playing on the level and shape of both European and US yield curves through their purchases of predominantly long dated US treasury bills, there is a strong case for the UK treasury in particular, to think again about its debt issuance strategy at the long end of the gilt yield curve.

“The world of fixed income is becoming increasingly complex as the range of new instruments and products grows dramatically. These changes bring opportunity but also new risks that need to be understood by managers and investors alike,” says James Mitchell, director fixed income portfolio management at the Russell Investment Group.

This is clearly evident in the three key trends that Mitchell believes are driving new mandates for European bonds, namely, “the search for higher alpha in European bond mandates, the growth in credit mandates and growing demand for liability-driven solutions”.

With major players in the global debt markets driven by objectives other than return maximisation, fund managers need to develop a global capability and a philosophy that can seek out opportunities for alpha wherever they are, and bring them to bear on mandates that may have a purely local benchmark. Mitchell says Russell has seen some convergence in the approach of US and European bond managers, with many European managers looking to add more alpha sources to their investment process.

“There are still many European bond managers who still only offer a core approach with emphasis on benchmark securities and duration management the key alpha driver,” he says.

In contrast, Mitchell adds, many US managers look to utilise a much broader toolkit; investing tactically in US credit markets, emerging debt, overseas government markets and currencies in addition to European bonds.

Principal Global Investors, for example, has 10 alpha ‘houses’ where it believes it can add value. These are the five government related but independent areas of duration, yield curve positioning, country, monetary policy (where it bets on the outcomes of individual meetings through swaps) and relative value between inflation versus nominal bonds, together with the five additional areas of asset allocation, sector allocation, single security selection, currency, and derivative based ideas.

Those fund managers who are able to combine deep US credit capabilities with European expertise are likely to be able to generate the widest range of alpha opportunities, according to David Buckle, European head of fixed income at Principal Global Investors.

The search for higher alpha is driving a separation of alpha and beta in the global bond markets that is transforming the way bond mandates are managed. “Clients are starting to accept that alpha can be generated from a diverse stream of investment strategies,” says Margaret Frost, senior investment consultant and head of bond research in the UK at Watson Wyatt.

While there may still be a domestic benchmark, managers are increasingly expected to be able to deviate from it.

“We are seeing more interest in a kind of aggregate European strategy that includes tactical allocations to sub investment grade debt or emerging market debt (EMD),” adds Frost.

“I think the client wants the manager to make those allocations when they feel the time is appropriate rather than the client allocating to those markets themselves. That is a trend we broadly agree with because if you find a skilled manager who is very good at multi asset management then it should be incumbent on the manager to make the tactical allocations when they feel that the time is right.”

She adds that Watson Wyatt is seeing an increasing emphasis on higher performance targets within European mandates.

“With higher performance targets you need greater flexibility of allowable investments,” she notes. “So not only flexibility to go below investment grade and EMD, even within a European benchmark mandate but also allowing derivative usage and currency as well to really open up the diversity of strategies.”

However, as she points out, this approach is more dependent on manager skill than a traditional mandate.

“Few managers excel at bringing together all of these constituent parts into a cohesive, well constructed portfolio where the risks are understood and properly measured,” Frost believes.

While most managers would agree that diversification away from the euro-zone does provide opportunities for adding extra return, there are very different approaches to structuring a global alpha domestic beta strategy for European institutional investors.

 

BGI, according to Dominic Pegler, head of fixed income strategy, considers global fixed income to be one world these days, whether the underlying mandate is a gilts mandated benchmark or not.

“We think the best way to build a portfolio is to get active return from anywhere, so we are not con-strained,” he says.

This means that a global portfolio of bets is overlaid onto a domestic index-matching portfolio.

So for a German pension fund, the first question would be to identify their benchmark, says Tim Webb, head of fixed income advanced active strategies at BGI.

“We would need to know the maturity of their pension funds, whether they have a surplus or a deficit and their risk tolerance. Having established the benchmark, we find out how much return they want relative to it, what their risk tolerance is [and] what kind of constraints they have. Typically they would be looking for outperformance of 50-200 basis points. Assuming that, we could build a portfolio more or less as we wanted it, we would separate the benchmark return from the active return.”

The client would then hand BGI their €100m, BGI would buy the benchmark with it and then apply a derivatives overlay.

“In the euro-zone we could do it another way as well, we can build a benchmark using derivatives. [Here] you have the flexibility [to take] the cash and buy bonds, generating the benchmark synthetically.”

Pimco, conversely, tailors portfolios to the domestic market, as Ravano explains.

“Normally we identify a fair benchmark and use futures, swaps and cash instruments to match the benchmark and then take risk by moving off-benchmark. We try to take advantage of the idiosyncrasies of the local market. For example, in Europe there is not a local mortgage market so we can take US mortgage bonds and hedge them into euros. In the UK, there is an inverted yield curve so why should I receive less for a 30-year bond where inflation risk is higher, than for a five-year bond where it is lower? It is not really a matching of a local benchmark with a global portfolio, but a local product for each market.”

However, Ravano believes that although the idea of alpha/beta separation sounds optimal, it may not be so easy to implement trades due to the costs and risks of going short in some markets and also owing to differing local regulatory regimes.

“There is a seismic change happening and within three years the style of investing will be a separation of alpha and beta, whether a fund does that in-house or via an investment bank,” says Paul Abberley, CIO fixed income at ABN Amro Asset management.

But he does not believe that institutional investors have yet caught on to this trend.

