Fortify your
bond portfolio
FOR PROFESSIONAL
INVESTORS ONLY
Fixed income vitamins in a low interest
rate environment
by STEFAN MESCHENMOSER AND DAVID GIBBON
T
he current market environment
is providing bond investors with
a cold headwind: nominal and real
interest rates are low or even
negative in many countries, while
Treasury bonds, traditionally
regarded as the ultimate ‘safe’
investment, are now subject to
credit concerns – so much so, in
fact, that some people now joke that
Treasuries no longer provide riskfree returns but return-free risk.
Achieving the two main traditional
objectives associated with bonds,
risk reduction and return
generation, has undoubtedly
become more difficult. So how can
bond investors inject some energy
into their portfolios?
The answer to this question will
depend largely on whether the
investor is focused on relative or
absolute returns. Relative return
investors typically have longduration liabilities. For them, risk
reduction means holding a portfolio
of matching assets that mitigates
the duration gap (ie risk due to
changes in the interest rate). An
optimal portfolio for relative return
investors will usually comprise a
strategic allocation to government
bonds, with additional returns
generated by deviating
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Currents June 2012
opportunistically from this
strategic weight.
Absolute return investors, by
contrast, might not require a
strategic weight in bonds at all. For
them, cash or even gold may be the
safe haven asset class. Positions
in fixed income assets are taken
opportunistically, when valuations
are attractive. Their portfolios
might be much more diversified
across various sub-categories of
fixed income investments
and less concentrated in
long-duration Treasuries.
Stefan Meschenmoser
BlackRock MultiAsset Client Solutions
(BMACS) Group
Boosting a relative return
portfolio
Government bonds typically entail
only two major risk factors: term risk,
the compensation for postponing
consumption by lending one’s
capital; and inflation risk, the
compensation for bearing the risk
that the purchasing power of one’s
capital will have declined when
returned at maturity. The shape (ie
risk and return characteristics) of a
bond portfolio might be enhanced by
adding a number of ‘vitamins’. These
could include: vitamin C (corporate
bonds, which adds credit risk to the
portfolio); vitamin H (high yield
bonds, which adds a dose of
Currents
June 2012 issue
illiquidity risk); and vitamin E
`` Assess the appropriate risk
(emerging market debt, adding
premium for different risk assets.
some political or macro risk to
Research into the aggregate
the portfolio).
financial health of corporate
borrowers, the macroeconomic
For bearing these risk factors,
investors typically ask for
compensation via higher yields.
Diversifying a bond portfolio within
its asset class might provide higher
returns; however, for these
potentially higher returns, investors
must give up some of the safe-haven
outlook, the demand for products
at different phases of the cycle,
and the availability and cost of
funding in markets: these all
inform a view of the right time to
be invested in specific sectors in
a tactical asset
allocation context.
attributes typically associated
with Treasuries.
High yield corporates and emerging
market debt were discussed
extensively in the January issue of
Currents (Loosening the Bonds,
January 2012 Currents, pages
26-30), so let’s consider the choices
facing investors who are free to
incorporate absolute return
strategies. There are various facets
of active management (which we
may call vitamin A), which could be
`` C
hoose the issuers and securities
to best express those asset class
views based on a combination of
factors. These include: deep
examination of individual
company fundamentals, an
analysis of the specific covenants
or investor protections in a
particular bond, quantitative
assessment of valuation or
market sentiment regarding an
issuer, or some combination
of these.
employed to enhance the risk
reduction and return generation
attributed to a bond portfolio (see
panel on the right).
Taking opportunistic advantage of
attractively priced sub-asset classes
and individual securities in the fixed
income universe can help to enhance
returns. However, translating
opportunities into returns requires
skill, experience and insight. In
particular, the manager will need to
be able to:
2
Currents June 2012
The appropriate techniques for going
active on this part of a portfolio will
depend on clients’ individual risk
objectives and investment
constraints. A traditional active
approach, for example, would have
an active opportunity set that is
largely defined by the benchmark
– namely, an active high yield
portfolio would generate the large
majority of its alpha over its
benchmark from high yield bond
selection aiming to identify attractive
sectors and issuers.
Active management
approaches to
boosting a bond
portfolio
}
Tactical asset allocation (TAA).
The bond asset class is broad
and diverse, and a range of
different risk factors can impact
the prices of sub-asset classes.
As such, the premia to which
investors are exposed tend to
vary over time. By dynamically
changing the allocations to these
sub-asset classes, a skilled
manager can enhance the return
or reduce the risk of a portfolio.
