F I X ED INCOME
The World Is Our
Oyster
June 2013
ManulifeAM.com
The World Is Our Oyster
The World Is Our Oyster
With yields at historical lows and spreads fairly valued in many sectors, plan sponsors are
facing a challenging fixed income market characterized by lower return expectations and
increasing risk for rising interest rates. In addition, they continue to struggle with several
issues related to their investment assets and corresponding funding levels. For example,
funding ratios for defined benefit plans have failed to improve despite the market’s
recovery since 2008, as lower interest rates have inflated liabilities. Given the low yield
environment, plan sponsors are reviewing fixed income allocations for opportunities to
increase their return potential and find protection should interest rates rise, all while
maintaining an adequate liquidity profile. In many instances, plans have chosen to shift
a portion of their fixed income assets away from core domestic strategies, opening the
opportunity set to include global bonds, lower quality high yield securities, emerging
markets debt and capital structure opportunities — all tools a manager of a Global MultiSector strategy can take advantage of.
Given the strong demand for increasing the return potential of a plan’s fixed income allocation, Dan Janis and
Tom Goggins, portfolio managers on the Manulife Asset Management Global Multi-Sector team, discuss their
investment philosophy, how they approach global fixed income markets and their current outlook below.
Strategic Fixed Income Strategy
Question: Let’s begin with a quick overview of the Strategic Fixed Income
strategy, particularly your philosophy towards global bond investing.
Dan Janis: We have the ability to seek out the best investment opportunities around the globe and the
flexibility to invest in a variety of sectors, across credit qualities and up and down the capital structure — we
like to say, ”the world is our oyster.” Just as important, since we are not tied to a specific benchmark, we
often can avoid the riskiest parts of the fixed income markets, which a benchmark-centric strategy may be
required to invest in. By expanding the opportunity set to a global perspective, including multiple sectors as
well as currency exposures, we believe we increase our potential to add value while reducing risk.
I also think our philosophy towards implementation differentiates us from other providers in the global
multi-sector space. This is a very complex strategy, from the breadth of the opportunity set at hand to the
multiple risks we must manage. However, we try to keep things simple and be as transparent as possible from
an implementation perspective so that investors can fully understand what we do and how their assets are
invested. What does that mean? Our portfolios are primarily comprised of physical bonds, limiting the use
of derivatives to manage interest rate and currency exposures. We do not use credit default swaps or other
over-the-counter swaps, nor have we invested in exotic structures like CDOs, CLOs or sub-prime mortgages in
the strategy (even though these are permissible investments). The strategy does not utilize financial leverage. I
believe this gives our clients an additional level of comfort when investing in global bond markets.
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Question: With such a broad opportunity set at your disposal, tell me
about the portfolio management team and your perspective on how the
team works together to source investment ideas.
Tom Goggins: Let’s start with two key points on the portfolio manager team for the strategy. 1) Experience.
The team averages over 25 years of experience in financial markets, having seen multiple market cycles and
witnessed firsthand the development of the markets in which we invest, such as high yield and emerging
markets. Lead portfolio manager Dan Janis has been on the strategy since 1999, providing a consistent
management style to the strategy for almost 15 years. 2) Complementary skillset. Each of the portfolio
managers brings a unique skillset to the table, from global bonds and currencies to credit research, asset
allocation strategies and risk management. For example, Kisoo Park, who specializes in global bonds and
currencies, is located in Hong Kong, which gives us a unique vantage point when it comes to various markets
in Asia.
When it comes to sourcing investment ideas, the firm’s
culture facilitates communication and collaboration
amongst portfolio managers (across all of the firm’s
strategies), credit research analysts and traders — within
local market investment teams as well as on a global basis.
We have regular daily and weekly forums that facilitate
communication across the globe and give us firsthand
knowledge of the markets we invest in. Having a global
footprint is one thing, but executing on it is what drives
performance for our clients.
When it comes to sourcing
investment ideas, the firm’s culture
facilitates communication and
collaboration amongst portfolio
managers, credit research analysts
and traders — within local market
investment teams as well as on a
global basis.
Question: In your view, why has demand for this type of strategy
increased?
Dan Janis: Two reasons come to my mind immediately, one investor-related and one market-related.
