Four Alpha Levers – and their potential to add value in changing fixed income markets

The credit cycle reflects how easy or difficult it is to borrow money or to access credit. Driven by changes in economic growth and interest rates, credit cycles move in four stages. The stages repeat over time, but rarely follow a timetable and can last for months to years.

Some active managers try to outperform a benchmark by understanding how different bonds perform during credit cycle stages. They adjust their holdings by "pulling" alpha levers to try to add value or to help manage risk. Alpha measures whether managers have outperformed (positive alpha) or underperformed (negative alpha) a benchmark. There are several levers, however, the four main levers are sector allocation, quality, security selection and duration.

While active managers may pull levers to add alpha, they may not achieve positive alpha. Also, credit cycles are not uniform and different levers may have less impact at different points in the cycle. The key is anticipating inflection points, repositioning early and having the patience to let the cycle play out.

Lever Number One: Sector allocation

Fund managers analyze bond sectors to determine what sectors may offer a better relative value and/or have better fundamental characteristics. Managers generally adjust the fund's sector allocation as their outlook changes. For instance, managers have often:

• Increased allocation to a higher risk sector like high yield bonds in the repair and recovery phases when yields may compensate for risk
• Or, increased allocation to a low risk sector like US government bonds late in the expansion stage and into the downturn to try to help reduce default risk and volatility

Lever Number Two: Quality

Fund managers move up or down in credit quality within different fixed income sectors to increase yield and return potential or to manage risk. Credit quality measures the likelihood that a company will default on paying interest and repaying principal. The higher the quality, the lower the default risk and yield. Conversely, the lower the quality, the higher the default risk and yield. Fund managers generally have:

• Moved up in quality late in the expansion stage and during a downturn to try to reduce default risk and volatility
• Or, moved down in quality during the repair and recovery stages to increase yield and return potential

Lever Number Three: Security selection

Fund managers analyze bonds to determine which bond is more attractive compared to a similar bond in the same industry or sector. Security selection is important throughout the cycle, but generally has mattered most late in the expansion stage and into the downturn, when downgrades and default rates rise due to weaker economic conditions. Active managers generally focus on issuers with strong fundamentals, healthy business models and appropriate levels of debt relative to earnings.

Lever Number Four: Duration

Duration measures a bond's price sensitivity to changes in interest rates. In general, bond prices fall when interest rates rise and vice versa. When interest rates rise, a bond with a longer duration will potentially lose more value than a shorter duration bond. Conversely, when rates fall, a bond with a longer duration will potentially gain more in value than a shorter duration bond. Fund managers shorten or extend duration based on their interest rate outlook. Managers have generally:

• Shortened duration to try to reduce price declines if the manager believes rates will rise
• Or, extended duration to seek to benefit from price gains if the manager thinks rates will decline

We believe that bond funds play an essential role in a portfolio, providing income, return potential and diversification to counter equity volatility. No two credit cycles are the same and at times, market dynamics can disrupt cycles. That's why we believe active management is so important. Because investment teams can make decisions based on current dynamics and the progression of the credit cycle.

At MFS, we take a long-term, strategic approach to investing across the credit cycle. By pulling alpha levers, we believe that an actively managed bond fund can manage risk and add value in any stage of the credit cycle.

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