Fixed IncomeJan 27 2016

Masters of the universe

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Masters of the universe
ByAdrian Hull

Many issuers have issued longer maturity bonds also adding to the duration of, for example, tracking funds. Selecting the right maturity in bonds portfolios is the second most important decision in duration management. For example, while there was a 425bps rise in US Fed funds between 2004 and 2006 and a similar increase in short dated bonds, 10 year US Treasuries increased by only 60bps. Yield curve shapes and management are the bread and butter of fixed income managers and strategic funds give managers the opportunity to choose the optimal part of a yield curve to be at in any given moment in a rate cycle as well to manage or hedge unwanted duration.

Asset allocation really encapsulates the need to manage risk within an unconstrained bond portfolio. Decisions to allocate between rates, investment grade, emerging or high-yield markets are core to unconstrained management. So it maybe that BB bonds provide the best returns in 2016, but it would be imprudent to invest all the assets in an unconstrained fund in BB bonds. Thus, a reasonable asset allocation process will be needed. Managers will typically look at allocation by a bonds rating as well as by geography. The allocation process will also figure the weighting between government markets (capturing the geographic allocation) as well as by sectors for credit markets. So the basket case of 2008 – financials – was among the strongest-performing credit assets in 2015. And while corporates have generally fared very well since the financial crisis, 2015 saw material underperformance of utility and mining sector bonds.

Despite strong returns in credit markets since 2008 it has been governments rather than corporates that have driven net new supply. Strategic bond managers regularly need to revisit the fund’s core holdings. For example, in 2015, holdings in individual names could have had a strong impact on returns, for instance, owning BHP as opposed to Glencore, National Grid rather than RWE and Daimler rather VW will have made material impact to fund returns. Inevitably investors will need to feel comfortable with a manager’s selection process and historic abilities.

One final vital consideration is liquidity: managers must have flexibility to manage their unconstrained freedoms. Flexibility means moving from one asset type to another to ensure better outcomes for fund holders and to that end, liquidity becomes very important. Managing portfolios of larger bond issuers (typically FTSE, S&P constituents) with deal sizes of at least $500m helps to ensure market price transparency.

Active managers will continue to focus on liquidity for unconstrained funds in 2016. The ability to shuffle assets along with understanding the drivers of duration, allocation and selection risk will as ever drive returns for strategic mangers in 2016.