From an investor or plan sponsor’s perspective, the low yield environment in the US is essentially forcing
investors to look for alternative fixed income strategies that have the potential to deliver higher returns while
simultaneously offering protection once domestic rates start to rise. The logical first step is to diversify away
from domestic markets, something that has been done on the equity side, but to a lesser extent within a
plan’s fixed income allocation.
From a market perspective, I believe the changing dynamics of the fixed income marketplace is a factor. As
a result of a reduction in liquidity, post financial crisis, fixed income markets are moving faster than ever.
This translates into higher volatility. However, in my opinion, it also means more opportunity. Managers who
have proven, long-term skill in global fixed income markets can strategically adjust fixed income portfolios as
markets move, but more importantly have the flexibility to take advantage of short-term dislocations.
Our dynamic sector allocation approach is a key part of the strategy’s investment process that investors are
attracted to. It gives plans the ability to be more nimble inside parts of their asset allocation and to take
advantage of market opportunities without having to go through the lengthy process of board approvals,
RFPs and manager searches. An illustrative example is when high yield spreads peaked in the fourth quarter
of 2008 at close to 2,000 basis points over Treasuries. In just six months, spreads had been cut in half to just
Because the financial market is influenced by a variety of changing conditions, past performance in not a guarantee of future results..
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1,000 basis points. This was an opportunity that we were able to successfully take advantage of, but may
have been missed if investors were not quick to react.1
Question: Since the strategy itself is not tied to a benchmark, how should
investors view risk?
Tom Goggins: We consider ourselves risk managers first, bond
managers second. Since we are not tied to a benchmark, our focus
is on overall volatility, or absolute risk, of the strategy rather than
exposure or tracking error versus a market benchmark. While we
monitor and understand the portfolio’s risk versus broad market
benchmarks, it is not the primary factor in making investment
decisions.
We consider ourselves
risk managers first, bond
managers second.
We have historically been successful in reducing volatility by having guidelines that ensure adequate
diversification at the portfolio level as well as the individual security level.2 Our goal is to deliver strong fixed
income returns while maintaining overall volatility consistent with fixed income instruments. Net returns have
historically fallen between 8–9% for most annualized periods with volatility of approximately 6–7%.3 Some
may say these are actually equity-like returns with fixed income volatility — which ties into the earlier point
Dan made regarding the factors that are driving demand for this type of strategy.
In reviewing the portfolio as a whole, we invest across three main buckets: US Treasuries and mortgages,
developed market credit (including high yield) and foreign bonds (including emerging markets). These buckets
have historically had low correlations to each other, and as a result, have served to keep the overall volatility
of the strategy down. The strategy must also maintain an average investment grade quality, which ensures a
balance between core high quality issuers and “higher risk” places, like emerging markets and higher yield.
At the individual security level, for every security that goes into the portfolio, we review four main risks: 1)
credit risk: the risk that we may not receive interest payments and principal at maturity, 2) interest rate risk:
the risk that changing yields will impact our portfolio valuation, 3) foreign currency risk: the risk that a bond’s
currency denomination will depreciate versus the portfolio’s base currency, and 4) liquidity risk: the cost to exit
a position or the risk that a security will not be able to be sold at a reasonable valuation in times of stress. To
manage issuer risk, we typically maintain diversification at the industry level and limit our below investment
grade corporate issuer exposure to 0.5% to 1.5%.4
Market Outlook
Question: What is your view on the Federal Reserve and when do you
expect they will start to raise rates and end quantitative easing?
Tom Goggins: The Federal Reserve has been very transparent in setting monetary policy; to date, they have
communicated that short-term rates will remain low until unemployment falls to 6.5%, so long as inflation
remains tame (2.5% or less), and they will continue their quantitative easing program for the near future. The
team’s expectations are the Federal Reserve may begin to raise rates at the end of 2014, possibly not until
2015. Quantitative easing will most likely continue through the end of 2013 and the first part of next year.
Because the financial market is influenced by a variety of changing conditions, past performance in not a guarantee of future results.
Volatility is measured as annualized standard deviation.
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Portfolio characteristics and guidelines may change from time to time and may differ for a specific account.
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We are watching for 3 key changes in the Federal Reserve’s statements that could be a catalyst for higher
interest rates. Today’s rhetoric is typified by “improving” conditions in employment and housing. However,
we believe a transition to stronger language such as 1) a self-stabilizing housing market or sustained housing
recovery, 2) self-stabilizing employment markets and/or 3) headwinds of Europe abating, would indicate a
higher Fed confidence with the economic outlook and possible reduction in stimulus.
