Date: September 2015
Author: Paul Kirby
Institutional investors in Canada generally think locally when it comes to their fixed income portfolios. Unconstraining their approach and looking beyond their borders provide more opportunities to improve outcomes.
While Canadian institutional investors have been steadily diversifying their growth portfolios through greater allocations to foreign equities and alternative investments, the fixed income portion of portfolios often remains managed on a fairly conservative basis. For some, this conservative approach results from a deliberate matching to liabilities. However, for others, it is still often the case that the fixed income portion of their portfolio is highly weighted towards Canadian government bonds and in many cases matching the FTSE TMX Universe Bond Index. This approach has worked well when compared with global market benchmarks such as the Barclays Global Aggregate Index over the last decade or so. But is this the right approach to take for Canadian institutional bond investors going forward?
More recently, institutional investors are looking at opportunistic or strategic fixed income investments outside the benchmark to improve their risk/return profile. Investments such as U.S. bonds, global sovereign debt, high yield bonds, and emerging market debt are early examples of Canadian institutional investors adopting aspects of global fixed income within their overall portfolios. This diversification can serve as an important feature, particularly today when diverging global monetary policies see Canada potentially poised to follow the U.S. in a rate hiking cycle while Europe and Japan are still easing. However, it is typically being done in a constrained approach where only a portion of the fixed income portfolio is being dedicated to these types of investments.There are merits in broadening the flexibility of fixed income investments to take a holistic global approach.
Canadian (as well as U.S.) interest rates today remain at all time lows. Both the Bank of Canada and the U.S. Federal Reserve’s monetary policies have been accommodative for quite some time. As the cycle moves towards a tightening bias and policy rates begin to rise, this will have a negative effect on fixed income market values in the U.S. and Canada. Exposure to international rate markets may benefit portfolios particularly if the outlook for the local bond market is weak. As a result, having flexibility to deploy capital outside of these markets can insulate, to a degree, institutional investors from the risk of rising rates at home.
For the time being, however, low inflation and economic growth has left government bond yields on a persistent decline to historically low levels. For example, long-term (10 year) Government of Canada bond yields reached 1.2 per cent earlier in 2015, a level not seen before. Rates have recovered somewhat since, but are still below what may be considered ‘normal.’
"For example, long-term (10 year) Government of Canada bond yields reached 1.2 per cent earlier in 2015, a level not seen before. Rates have recovered somewhat since, but are still below what may be considered ‘normal."
Global bond portfolios offer diversification away from and a potential defense against a low and rising home interest rate environment. Many of the global sovereign and investment grade corporate debt markets, for example, have grown significantly in scale and represent a high-quality investment opportunity not available to home biased mandates. The ability to adjust market exposures on relative value and/or market outlook represents an extra active management tool available to the bond manager, as does the decision to hedge or not hedge foreign currency exposure.
This brings to light an implementation aspect of global bond investing known as ‘unconstrained’ fixed income.
Unconstrained Fixed Income
To understand what unconstrained fixed income is, we must look at the current implementation strategy. Most institutional investors are benchmark-focused and will use benchmarks like the FTSE TMX Universe Bond Index. They will have investment guidelines with risk controls put in place that do not let them deviate too far from the index. It may be that they can deviate plus or minus one year of duration or it may be plus or minus 25 per cent of allocations to particular sectors. Either way, the guidelines can be fairly restrictive and/or constrained and may not allow for too much deviation outside of the home bias or away from the benchmark.
Unconstrained strategies are simply those managed without traditional index/benchmark constraints. These strategies have flexibility to invest across fixed income sectors, geographies, and currencies. Since these strategies offer a broader opportunity set without undue influence or ‘anchoring’ of traditional benchmarks, they allow skilled managers more freedom to deliver optimal risk-adjusted returns across different market environments (rising rates, widening credit spreads, high currency volatility).
Several reasons exist for investor interest in unconstrained strategies, but the recent proliferation and success of these funds is mostly due to the interest rate environment. The decades-long secular decline in interest rates across developed economies (including Canada), which has been a major boon to fixed income total returns over the years, appears to have reached its endpoint. A major risk factor for fixed income portfolios, therefore, is the impact of rising rates. Today, the common Canadian bond benchmark, the FTSE TMX Universe Index, has a duration of over seven years, which implies a negative price return of approximately seven per cent for every one per cent increase in interest rates.
Since unconstrained bond managers have the freedom to maintain lower duration (or even negative duration) through a rising rate cycle without fear of increased tracking error to the benchmark, they can mitigate the impact of interest rate volatility on portfolio price return.
An unconstrained investment approach can work in different ways. The example mentioned above only looks at changing duration within a home biased fixed income portfolio. However, when looking at unconstrained approaches, it is best to expand the opportunity set and allow managers to invest in different parts of the bond market where risk/return trade-offs may make more sense in a given environment. In fact, by removing the traditional benchmark, managers can seek to avoid any risk factor they believe is unattractive and instead focus on areas and strategies in which they have the highest conviction.
This ability to allocate the portfolio based on tactical and strategic themes can be a powerful tool. Known as sector rotation, this tool is already used by many bond managers in the Canadian market as a source of excess return, but within the limited context of mostly Canadian bonds. The manager is constrained by a decision to invest in government or corporate bonds plus additional sub-sector decisions within these major categories. Core plus managers add incrementally to the opportunity set by allocating a modest portion of their capital to additional sectors outside the benchmark. But both methods are anchored to a domestic benchmark and potentially forgo more attractive returns elsewhere in the bond market.
Globally, expanding the investment opportunity by reducing traditional investment constraints provide managers the necessary flexibility to pursue potentially more attractive investment returns in a variety of market environments.
Moving forward, institutional investors thinking about their own portfolio investment constraints and what to do about a potential rising interest rate environment in Canada should start to look beyond the risks and instead at what the opportunities are. Also, they need to understand the different ‘flavours’ within this space. There are different ways to structure a globally unconstrained fixed income portfolio and not all strategies are the same or work as a one-size-fits-all solution.
Current Market Headwinds
However, it is important to remember that while we agree unconstrained strategies offer a better solution to what many believe will be current market headwinds (rising interest rates) and allow for a pure expression of portfolio manager views, fixed income allocations do not exist in a vacuum. Fixed income serves many strategic roles in client portfolios (liability hedge, income, liquidity, etc.). For some investors, the most important feature of fixed income is its liability matching properties or its ability to diversify returns of other common risk asset allocations (equity, real estate, alternatives), particularly during times of market stress. For these investors, more conservative Canadian-based fixed investments may still be appropriate.
However, for those investors with a larger risk budget or who have significant concerns about the impact of a rising interest rate environment, unconstrained bond strategies deserve a closer look.This article originally appeared in the September 2015 edition of Benefits and Pension Monitor
About the Author
Paul Kirby is a principal and senior manager research consultant at Mercer
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