“If we were to offer a global product swapped into a local benchmark, it would not be to the taste of most of our clients. Most of our clients prefer a clear link between the bonds and the benchmark,” he says.

Russell’s Mitchell agrees: “We have seen relatively few investors opt for a portfolio using a global bond benchmark. Although this global option, on a euro-hedged basis, seems attractive as it offers similar return opportunities but with potentially lower risk given the diversity of markets in the benchmark, most European based clients seem to prefer to keep their bond allocation in their home market.”

Henderson Global Investors is one of the European firms that does have a global approach with flagship global bond funds, according to investment director Mitesh Sheth.

Henderson’s philosophy for the management of long term funds uses the three key themes of exploiting illiquidity through accessing instruments such as bank loans and ABS securities, diversification of investments to gain the maximum uncorrelated sources of alpha and the ability to produce symmetrical return profiles through the use of derivatives, allowing a manager to go short, thereby enabling them to take advantage of negative views, for example, on corporates.

 

Gaining access to global sources of alpha, many of which may be illiquid, and others requiring highly specialised sources of expertise, is arguably much better undertaken through a large pooled vehicle, which can be combined with swaps and futures separately to match local liabilities if required.

Henderson has a standardised global portfolio available through a pooled fund and has specific experts in each fixed income category contributing their ideas to the portfolio.

Payden & Rygel according to senior bond strategist Nigel Jenkins, has seen a lot of interest in Libor plus 2% mandates with a tracking error of 3-4%, typically from disillusioned bond investors.

“They see these as a halfway house to investing in hedge funds,” explains Jenkins. “While these are European mandates, they have global flexibility, in contrast to mandates with European bond benchmarks which only allow you to do things in Europe.”

Principal recently completed the European launch of an absolute return orientated, Libor benchmarked global fund. This essentially uses the same strategy as that of a fund launched in the Australian market three years ago.

Payden & Rygel’s Global Strategic Income fund, taps the skills of the firm’s global network of investment teams and also includes sub-portfolios of US high yield and US preferred securities managed respectively by its autonomous subsidiaries Post and Spectrum, according to Nick Lyster, Payden & Rygel’s London based European CEO.

Such strategies can be implemented alongside an LDI strategy. But as Watson Wyatt’s Frost points out, if you buy an LDI product where the beta and the alpha comes from the same manager, you have to keep in mind that it is much harder to dispense of the manager’s services for poor performance.

“The whole LDI structure is underlying and that is a very difficult thing to dismantle,” she explains.

“If you swap your liabilities out to the swap market and look for Libor type strategies to pay for the Libor leg of the swap, you have essentially separated the two functions out. If you don’t like them you can dispense with them and hire new ones, you don’t have to dismantle the swap. That approach uses up a lot of governance, so it’s not for everyone. I would say, if you can separate the replication of the swap and the delivery of the alpha between two different sources, that can be quite optimal.”

 

learly, depressed government bond yields in Europe are a major factor in the search for global alpha. Pimco’s Ravana argues that in Europe there is not much of a return, with the yield on 10 year government bonds at 4.4% and inflation at 2%, so managers are forced to go elsewhere for higher yielding bonds, such as the UK or New Zealand. ABN Amro Asset Management’s Abberley also feels that index-linked bonds offer better value than government bonds in Europe. He says he prefers currencies such as sterling, as well as high yielding markets such as Canada and New Zealand.

“In Europe the market is watching the US and remains nervous. There has been a lot of issuance relative to history recently but the situation is fundamentally comfortable,” says Buckle of Principal.

Threadneedle’s European high yield bond manager Roman Gaiser sees that spreads could widen from current levels before stabilising, although they have already widened somewhat.

“As a result, some of the more aggressively financed leveraged deals are difficult to implement as invest-ors are reluctant to finance at previous spread levels,” he says.

The big concern for Buckle is the sub-prime scene. “We don’t know whether Bear Sterns is the first of many. The ratings agencies have rated these collateralised debt obligations (CDOs) but you hear people saying, ‘it might be AA-rated but it’s [still] one of those instruments’. “

The spillover into the wider credit markets has given rise to far more volatility in the high-yield sector , with spreads for a typical high single B-rated name having widened to around 400 basis points at the end of July, from below 200 only a few weeks earlier, according to Payden & Rygel’s Jenkins.

“The market looks oversold, but in high yield, this happens every cycle. In seven periods out of eight you gain and in one period, you lose the equivalent of three to five periods’ gains,” says Jenkins.

The increase in spreads has essentially closed down the LBO market, according to Payden & Rygel.

The European bond markets are also subject to the effects of two key non-profit maximising players, namely central banks and liability matching investors.

As Principal’s Buckle points out, “I think one thing that is coming out of the IMF data is just how popular gilts are for reserve managers. They are attracted to the yield, probably because they don’t have the same mark to market responsibilities as asset managers. The US has chosen to service that need and they have been a big issuer of debt but for some reason the UK has managed it differently. Although it is arguable that if you have price insensitive demand you should issue into it.”

With a new UK Chancellor, there may even be scope to move beyond Gordon Brown’s strategy to avoid net borrowing over the business cycle.

The government could then use the international bond markets to create a funded state pension scheme by taking advantage of the Asian central banks’ buying activities in the US and European long maturity bond markets. It could then sell tens of billions of 30 year gilts to Asian central banks and invest the proceeds in a portfolio of assets, including emerging market equities, that will produce income to pay for the pensions of the ageing population of the UK.