Return-seeking strategies in
fixed income: adopting the right
approach for your portfolio
Pension funds typically generate return by harvesting two main
risk premia: equity and term premia. This has primarily been the
case because for many years the prevailing wisdom in
investments was that the equity risk premium offers the highest
potential returns and government bonds are a good way to
diversify that due to negative correlations.
This asset allocation is insufficient for generating future returns, given the extremely
low interest rate environment and the rather high level of equity valuations eight
years into an economic recovery.
Thus investors are being forced to look at other ways to generate returns, be that
through alpha or less traditional risk premia, in order to continue to grow their asset
base. This has led to the need for investors to embrace flexible outcome orientated
strategies, where non-traditional betas are emphasised, dynamic management is
employed and alpha strategies are maximised to augment returns.
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The problem with traditional fixed Income
Traditional fixed income strategies are not well designed for the
current market environment. The typical aggregate benchmark is
heavily tilted towards term premium as a return driver. Over 68%
of the contribution to risk comes from term premium with less
than 32% coming from credit risk premium.
Traditional fixed income
strategies are not well
designed for the current
market environment. The
CONTRIBUTION
TO TOTAL
VOLATILITY
31.8%
typical aggregate
CREDIT
a return driver.
benchmark is heavily tilted
towards term premium as
68.2 %
INTEREST RATE
Source: Barclays Capital. Historical data from Jan 2001 to May 2016
This is a risky strategy to base future returns on given the low level of
yields, and the very small margin of safety to absorb capital losses. For
example, at the end of July 2016, the Merrill Lynch Global Government
Index yielded 50bps and had 8.2 years of duration. It takes less than
10bps of yield increase to wipe out the expected yearly total return of
the index over that period. The daily volatility of this index over the last
year is 20bps, two-fifths of the expected yield from here. In other words,
the margin of safety is so small that an average one day move could
erase two-fifths of the expected annual return.
As a result, growth in new product has resulted in non-traditional fixed
income strategies, from single strategies such as high yield (HY) or
loans, to multi-strategy solutions such as multi-asset credit and
unconstrained bonds.
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For the single strategy solutions on offer, these may offer a
solution for today’s investment environment, but that solution is
time-sensitive as individual strategies generally operate in their
own cycles. While HY recovered faster than the mortgage market
in 2008, it was the mortgage market that was more stable
through the recent sell-off at the end of 2015 and beginning of
2016. For investors to buy single strategies they need to be able
to react to changing market circumstances as well as have solid
views on when to time these asset classes.
For many investors, multi-strategy outcome orientated
solutions are more palatable as they have more longevity,
allowing investors to broadly express their risk tolerance and
acceptable level of drawdown. However, there is little
commonality among different product offerings available to
solve this problem and this has made it difficult for investors to
form expectations of products’ performance and how to use
them. Furthermore, for the multi-strategy products there is
very little first-principles thought put into which product is best
for the client, and which product has a longer term future in
an asset allocation.
Credit risk premium and outcome orientated
fixed income
Russell Investments believes that there are two major ways
of accessing non-traditional fixed income using multistrategy approaches that actually solve problems for
investors: unconstrained fixed income and multi-asset
credit. We believe the difference between the two is a
function of clients’ risk tolerance. Unconstrained fixed
income offers a lower risk/return approach based on more
diversified fixed income exposures and featuring a selective
approach to the credit risk premium, and multi-asset credit
offers a higher return with higher risk, based on
comprehensive exposure to the credit risk premium.
The credit risk premium is key to understanding the nature of
both these alternative products, because it is a reliable return
driver to which clients can allocate meaningful amounts of
capital. This differentiates it from many other alternative risk
premia or return drivers. There are many types of strategies
and answers that the asset management community has put
forward; but most suffer from some drawbacks, such as they
rely on manager skill, or they may be interesting risk premia but
are too illiquid to be able to absorb significant amounts of
capital. At Russell Investments we believe that a successful
investment strategy involves harvesting risk premia, and
complementing those returns through alpha strategies. In
unconstrained fixed income, alpha strategies can play a role,
but credit should have a central role.
Russell Investments believes
that there are two major
ways of accessing nontraditional fixed income
using multi-strategy
approaches that actually
solve problems for investors:
unconstrained fixed income
and multi-asset credit.
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Why is the credit risk premium a reliable
return driver?
Treasury bonds, for the most part, come with a high degree of
certainty of return over a given horizon. This is because there is a
high degree of relationship between initial yield and hold to
maturity return.
Relationship Between Yield & Return
Annualised Return of 5 Year
Treasury
20.0%
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
5 Year Treasury Yield (at purchase 5 years prior)
*Source: Barclays Capital 5Y Bellwether Treasury Index. Historical data from Jan 1981 to
May 2016.
This relationship is less certain when it comes to credit bonds as
there is a risk of not getting paid back either coupon or principal.
However, default events are not as frequent as the market
expects and there is a meaningful amount of excess yield from
credit over the long -run default expectations. This excess is
substantial when one considers the very low expected returns of
government bonds over the next five years. Therefore, extended
credit sectors, such as HY, loans and emerging market debt also
have return expectations that are meaningfully better than cash.
These two factors mean that extended credit sectors tend to
offer very strong risk -adjusted returns, and make good total
return instruments in a world where pension portfolios typically
combine volatile equity risk with unattractive term premium risk
from government bonds.
