LONDON, 23 December 2002 — The sixties and seventies were characterized by strong nominal GDP growth, rising inflation and rising bonds yields. From 1980, this trend reversed and over the last 20 years, we have experienced progressively lower rates of inflation with 10-year US government bonds yields falling continuously to around 4 percent. In the present low yield environment, and given the recent negative performance of equity markets, investor orientation has shifted in favor of absolute return strategies focused on capital preservation. The core-plus approach is designed to cope with this change in investor focus while at the same time exploiting optimally the benefits of new asset classes.
Let us begin by reviewing some key trends over the last 20 years and, thus, the background to an increase in bond asset classes, which has occurred over this period.
The two oil shocks of the seventies (1973 and 1979) had a severe impact on prices in the developed world and in particular, boosted already high inflation expectations. However, the past two decades have been characterized by a strong and progressive disinflationary tend, which has brought 10-year US bond yields down to around 4 percent. This period provided the bond investor with an extraordinary average annual return of almost 10 percent. Together with strong economic growth, this was the fuel for an unprecedented stock market boom.
In their continuous search for an optimal capital structure in order to maximize ROE, many companies took advantages of this boom and restructured their balance sheets through share buybacks and by making increasing use of debt financing. Higher financial leverage was good news for equity investors in good times. In the more difficult recent environment, it has resulted in lower credit ratings, a trend which is still continuing.
Whereas AAA/AA rated companies used to dominate the market, the investor now faces a wide choice across the entire rating spectrum. In addition to initially top rated companies being downgraded and passed down the credit quality curve, a growing number of companies have found access to an ever more mature market place. In fact, we can observe a significant shift of the rating distribution from the upper-end toward the middle/lower part of the investment grade universe. The downgrading of entire industries (e.g. car manufacturing and banking) has led to an immediate increase in the cost of financing. In order to keep financing costs under control, new instruments have been created and brought to the market. Products packaged as special purpose vehicles, backed by specific assets or future cash flow streams (e.g. mortgages, credit card receivables) have quickly gained widespread acceptance, as they have been structured in a way to qualify for better ratings than the senior debt of the respective issuing companies.
Economic growth and the regulatory environment have combined to force the banking industry to strengthen balance sheets. Substantial portions of loan portfolios have been securitized (e.g. as asset-backed securities such as CMO’s or CLO’s) and, based on a collateral structure, which leads to enhanced ratings, brought to the capital market.
Investments in corporate debt, particularly in the non-investment grade area and in instruments with complex pay-off structures such as asset-backed securities may produce higher yields than available from top rated, “plain vanilla” bonds. However, obtaining the full benefit of such investments requires more research capacity, particularly since the continuing globalization and disintermediation trends will accelerate the process of separating winning companies from losing ones, whose bonds thus carry an increased risk of default.
As recent history has shown, the “too-big-to-fail” theory is flawed and investors cannot count on being bailed out by the government when corporate titans collapse. Other familiar companies could follow Enron, WorldCom or Swissair, to name just a few prominent examples, which have recently filed for bankruptcy or else disappeared form the corporate landscape.
The disinflationary process has not only brought the yield curve to historic lows, the market has also become much more complex. At the same time, the non-investment grade universe has experienced massive growth. In an increasingly competitive, complex and ever-changing market environment, the traditional buy and hold bonds strategy, with its emphasis on income, safety and liquidity will gradually give way to an equity like approach and a focus on total return.
Not every investor has access to asset managers with the necessary research capacity to exploit optimally the new opportunities. Often, a more flexible approach to analyzing and managing bond portfolios is needed: Hence the core-plus approach which evolved in the US in the 1990s. The concept has been adapted to the global fixed income environment and introduced at Clariden Bank.
The core-plus concept
Based on the substantial changes in bother market structure and investor needs, core-plus must primarily fulfill following requirements: Preservation of capital and return enhancement.
