Plus or Minus?
In this low yield environment, many fixed income investors continue the quest for assets that provide for a stable but higher total return. The Barclays U.S. Aggregate Index now yields approximately 1.9% – only marginally higher than its lowest reading in September 2012 (1.5%). While its duration is at its highest level in the last two decades, seeking a yield cushion is paramount in an effort to protect portfolios with a “Core” home-bias from rising risk-free interest rates. We believe that granting leeway in the portfolio guidelines to extend (Plus) modestly beyond core sectors could achieve a significant 100-150 bps yield advantage, thus a competitive return potential. For institutional investors with limited staff and resources, this extension is an opportunity to allocate within and across the Plus sectors but without the headache of having to make relative value decisions requiring sophisticated analytic tools and disciplined judgment.
The “Plus” presents a return enhancing opportunity set including corporate high yield, securitized products, debt issued by non-U.S. entities and privately placed securities. Within high yield, the higher quality parts of the market still remain attractive, thanks to low expected default rates. In addition, investors with guideline flexibility to buy downgraded securities in well researched issuers can reap an attractive return by providing liquidity to rating-constrained sellers. Non-agency MBS continues to enjoy a strong market technical with no supply met with a strong appetite for attractive default-adjusted yields. Higher yields in select sovereign and corporate EM issuers benefitting from the macroeconomic environment present tactical opportunities in credit, rates and FX. Finally, private debt offers strong risk adjusted returns over its public counterparts as availability of credit remains constrained for private corporate and commercial real-estate deals.
The approach to allocating a portfolio’s risk-budget within Plus sectors varies by asset manager and investment success has been mixed. Most Core Plus managers are structurally underweight government sectors in favor of higher yielding spread sectors to generate excess returns. This strategy worked in stable and risk-on markets; however, the backup in spreads during the 2007/08 credit crisis translated into a much higher volatility and lower liquidity profile than institutional investors had mandated. From this experience, today’s investors are more closely examining managers’ usage of sector and security selection (alpha) versus structural exposures to extended sectors (beta) to generate excess returns. As the risk profile within fixed income sectors evolves, Core Plus managers that can be nimble allocating among sectors, including zero allocations in the absence of investment conviction, are most likely to succeed in 2013 and beyond. In addition, managers that institute thematic elements within their credit investment process are likely to successfully manage idiosyncratic risks from activist shareholders, leveraged buy-out (LBO) activity and other M&A deal-making. Finally, managers who have local roots in global regions will have an informational advantage over predominantly U.S. fixed income managers or those lacking a globally integrated investment process. In this yield starved environment, skillful utilization of extended sectors could be a plus for investors’ portfolios.