Unconstrained Fixed Income Risk Lurking

Risks lurking in the shadows.

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William J. Adams

Chief Investment Officer - Global Fixed Income

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IN BRIEF

  • Significant assets are flowing into unconstrained fixed income strategies as investors search for higher risk-adjusted returns in an investment environment influenced by central bank activity and dominated by low global interest rates. 
  • These products that permit managers to run dynamic portfolios with lower duration risk are usually exchanging types of risk: Interest rate risk is exchanged for credit and currency risks, as well as considerably higher levels of manager risk.
  • While diversification within fixed income allocations and a fear of interest rate duration are frequently cited as rationales for this approach, the diversification of an aggregate investment portfolio that includes equities is in fact diminished by strategies that reduce duration. 
  • In addition, more credit exposure with high equity market correlation further constrains the ability of these fixed income allocations to act as ballast in a portfolio, an important function of fixed income in a diversified portfolio. 
  • The considerable dispersion in duration, performance, credit quality and volatility of unconstrained strategies should be considered a warning signal. These investment strategies should not be modeled as alternatives to traditional fixed income approaches. 

The current low yield environment has left fixed income investors to navigate the choppy seas between Scylla and Charybdis:1 searching for much-needed yield while avoiding the potential rocky terrain associated with the expected US Federal Reserve rate hike, on the one hand, or greater exposure to more volatile and less liquid sectors of the bond market, on the other. The quest for greater investment performance in the current slow-growth, low-rate environment has led some investors to veer from the traditional fixed income waterways and look to source total returns from contributors like low-quality credit and currencies rather than duration — interest rate risk — and to place less reliance on fixed income benchmarks. 

It is in this context that “unconstrained” bond strategies have emerged as a mechanism that enables managers to chart an unrestrained course in an effort to capture total returns and adjust risk exposures much more tactically. Compared to traditional core bond strategies, unconstrained mandates permit managers to run dynamic portfolios with highly flexible duration levels and greater exposure to noncore investments such as high yield, bank loans, emerging market debt and currencies. These “go anywhere” strategies are not usually tied to a benchmark.

While the nature of these strategies may argue for little or no reliance on a benchmark, it is very difficult to evaluate a manager’s risk profile in the absence of a risk barometer, i.e., a benchmark. In this paper, we argue that it is prudent to adopt a “benchmark-aware” approach to multi-sector fixed income investing, allowing one to incorporate some of the discipline benchmarks provide along with an appropriate level of flexibility to make suitable investment decisions.

We believe it is unwise to abandon the benefits of benchmarks that emerge through the market cycle in a tactical attempt to side-step a risk inherent in the cycle. This is especially the case given that this post-crisis cycle is not necessarily following historical patterns.

In our view, the adoption of a benchmark-aware approach can provide the appropriate guard rails — the discipline, in essence — to enable fixed income investments to behave as they are usually intended, i.e., as ballast in an overall portfolio.

It is in this context that we outline some of the perils of investing in unconstrained strategies based on the observed dispersion in duration, performance, credit quality and volatility — and make the case for a benchmark-aware approach when investing in multi-sector strategies. 

Flows abound

Flows into unconstrained strategies have exhibited a striking trajectory in the period since the global financial crisis. Both retail and institutional assets under management (AUM) have grown exponentially, along with the growth in the number of strategies in this category (shown in Exhibits 1 and 2).

In the eVestment universe that captures institutional flows, AUM has grown by 29% on an annualized basis since 2007 and now totals US$229 billion. The number of institutional strategies on offer has also risen significantly, from 48 in 2007 to 118 in 2014. In the Morningstar mutual fund universe, the number of funds has risen from 20 in 2007 to 113 in 2014; the AUM has grown by an annualized 39% since 2007 and now stands at US$150 billion. 

In our view, the adoption of a benchmark-aware approach can provide the appropriate guard rails — the discipline, in essence — to enable fixed income investments to behave as they are usually intended, i.e., as ballast in an overall portfolio.

By comparison, the eVestment institutional flows into global aggregate fixed income strategies have grown by an annualized 7% since 2007 and now total US$361 billion, down from a peak of US$395 billion in 2014; similarly, the institutional asset flows into US core plus fixed income rose by 1% annualized in this period to reach an aggregate level of US$680 billion.

The growth in the number of strategies and AUM since 2007 illustrates the prevalence of these products in the post–financial crisis environment. This period has been characterized by a credit bull market. In view of this, it should be noted most of the performance streams of these products have not been tested through a full credit cycle. There is little precedent for how these strategies will perform in the latter stages of a business cycle or an equity market downturn. Few fixed income strategies come with as much manager risk as unconstrained fixed income. One would think investors would ideally want to engage managers who have managed portfolios effectively over multiple market cycles. Product proliferation and asset growth post-crisis suggest many investors are buying untested strategies.

There is little precedent for how these strategies will perform in the latter stages of a business cycle or an equity market downturn.