However, we first have to define the primary differentiating factors of the core and the plus. The core part is the foundation for preserving the invested capital. Consequently, it must consist of asset classes with little volatility hence, minimal exposure to the primary risk factors such as duration, liquidity or default risk. The plus components will be used to generate incremental returns. Of course, exposure to various risk factors is also associated with higher volatility. In order to mitigate the impact of this volatility on the overall portfolio, a diversification strategy is crucial as it enables investment combinations to be identified in which the various components have low correlation with one another.
Preservation of capital: The investment universe is first divided into two main areas according to an asset’s expected risk profile. The core part, the center of the portfolio, invests in assets with low risk profiles and stable return. It mainly comprises money market instruments and short and medium term government and other investment grade bonds. Low volatility and stable returns, the main characteristics of the core portfolio, build the basis for preserving invested capital.
Return enhancement: In order for an asset class to qualify for the plus portfolio, there are two important conditions. First, a higher expected return than in the core portfolio must be attainable and, second, a low correlation to the other assets in the portfolio is required. A fast maturing market offers ever more choice, ranging from long-term government bonds through spread products, such as asset-backed securities, high yield and emerging market bonds to convertible bonds. Return expectations are based on macro-economic analysis as well as on a relative value analysis of different asset classes. The conclusion of this analysis is a tactical allocation between individual asset classes. Plus components are usually volatile. The main task here is to combine assets with a low correlation so that overall portfolio volatility can be reduced.
In an economic upswing, long dated government bonds typically come under pressure (fears of inflation). However, a growing economy should have positive impact on investments in money markets (rising reinvestment rates) and higher yield bonds (higher earnings expectations and reduced default risk) or emerging market bonds (rising proceeds from exports)
It becomes clear that the aim of core-plus is to produce on a consistent basis higher returns than available in the money markets and to maintain a lower volatility level than pure bond investments.
A historical analysis of monthly returns of a US dollar-denominated core-plus conservative portfolio has produced mostly positive monthly results with only two periods with two consecutive negative monthly returns. The longest underwater period (or time to recovery) lasted 6 months, namely form autumn 2001 to spring 2002, when corporate failures (e.g. Enron) and rising concerns about Argentina had a massive negative impact on high yield and emerging market bonds. At the time, fears of a global recession became widespread and some investors abandoned their high yield investments at almost any cost.
However, our conservative core-plus portfolio experienced a rapid recovery thereafter as the negative economic outlook led to a further fall in inflation expectations. A resulting “flight to quality” was responsible for the strong performance of long-term government bonds, a sub-component of the plus portfolio.
The performance of our core-plus portfolio illustrates the importance of diversifying among lowly correlated asset classes in order to reduce overall portfolio volatility. In a recession, plus components such as high yield, emerging markets or convertible bonds typically perform poorly whereas a “flight to safety” will favor government bonds. We believe that a core-plus portfolio can be ideally structured in a way that, independent from the current economic cycle and market environment, the volatility of the core and the plus elements are neutralized through their low correlations. In this context, money market instruments, which are part of the core portfolio, can play an important role as they are basically uncorrelated with the bond classes represented in the Plus portfolio.
Different risk factors require the analysis of separate fundamental elements influencing performance. Consequently, the investment process is set-up in order to optimally combine the research capability with investment performance responsibility. First, a thorough analysis of the global macroeconomic environment leads to the allocation between core and plus. It is at this level, where the profile of the portfolio is controlled; the goal of capital preservation will therefore always play an important role at this stage.
Further, relative value analysis leads to tactical allocations within the core and the plus. The main focus here is on expected returns, risk profiles and correlations.
Last but not least, specific securities are selected. In an increasingly complex, segmented and competitive market, security selection becomes an ever more important contributor to a portfolio’s total return. For every asset class, specialist managers are evaluated and clearly defined mandates awarded. At this stage, a broad diversification of all risk elements of the portfolio is ensured.
This approach allows maximum flexibility in the implementation of tactical allocations while at the same time maintaining the ability to work with the best available specialists in every single segment of the portfolio.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)