Extended credit sectors
tend to offer very strong
risk-adjusted returns,
and make good total
return instruments.
Average Default and Average Recovery Rates:
1% and 40% are fair long-term rules of thumb
BB Mean Average Annual Default Rate 1920-2010
1.1%
BB 5-year Cumulative Average Recovery Rate 1982-2010
40.8%
Source: Moody’s Investors Service’s 2011 study, ‘Corporate Default and Recovery Rates, 19202010’. Note: Moody’s use the designation Ba as their equivalent rating to S&P Global Ratings’
BB grade. Average Default statistic is Moody’s Annual Issuer-weighted corporate default rate
for their Ba rated survey group over the whole period 1920-2010. Recovery statistic is for
Moody’s Average Senior Unsecured Ba survey group over the period 1982-2010. This shows
the percentage of assets that investors recovered over time from bonds in default. Moody’s do
not provide this statistic for the whole period 1920-2010.
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Therefore, it is not surprising that the most common element of all
the next generation fixed income strategies, and indeed even
broad multi-asset funds, is the inclusion of credit risk premia.
Yet while credit may provide a significant portion of your
return needs and be able to deliver it with some certainty, it
has some properties that make it difficult for some investors
to hold. In particular, on a mark-to-market basis credit can
suffer tail risks with sharp drawdowns, and be fairly sensitive
to market events.
High Yield Drawdown Comparison
0%
-5%
-10%
-15%
-20%
-25%
-30%
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
-35%
BofA Merrill Lynch US High Yield Index
Source: Bank of America Merrill Lynch High Yield Index. Historical data from Dec 1999 to May
2015.
Credit asset classes are
Drawdowns illustrate the extent of each fall from the previous highest closing value.
going to be pulled to par as
they approach maturity
Furthermore, short term correlations to equity markets can be
high, which means on a mark-to-market basis your portfolio
return drivers can dip at the same time.
Given that we can see that the return of a credit portfolio over a
given horizon has a reasonable relationship to the initial yield, we
know that this drawdown risk and equity sensitivity is, in many
cases, a temporary phenomenon. In other words, credit asset
classes are going to be pulled to par as they approach maturity
unless they actually suffer a default; which makes this risk more
about the investors’ ability to stomach the journey than whether
they will arrive safely. Nonetheless, not all investors have the luxury
of waiting out a drawdown.
unless they actually suffer a
default; the risk is more
about the investors’ ability to
stomach the journey than
whether they will arrive
safely.
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Russell Investments view of outcomeorientated fixed Income strategies
Thus investors can choose to focus on harvesting as much of the
credit risk premium as possible and allow the maturity profile of
the asset class to manage their risk, or they can seek to focus on
mitigating the drawdown by targeting their exposure in credit
and diversifying the drawdown risk with targeted alpha
strategies. These two strategies equate to multi-asset credit and
unconstrained fixed income.
We believe multi-asset credit strategies are typically capable of
delivering up to 4% in excess of LIBOR over a five-year period,
and seek to capture credit exposure through all the primary credit
instruments; HY bonds, loans, mortgages and emerging market
debt. These asset classes cover the three main credit balance
sheets: the corporate balance sheet, the individual balance sheet
and the sovereign balance sheet. This is important as each
balance sheet goes through its individual cycles. Volatility for this
strategy is meaningfully lower than equity volatility but is still
prone to bursts of volatility.
In Russell Investments’ own unconstrained fixed income strategy,
we use a focused credit book targeted on the best risk adjusted
points of the credit market to reap the benefits of the credit risk
premium. We combine this core exposure with diversifying
strategies to mitigate the volatility and potential drawdowns, and
with higher-risk actively managed bond strategies that we include
opportunistically to enhance returns during favourable points in
the credit cycle. There is a return cost to smoothing the return
stream in this way, but we expect our unconstrained strategy can
deliver LIBOR +3% over a three-year horizon. Our strategy
focuses on higher-quality HY bonds with shorter durations to do
the heavy lifting in generating returns. These are complemented
by dynamic management of cash levels and by targeted alpha
strategies that offer strong diversification properties versus credit.
We believe multi-asset
credit strategies are
typically capable of
delivering up to 4% in
excess of LIBOR over a
five-year period; we expect
our unconstrained strategy
can deliver LIBOR +3%
over a three-year horizon.
Russell Investments’ two alternative approaches
to filling the credit deficit
UNCONSTRAINED
BOND FUND
MAC
Target exposure to
credit risk premium –
Yield Engine
3 year horizon
Comprehensive exposure
to credit risk premium to
maximize return
5 year horizon
Utilize broad range of
diversifiers and cash to
manage drawdown risk
Opportunistic trades
as opportunity arises
Periodic drawdown risk
as generally fully
exposed to credit
Fully exposed
continuously
Source: For illustrative purposes only.
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For more information: call your usual Russell Investments contact or email
[email protected]
IMPORTANT INFORMATION
For professional clients only
All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that
of Russell Investments, is not a statement of fact, is subject to change and does not constitute advice.
The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally
invested. Any past performance figures are not necessarily a guide to future performance.
Issued by Russell Investments Implementation Services Limited. Company No. 3049880. Registered in Englan d and Wales with registered
office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone 020 7024 6000. Authorised and regulated by the Financial
Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS. Russell Investments Implementation Services Limited is
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UKI-2016-08-19-0624
EMEA 0881. First used June 2016.
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