While this paradigm shift has been occurring in the fixed income markets over the course of the past several years, it has recently accelerated in the aftermath of the credit crisis. Although the U.S. debt market remains the largest, most liquid debt market in the world, it is at risk for becoming less dominant in the context of the total global debt markets (both emerging and developed). But, not only have global debt markets changed, so too have fixed income investors. Factors such as pension liabilities, cash flows, liquidity, diversification and alternative sources of return generation are driving new asset allocation modeling. As the landscape of fixed income investing has changed, re-examining the deployment of fixed income allocations is essential in ensuring investors keep pace with the changing paradigm. We believe that benchmark constrained portfolios are faced with several challenges that may be mitigated by allowing a manager the flexibility to invest freely across the fixed income markets:
• First, benchmark constrained portfolios generally have significant sensitivity to changes in interest rates due to the duration of the index. Performing closely in line with a market index will likely hold little attraction if and when interest rates begin to rise.
• Secondly, issuer concentration has reduced the diversification within the aggregate index. In market weighted indices, exposure to individual issuers grows as they increase their issuance of debt. In the case of the aggregate index, the U.S. government has, over time, become an increasingly larger component; first due to increased issuance to fund the federal deficit and second due to effective ownership of Fannie Mae and Freddie Mac. In contrast, the opportunity set in emerging economies is becoming more diverse.
• Lastly, as a global, active, fixed income manager, we believe opportunities exist across the full range of fixed income markets many of which are not represented by standard U.S. benchmarked fixed income products. Active, global investing offers investors a much larger universe of countries, sectors and issuers from which to generate returns and to improve diversification.
In an environment of modest growth, limited signs of inflation and a potentially extended period of de-leveraging, investors are increasingly challenged to find attractive returns. We believe those who adopt a more flexible “multi-sector” approach to investing will be rewarded with greater returns than those who adhere to traditional aggregate benchmark allocations.
High Sensitivity to Changes in Interest Rates
After falling steadily for nearly 30 years, interest rates sit at historically low levels. While it is possible that they could drift lower, the next, longer-term move in rates is most likely higher. When interest rates rise, bond prices decline. When the absolute level of interest rates is high it provides a cushion against this price decline. However, when yields are as low as they are today and rates begin to rise, there is less of a cushion leaving investors at risk for losing money. From September to December, the yield on the 5-year Treasury yield rose 63 basis points from 1.65% to 2.28%. With a similar duration as the Aggregate index, more than a full year’s yield on this bond was erased in three months.
Market Environment May Warrant Deviation from Benchmark Positions
In the aftermath of the credit crisis, debt issuance by developed market governments has skyrocketed leaving many index oriented portfolios highly concentrated in government debt. For example, in the U.S., the combination of an increase in Treasury issuance and ongoing government intervention (through QE2 and nationalizing the GSEs) has resulted in a high concentration of U.S. Treasury bonds in the Barclays Aggregate Index.
In contrast, the opportunity set available outside the confines of a U.S. aggregate index has grown. As the aggregate index gets more concentrated and other, global markets continue to grow, fixed income portfolios benchmarked to an aggregate index may not be as diversified as once thought. When looking at the emerging markets, approximately 84% of the broad market is also government or government related securities.
Although on the surface it appears even more concentrated than the U.S. Treasury portion of the U.S. aggregate index, more than 42 different countries from four different regions compose the sovereign debt available in the emerging market debt universe. Exposure to any one country is limited, providing the benefit of diversification; what happens in one country would not necessarily dominate returns. It also provides diversification from any single economy, i.e., the United States.