As the market becomes unsure of current policy and we move closer to the end of Bernanke’s term next
January, the yield curve may steepen and fixed income markets, particularly governments and mortgages,
may be vulnerable in that environment.
Question: The situation in Europe seems to be on all investors’ minds and
has been the main factor in the “risk on/risk off” markets over the past
2–3 years. Where do we go from here and how have you dealt with it in
the portfolio?
Dan Janis: We continue to closely watch the developments in the euro zone as its resolution has an impact
on not only the euro zone economic outlook and future of the euro currency, but also to the global
macroeconomic picture. The situation in Europe can be broken into two parts — a banking crisis and a
sovereign debt crisis. While we believe we are on a “path to a solution” in the euro zone, it could ultimately
take 2–3 years or longer to play out.
To help alleviate the banking crisis, the ECB’s LTRO (long-term refinancing operation) has essentially
backstopped the banks, averting, in the short-term, a liquidity crisis. Similar to the programs instituted in the
US in ‘08/’09, such as the TARP and TALF, the LTRO combined with the establishment of the temporary EFSF
(European Financial Stability Facility) and permanent ESM (European Stability Mechanism) have limited the
downside risks over the past year and are helping to improve liquidity and relieve some of the pressure on
banks.
With regards to the sovereign debt crisis, we are closely watching the political environment. Austerity in
the UK, structural reforms in France and political uncertainty in Italy have all weakened growth prospects
for the region. We believe the general elections in Germany this September hold significant importance in
regards to shaping future policy for the euro zone, given the central role Merkel has played throughout the
crisis. Recent polling has showed the most likely outcome to be a favorable one for the region, resulting in a
‘Grand Coalition’ between Merkel’s CDU/CSU and the Social Democratic Party. This combination should not
produce material changes to the current handling of the crisis, and one that we view as essential to provide
leadership with a stronger resolve to come to a final solution to the debt crisis and for further stability in the
region. Until the elections are settled, we likely will not see significant changes to policy and anticipate further
downward revisions to GDP in the coming months.
Lastly, how have we dealt with this from an investment perspective? As I noted earlier, a very important part
of the strategy is not only what we choose to invest in, but also what we can avoid. And we have avoided
peripheral European government issuers since late in 2008 (with the exception of a tactical position in Ireland
late in 2012). It isn’t that we predicted the severity of the situation, but rather, we did not feel we were
compensated for the risk inherent in these issuers. Historically, those countries that over-extended from a
debt perspective could devalue their currency to help reduce the debt burden. However, in the case of the
euro, this was no longer an option. So where does the pressure build? On the bond spread. And this is what
we have witnessed in many of the peripheral European countries.
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At some point will there be opportunities in Europe? Yes, we have been tactical in places like Ireland,
but from a long-term, strategic perspective, we are not comfortable with the situation today. We see
questionable growth looking forward as banks, consumers and governments all look to deleverage at the
same time. It’s hard to envision substantial growth under these circumstances, and while we remain ready
to take advantage of market dislocations when presented with such, we believe there are better risk-reward
opportunities elsewhere.
Question: What is your stance on the US Economy?
Tom Goggins: We believe that the risk of a double dip in the US is low. Most likely the US will continue along
a path of slow, sustainable growth, with the potential for the US to decouple from the rest of the developed
world and surprise to the upside.
We are closely watching the jobs situation and witnessing improving trends as the weekly jobless claims
number trends downward and non-farm payrolls trends upward. We’d like to see a consistent period of
weekly initial claims below 350,000, coupled with non-farm payrolls consistently averaging above 200K
over the coming months and quarters (fully understanding the accompanying volatility of the monthly nonfarm payrolls). Job creation and a subsequent lower unemployment rate is a key driver that feeds economic
output in the form of increased consumer spending, higher demand for housing, improved consumer
creditworthiness, higher tax revenues and business investment.
Very briefly, on the housing front we do not believe a rebound in housing is a prerequisite for growth, it just
has to stop declining. Although the most recent data looks to support the notion that the market has begun
to turn a corner, we will continue to monitor any new developments. On manufacturing, we are watching
trends in the ISM, and the composite indices of new orders, production, employment, supplier deliveries and
inventories. Expansion in commercial and industrial (C&I) loans data is supportive of business investment and
economic growth.