} Benchmark strategies.
Standard bond market
benchmarks are not always ideal
because large issuers of debt
tend to get larger weights than
more prudent issuers, which can
cause a performance drag. By
using alternative weighting
schemes, such as fundamental
or credit-rating-based indices,
the issuer concentration of
standard benchmarks can be
improved. Investors may also
wish to apply screening
techniques to the benchmark.
The objective of these screens
can either be to reduce the
weight of bad issuers within the
benchmark (contributing to risk
reduction) or to enhance returns.
Screening techniques can either
be applied to government or
corporate bonds.
} Active security selection.
Active managers are able to
investigate the attractiveness of
individual securities in the
benchmark and construct
portfolios that express views on
these titles. If the managers are
skilled, an investor can earn a
diversifying excess return in
addition to the return of the broad
bond market. Active managers
can also seek to construct
portfolios that mitigate the
impact of bond markets on the
return on the portfolio. In extreme
circumstances, such a portfolio
can be market‑neutral.
Thinking outside the box
Today’s low yield environment is also
characterised by high volatility and
dislocations in the global fixed
income markets. Although this is
generally bad news for a long-only
investor, it creates opportunities for
investors who are willing to think and
invest outside their traditional fixed
income instrument set. The ability to
select the best issuers and securities
across the corporate and sovereign
universe is a very useful skill, but it
still leaves traditional investors
vulnerable to shocks due to
the directional nature of
long-only investing.
But if the skill of choosing and buying
attractively priced assets is
combined with the skill of identifying
and selling unattractively priced
assets, fixed income investors can
create less directional, marketneutral returns. As a result, they can
achieve a superior position on the
risk/return spectrum. This effect is
amplified if the investor is able to
screen the global rates and credit
markets for opportunities globally.
Clearly, not all fixed income investors
have the skills or experience to
enhance their risk/return position in
this way. For such investors,
allocating to hedge fund managers
3
Currents June 2012
who do have these attributes is often
a preferred option. The highly
challenging market environment in
the last few years provided the
toughest of tests for hedge fund
managers, and those who
successfully weathered the storm
can be seen as efficient all-weather
additions to a fixed income portfolio.
Investors in fixed income hedge
funds need to determine how to
incorporate their hedge fund
exposure within their overall fixed
income allocation. This can be
achieved by using derivatives to
replicate the market exposure of
parts of their fixed income
benchmark synthetically (such as
government bond futures for a global
treasury index, credit default swaps
or total return swaps for corporate
indices), which can free up cash to be
invested in a hedge fund.
Alternatively, a security lending
programme can be applied to an
indexed portfolio to efficiently raise
cash for investment in a hedge fund.
Both methods allow investors to
maintain their chosen beta exposure
while adding significant
alpha potential.
These are just a few of the options.
Adding active management, credit,
high yield and emerging market debt
David Gibbon
BlackRock’s ModelBased Fixed Income
Portfolio
Management Group
or fixed income hedge funds can help
to diversify a portfolio in a way that
enables it to weather the current
cold headwinds of bond markets
more effectively. In addition to
boosting a bond portfolio with
vitamins, investors could also think
outside the box and consider more
exotic bond exposures, such as
insurance-linked securities or
mezzanine real estate debt.
Furthermore, non-bond assets that
are related to bonds, such as equity
income strategies or infrastructure
assets, could further boost a bond
portfolio’s resistance against
weather conditions even worse than
those at present – however, the
relatively illiquid nature of these
assets would have to be considered
before any such investment
was made. 
“In addition to boosting a
bond portfolio with
vitamins, investors could
also think outside the box
and consider insurancelinked securities or
mezzanine real
estate debt.”
Vitamin A: Active/dynamic asset allocation
Active management to improve risk and return characteristic
4
Risk reduction
Return generation
Screening techniques
Screening techniques
Non-market-capitalisation-based indices
Dynamic intra-asset class allocation
Rating- rather than category-based universes
Long-only title selection alpha
Tailored benchmarks, eg ex-Japan
Hedge fund techniques
Derivative overlays
Macroeconomic trades
Market-neutral hedge fund
Relative value trades
Currents June 2012
Currents
Published by BlackRock, Inc.
Please direct story ideas,
comments and questions to:
Nicholas Loney
Telephone +44 (0)20 7743 1895
Facsimile +44 (0)20 7743 1000
[email protected]
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