Fixed income: Is it as defensive as you think?

The global downturn has tempted some super funds to reduce their exposure and risk budgets to the fixed income asset class. A new benchmark construction process tailored to client needs is necessary, writes Greg Michel.

The global financial crisis has raised many questions about the effectiveness of traditional approaches to defensive investment strategies. At the centre of this controversy has been the role of fixed income.

Disappointing performance and the discovery that many fixed income portfolios were not as defensive as investors supposed has raised concerns about the quality of their portfolios and the ability of their fixed income managers.

While there is no need to abandon all the fundamental rules of investing, the impact of the volatile financial climate has highlighted some inherent weaknesses in the current structure of the fixed income market.

In constructing investment portfolios, investors focus on two key areas — the strategic amount to be allocated to an asset class and the appropriate index or benchmark from which a fund manager’s performance will be measured.

In our view, the traditional benchmark that has been applied for fixed income portfolios has fundamental problems, particularly its overreliance on a high frequency, aggregate index-based measurement of performance.

What’s the problem?

1. An inefficient index

Let’s start with the idea that fixed income indices are inefficient. They are based on issuance rather than performance (as is the case in equity markets) and, as a result, they are biased towards corporates or government bodies issuing the most debt.

In the corporate world (and to a certain extent more broadly), the need for more debt tends to reflect a less-than-desirable financial position. This has resulted in an index that is tilted towards companies that are under greater financial stress and, ultimately, leads to a sub-optimal performance outcome.

2. Increasing risk

Another point to make about the index is that the increased emphasis on aggregate or composite-style bond indices over recent years has resulted in a material increase in corporate and securitised exposures; the outcome being significant changes in index characteristics away from those traditionally assumed for a defensive asset class. In other words, bonds are not the safe haven they used to be.

3. Duration has lost significance

Over the last decade or so, the UBS Composite Index has seen a significant decline in modified duration. The combination of a lower weight to Commonwealth Government securities and shorter duration has reduced the benefits of a natural cyclical hedge.

4. Losing its role as a natural diversifier

The increased corporate exposure within the fixed income index also implies a potential increase in correlation with the equities market and an increase in volatility — particularly during times of stress. As a result, the natural role for fixed income as a defensive hedge against equity has been greatly reduced.

Investor risk appetite has come at a cost

While issues around the fixed income index structure are an easy target for those looking for a reason behind the recent disappointing performance of the fixed income sector, there is a bigger issue at hand.

The trend towards pursuing more sources of value-add and an increasing focus on short-term performance has contradicted the very nature of why an investor chooses to invest in fixed income.

Over time, investors have been increasingly focused on fund managers delivering short-term top quartile performance at the expense of long-term value-based opportunities.

During the long period of economic prosperity before the financial downturn, there was an increasing search for spread-based yield enhancement and a gradual shift away from active duration management.

However, spread-based enhancement is not a free lunch and has come at the cost of a material deterioration in credit quality.

These trends were effectively reinforced by competition in the marketplace and ultimately led to a change in behaviour by market participants in order to remain competitive.

How can we address these issues?

While a fairly grim picture has been painted of fixed income processes in general, it is important to remember that fixed income markets are extremely diverse and offer investors a broad range of characteristics and sources of both beta and alpha.

Recent experience has resulted in fixed income investors reducing their exposure and risk budgets to this asset class.

However, instead of stepping away from the market, we believe a different approach needs to be employed that will maximise the opportunity available to investors.

By this we mean a benchmark construction process that is tailored to specific client needs rather than adopting an aggregate benchmark-based performance.

Instead of a high frequency, index-based measurement, we recommend longer-term performance hurdles and a fee structure that encourages truly active portfolio management and better overall management of clients’ risk budgets.

Therefore, client portfolios would be managed within a framework that:

• is not aligned to the traditional benchmarks — which carry much greater risk than they used to;
• utilises a much broader investment universe — which will allow the investment manager to deliver value over all cycles; and
• can be specific to risk/return requirements.

The solution requires investors to re-think their current performance hurdles. Using traditional fixed income indices as a benchmark for success has led to much higher beta risk than anybody anticipated.

The industry has changed, the goal posts have clearly shifted, and if anything, the impact of this crisis may well be the trigger for a better portfolio construction process.

Most of all, it would be nice for investors to get what they expect from fixed income.

Greg Michel is head of fixed income, ING Investment Management.