2 fixed-income fundies dish up on managing risk and volatility
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A long-held assumption that fixed-income assets are largely risk-free has been turned on its head, meaning investors need to work smarter to help ensure their credit strategies are effective--but how?
Amid sluggish global economic growth, bond yields are tightening in most of Europe, are flat in Japan and widening only slightly in the US and Australia, according to Morningstar.
Conversations with senior fixed-income executives from bond specialists AllianceBernstein (AB) and Nikko Asset Management give some insight into how fund managers, and in turn retail investors, are responding in this environment.
"I think the response for many investors is to say, 'Do I have to accept beta from fixed income being low, or is there some other way I can use fixed income to generate higher returns?'" says James Alexander, Nikkos's head of Australian fixed income.
"That lens is still looking towards unconstrained global fixed-income products ... where we're not really locking someone into the beta, but using fixed-income markets around the world to try and generate alpha (above-benchmark returns)."
Portfolio manager of AB's dynamic global fixed-income fund, John Taylor, says much the same thing: "Our response ... has been to emphasise global, multi-sector fixed-income investment strategies [using] government bonds, corporate bonds, asset-backed bonds, high-yield et cetera which increases the opportunity for attractive investment returns while also helping to mitigate risk."
Benchmark risk is one of these, which Taylor suggests is being driven by increased borrowing by several international governments over the last few years.
"To the extent that their borrowings are reflected in market-weighted bond indices, these benchmarks become more inherently risky too. One way around this is to invest in a way that focuses on absolute returns and essentially ignores benchmarks for portfolio construction purposes," he says.
Another is liquidity risk, which has ramped up as global financial market regulators have tightened capital adequacy requirements for banks and other financial services companies trading bonds on their own balance sheets.
"The additional cost imposed by this heavier regulation has forced a number of these banks to withdraw from the bond market, and this has had an adverse effect on liquidity levels. One way to meet this challenge is through sophisticated trading techniques which can source liquidity more effectively than traditional trading methods," Taylor says.
Both Nikko's Alexander and AB's Taylor agree Australian fixed-income investors also face an added risk in the lack of diversification available in domestic corporate bonds and hybrids.
"When you're looking at the diversification of a non-government corporate bond portfolio for Australians, yes it does make it difficult to have a diversified portfolio," Alexander says.
"If you look at just the corporate bonds of the Australian bond indices, then it's quite clear that financials ... dominate that. If you carve that out as a standalone portfolio, that may not be one you'd want to own because of the concentration risks."
Taylor believes it is "extremely difficult for Australian bond investors to be sufficiently diversified in a home market which represents such a small proportion of global bond markets in capitalisation terms, and which is also heavily concentrated in the finance sector".
He sees a global approach as perhaps the only way for Australian investors to become more diversified.
Alexander agrees that increasing fixed-income exposure to foreign markets "may well be the only way to do it [reduce concentration risk] if you're running a portfolio of any size".
"You'd look to participate in offshore credit markets, where you buy issuances you can't access locally, but can do so in the European or US markets, and use derivatives to hedge out the currency risks," he says.
"But there is ... the other problem in the non-financial space, that the issuance tends to be smaller, so it's more difficult to get them [and a proportionately small secondary market]."
For Australian investors running a smaller fixed-income portfolio, Alexander suggests they may be able to achieve sufficient portfolio diversification while remaining domestically-focused.
Looking ahead, Taylor believes low economic growth and inflation, and a broad mix of monetary policy settings--especially in developed countries--mean bond market volatility will continue in the mid-term.
"We are prepared for this by emphasising a balance across our portfolios between duration (interest-rate exposure) and credit (corporate bonds)," Taylor says.
"These sectors tend to be negatively correlated, so that when one rises the other falls and vice-versa. By maintaining a barbell approach, we seek to limit the impact of volatility on our portfolios."
According to Alexander, Nikko anticipated the US Federal Reserve's September decision to leave official interest rates unchanged, but believes rates will go up once this year "whether in November or December ... our expectation is that on the current path, they're not intending to lift rates before the end of the year".
He says this does have flow-on affects in Australia, "but partly because the Fed hasn't tightened, the RBA has had to take matters into its own hands, in a way, and just ease policy to make sure the economy is supported".
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Glenn Freeman is Morningstar's senior editor.
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