Rationale for inflows

Flow data and anecdotal evidence suggest that some investors have found a place for unconstrained fixed income strategies — which largely hold satellite asset classes — within the core fixed income component of their portfolios, while others with a core-satellite asset allocation strategy have elected to use a single unconstrained mandate alongside the core fixed income holdings as a composite alternative to holding a few niche satellite strategies.

Managers of these strategies usually claim to build portfolios from a globally diversified universe, dynamically holding exposures that may or may not possess characteristics consistent with traditional fixed income strategies. No doubt, interest in these strategies is being fuelled by a fear of duration and a desire to provide managers with the flexibility to tactically avoid duration exposure in a rising interest rate environment. This is being done by allowing them to nimbly shift risk into shorter duration and noncore investments to capitalize on nonduration return contributors such as credit.

The argument being made is that while benchmarkconstrained approaches may have been appropriate in the past, they are unsuited to the current landscape — and that, currently, it makes sense to look to a wider opportunity set and to a flexible strategy that can target risks and seek out new sources of uncorrelated returns. A prominent manager recently described these strategies as the “natural evolution” of the fixed income market, given the “increasing emphasis on wider diversification to boost alpha.”

While we agree with the concept of greater diversification, these strategies are not necessarily consistent with the traditional rationale for fixed income investments, and reducing duration diminishes the diversification potential of fixed income in an investment portfolio. It is precisely the duration component that provides the diversification properties of a fixed income allocation within an overall investment portfolio. These mandates are generally exchanging types of risk: Interest rate risk is exchanged for virtually pure credit and currency risks, as well as considerably higher levels of manager risk.

Role of fixed income in a diversified portfolio

Since the modern bond market began taking form in the 1970s, investors have purchased bonds for a few main reasons: to generate a steady income stream including total return, to preserve capital and to diversify equity market risk. Bonds, and the cash flows and diversification benefits they generate, enable investors to weather subpar stock market returns. It has been shown historically that investing in fixed income as a complement to equities lowers the volatility and total risk of a portfolio of financial assets. 

The important, traditional role that fixed income plays as ballast in a diversified portfolio appears to be frequently overlooked in the current discourse about unconstrained strategies. While diversification within fixed income allocations is often referenced as a rationale for these strategies, not enough attention is paid to the fact that the overall diversification of an investment portfolio is reduced by fixed income strategies that minimize duration. 

 

These mandates are generally exchanging types of risk: Interest rate risk is exchanged for virtually pure credit and currency risks, as well as considerably higher levels of manager risk.

In addition, the penchant for credit securities favored by many of the managers overseeing these strategies further reduces the diversification benefit of this type of allocation, since credit is highly correlated with equities, as we will discuss further below. Simply stated, the performance of many of these products often appears one-directional: a risk-on trade that is highly correlated with equity markets. Investors should be aware that by shifting assets into unconstrained fixed income, they are effectively increasing their ratio of equity-like assets to fixed income in their overall allocation plan.

Characteristics and performance of unconstrained strategies

The nature and performance of unconstrained strategies is characterized by a great deal of dispersion: duration dispersion, performance dispersion and credit risk dispersion. The degree of variance observed across these dimensions raises the specter of high levels of manager risk — risk that can easily be overlooked if one examines only a few strategies in any depth. Moreover, the universe is less a collection of likeminded strategies and more a catch-all for any strategy that has extreme global flexibility: a signifier of difference rather than similarity. The importance of understanding one’s investment objectives and performing detailed due diligence on managers may never have been more imperative for a mainstream strategy.

Duration dispersion

Duration is one of the largest drivers of performance in a fixed income portfolio. The duration of unconstrained strategies currently ranges from -2.71 to 11.26, with a median of 3.12 years, an extremely wide range that speaks to the broad spectrum of investment approaches that fall under the unconstrained umbrella (see Exhibit 3). The duration variance points to a high degree of manager latitude — too much in our view. 

Duration is a binary position, and forecasting interest rates is difficult to do with any accuracy. In recent years the actions of central bank policymakers have been central to determining the direction of rates, compounding the challenge of forecasting them. The actual path interest rates have taken over the last few years has markedly diverged from consensus forecasts. This is illustrated in Exhibit 4. 

With this kind of latitude and variance, how can the investor predict with any accuracy how the strategy will perform in a particular environment? Will it be positioned correctly for a move in interest rates? Will it rally or sell off if credit rallies or emerging market currencies drop? How will it complement the equity exposure in the portfolio? The flexibility of these strategies makes it impossible to model the exposure in a diversified investment portfolio. Consequently, it is not possible to credibly answer any of these pertinent questions.

Performance dispersion

Perhaps not surprisingly, given the lack of investment parameters, the returns for these strategies vary widely — particularly for fixed income strategies in the current lowerreturn, low-yield environment. This is shown in Exhibit 5. The divergence in the median and 25th and 75th percentile calendar-year performance all point to a great deal of variability in the underlying strategies and their efficacy overall.