While plenty of risks still exist, such as continued household deleveraging, contagion from Europe and the
price of oil, we expect US growth ranging between 2–3% in 2013, and are cautiously optimistic that it may
surprise to the upside.
Question: Your allocation to emerging markets debt has been growing
steadily over the past two and a half years. What has been the catalyst
behind that?
Dan Janis: As spreads in high yield hit historical wides in 2008, we increased our exposure to take
advantage of those opportunities. Fast forward to the beginning of 2010 and high yield spreads had
started to normalize as the global economy continued to gain steam. As we searched the globe for the next
opportunity, emerging markets debt offered competitive yields, opportunity for currency appreciation and
diversification.
We believe emerging
markets will perform well as
those economies continue to
outperform global averages.
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We believe emerging markets will perform well as those economies
continue to outperform global averages. The largest component
of our emerging markets allocation is currently in Asia ex-Japan.
On-going structural change to the Asian markets will present
investment opportunities over the next 5–10 years as countries
transform their economies from export driven to consumer driven.
The World Is Our Oyster
As the middle class grows, there will be continued infrastructure improvements and business investment that
will need to be financed. This will require the development of bond markets in this region, both in corporate
issuance and local currency issuance. We believe this will create investment opportunities going forward.
In some cases, I think emerging markets investing still carries a stigma of higher than average risk and
instability. But what is overlooked is that many of these countries are rated investment grade. In fact, of the
J.P. Morgan EMBI Index, approximately 60% as of March 31, 2013, of the exposure is rated BBB- or above.
Brazil and Indonesia are prime examples of countries that have experienced ratings upgrades for developing
their bond markets and liquidity, taking steps to contain budget deficits and bolster growth, and stabilizing
the political environment. We like these situations, which may carry a higher yield, when compared to
developed market counterparts that are experiencing downgrades due to large debt loads, low growth
expectations and/or unstable political environments.
Question: Economic growth expectations for China are being ratcheted
lower and worries of a housing bubble seem well founded. Does China
experience a hard landing?
Dan Janis: Recent data from China has raised investor concerns over the sustainability of that nation’s
growth and the potential global impacts from a slowdown there. Industrial production, retail sales, and
exports numbers were reported weaker than market expectations, and the government announced a target
growth rate for 2013 of 7.5% — unchanged from 2012 and the lowest since 2008’s 6.8% rate. However,
this gradual slowdown in the rate of growth is in line with our expectations and constitutes a downward
adjustment to a more sustainable long-term pace. It’s also important to note the base effects being seen here;
that each year’s growth is on a larger base amount so that it takes a smaller percentage change to generate
similar levels of new absolute economic activity. Ultimately the economy is still in fact growing, and a 7.5%
rate would continue to be powerful to the region.
We don’t believe China will experience a hard landing. Even if a cooling housing market in China leads
to bank losses and write-downs, China’s largest banks are state owned and if needed, the government
can provide the necessary funds to keep banks solvent. China has staggering amounts of savings and
foreign reserves and a stable political system, which will enable it to weather a few storms. In the end, the
government has many levers it can pull to manage growth, including cuts in the interest rate and required
reserve ratio for banks and controlling the path taken by the exchange rate.
From an investment perspective, our expectation is that the yuan will continue to appreciate over the
coming years (5–7 years) although at a lesser pace and with more volatility. The offshore yuan fixed income
market trading in Hong Kong, or Dim Sum Bond market as it has become known, continues to expand. We
anticipate attractive investment opportunities as more global firms issue yuan denominated bonds, since it is
cheaper than the loan market within China.
Question: In reviewing the current positioning of the portfolio, US High
Yield is a core component of the allocation — at what point do you
believe US High Yield becomes fully valued?
Tom Goggins: We successfully took advantage of the recovery in high yield that began in 2009 and continue
to maintain a core position there. Current valuations and financial positioning of issuers lead us to believe
high yield will continue to perform well.5
Past performance in not a guarantee of future results.
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From a valuation perspective we feel that with high yield spreads less than 500 bps over treasuries, the
sector as a whole is fairly valued. As a result, we have continued to cut our exposure to CCC companies in
favor of bank loans, which are typically slightly higher quality, increases our position in the capital structure
and are floating rate instruments (which should provide some protection in a rising rate environment). From
an issuer perspective, we like high yield for the following reasons: default rates are currently less than 2%,
which we believe can stay in the 2–4% range for the next two years; strong balance sheets exist due to the
deleveraging and cost cutting measures that took place as a result of the 2008 financial crisis; companies
have record levels of cash; and maturities have been pushed out with historically low financing rates.
At what point do we believe high yield has run its course? We’re
watching the market for changes in our investment thesis to
adjust our current allocation. Examples of what might trigger
a change include the following: spreads move below longterm averages to historical tights; covenants of high yield bond
issuance deteriorate, so called covenant-lite deals; unattractive
use of proceeds from new issuance — special dividends or to
payoff equity sponsors; and lastly, if we were to see an uptick in
the default rate.
Overall, we find corporate issuers attractive when compared to
developed market governments around the world, those that
have over-extended with debt and are struggling to raise taxes
and cut costs in a weak economic environment.
Overall, we find corporate
issuers attractive when
compared to developed
market governments around
the world, those that have
over-extended with debt
and are struggling to raise
taxes and cut costs in a weak
economic environment.
Question: As you noted earlier in our discussion, one of the risks that
accompanies global bond investing is foreign currency risk. How do you
manage this risk in your portfolio?
Dan Janis: Managing currency risk in a global bond portfolio should not be overlooked. Overall volatility of
an unhedged global bond portfolio can be twice as high when compared to the same fully hedged portfolio.
However, by embracing currency risk in a global bond portfolio and actively managing that risk, investors can
increase the return potential and diversification of their fixed income allocation. Within the Strategic Fixed
Income strategy, currency decisions are based on a long-term strategic basis, short-term tactical basis and for
managing tail risk events.
Strategic currency positions, generally implemented through bonds denominated in local currencies, are put
in place where we believe there is potential for long-term appreciation of currencies. These trends can last
upwards of 5 to 7 years.
Tactical positions, generally implemented though currency forwards and options, are executed to take
advantage of short-term dislocations. These types of positions are generally based on 3 to 6 month views but
can be as short as a few weeks or less depending on the volatility of markets. Currency risk is hedged back to
base currency or cross-hedged to a different currency which has the potential for appreciation.
To manage tail risk, we use liquid foreign exchange markets as proxy hedges for parts of our underlying
bond portfolio in times of market volatility and distress. An example of this occurred in 2008. Our goal was
to hedge against weakness in the high yield sector and observed that the correlation between Japanese yen
strength and high yield spread weakness was very high. We chose to buy options — Japanese yen calls that
are very liquid — as a proxy hedge for our high yield exposure rather than enter into credit default swaps
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where counterparty risk was a major concern, as was liquidity. This is an excellent example of how we use
currency management differently from our competitors.
Our current positions from a currency perspective are as follows: We believe non-Japan Asian markets offer
the most attractive opportunities, and we have strategically taken a position in these currencies though local
currency bonds. From a tactical position, commodity-related currencies, including the Australia, New Zealand
and Canadian dollars, have tended to trade as a proxy for risk over the past three years, and therefore we
have been tactically hedging and unhedging these exposures as market opportunities present themselves.
Lastly, we believe the developed currencies such as the British pound, euro and the Japanese yen will
underperform and currently do not have exposure to them.
Conclusion
Question: If you had to sum up the factors that differentiate your strategy
or portfolio management style from your competitors, what would they
be?
Dan Janis: We hit a number of those differentiators in this interview, but let me summarize:
Experienced team with a complementary skillset — the Manulife Global Multi-Sector Team averages
over 25 years of experience, each with a unique perspective on global bond markets
Long-term track record in global multi-sector — Manulife Asset Management has been running this type
of strategy since the mid-80’s, and from a portfolio management perspective, I have been on the team since
1999.
Dynamic sector allocation — proven skill in our ability to dynamically allocate the portfolio as market
opportunities present themselves while strategically avoiding the more risky parts of the bond market. In
delivering those returns, we’ve lowered volatility by maintaining a diverse portfolio of low correlated fixed
income sectors.
Physical bond portfolio — we deliver a complex global bond strategy in a transparent fashion, which helps
investors understand our investment process and gives them comfort in how their capital is invested.
Active currency management — we take a unique approach to currency management, which is utilized as
a risk management tool, an alpha driver and for diversification purposes.
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TL.WO.P.062013.AP