Exhibit 6 depicts the dispersion in performance based on the difference from the mean. For example, in 2014, the difference between the mean calendar-year returns of 3.26% and the 95th percentile performance of -10.76 to -7.5. The chart also traces the VIX, the CBOE Volatility Index, a popular measure of the implied volatility of S&P 500 Index options. The performance dispersion juxtaposed with the VIX reveals that returns have continued to show wide variance, even in the muted volatility environment that has existed for the most part since 2012. If many of these strategies are achieving significant levels of performance variance during periods of lower volatility, investors have to be wary of potential variance during periods of higher volatility and question the role of these “fixed income” products in a broader allocation.

There is also sizeable dispersion in the volatility of these strategies, a consideration investors may underappreciate at their peril (see Exhibit 7). Three-year standard deviation ranges from 1.71 to 13.96, while the median is 3.88. The Sharpe ratio also shows a wide variance, from 0.70 to 2.86 according to eVestment.

This degree of dispersion in volatility should be a concern for investors. Not only does it imply a high level of manager risk, it also suggests investments will likely suffer from volatility drain, with its corrosive effect on returns.2 Volatility diminishes the rate at which an investment grows over the long term. The variability in performance and volatility raises a number of questions: Do you know the risk-return profile of these strategies? Do you know how they will perform through a complete cycle? The exponential growth of the number and AUM of these unconstrained strategies since the global financial crisis means that the majority have not been tested through a full market cycle. Indeed, the majority did not exist in 2008. 

Dispersion in credit quality

The spectrum of holdings of both investment-grade and below-investment-grade debt in unconstrained strategies is shown in Exhibit 8. While the median levels of investmentgrade debt are in line with global aggregate strategies, the below-investment-grade holdings are quite a bit higher. Unconstrained strategies tend to hold more below-investmentgrade debt as a way to garner higher returns to compensate for the return give-up inherent in the generally lower duration of these portfolios. 

If many of these strategies are achieving significant levels of performance variance during periods of lower volatility, investors have to be wary of potential variance during periods of higher volatility.

Correlation with equities As noted above, fixed income is traditionally held in a diversified portfolio as a way to hedge equity market risk, since equity and bond markets exhibit low levels of correlation. When stock markets fall, bond returns often move in the other direction.


Investors may not fully appreciate that the diversification benefit of fixed income is often muted in the case of unconstrained strategies: They are much more correlated to equity markets than to fixed income markets (see Exhibit 9). It is noteworthy that only 14% of the portfolios shown in Exhibit 9 had a correlation to fixed income greater than 0.50, while 77% of the portfolios had a correlation to equities greater than 0.50. Consequently, many of these investments are unlikely to perform well during equity market downturns. Fixed income 

investments with high levels of equity market correlation are precarious from any vantage point. 

By way of comparison, a similar analysis of the global aggregate universe showed significantly less correlation to equities and greater correlation to fixed income: 37% of portfolios had a correlation to equities greater than 0.5, while 43% had a correlation to fixed income greater than 0.5 (see Exhibit 10). 

We take the view that duration should not be considered the foe in the current investment environment; it just needs to be harnessed and managed appropriately.

An examination of the performance of these unconstrained strategies since 2007 during times when the equity markets declined more than 5% is revealing (see Exhibit 11). The correlation with equity markets is clearly shown: When US and  global equity markets experienced ownturns, unconstrained strategies moved into negative territory in lockstep, while traditional bond indices like Barclays Global Aggregate (US dollar–hedged) posted positive returns.  

Conclusion

The upward trajectory of asset flows into unconstrained strategies is undeniable. As investors evaluate the merits of these approaches, we would implore them to analyze and understand the risks they are taking and the exchange of risks implicit in products of this nature. In many cases, interest rate risk (duration) is being traded for credit and currency risks, as well as significant levels of manager risk. Moreover, if unconstrained strategies are being funded from more traditional aggregate products, investors should be aware that many of these strategies are not likely to perform like traditional fixed income products in a period of market volatility. A good number of these strategies are more correlated to equity markets than to fixed income markets and will generally move in tandem with equities.  

This means that these allocations cannot fulfill one of the key strategic asset allocation functions of fixed income, i.e., to act as ballast in a diversified portfolio. We believe it is critical for investors to fully understand that these strategies can have a potentially damaging effect on diversification when added to their overall portfolio. We take the view that duration should not be considered the foe in the current investment environment; it just needs to be harnessed and managed appropriately. We believe fixed income investors should remain steadfast with regard to risk management and manager assessment. Importantly, they should remain “benchmark aware” rather than jettisoning benchmarks.

A benchmark-aware approach provides the appropriate structure and discipline to ensure fixed income portfolios behave as they should and mitigate, rather than contribute to, the volatility of a portfolio. The noted dispersion in duration, performance, credit quality and volatility of unconstrained strategies should be considered a warning signal, a warning that it is not improbable to get caught on the wrong side of a trade. Investors without the stomach to navigate the stormy seas between Scylla and Charybdis that are likely to characterize these new types of high-risk strategies will want to consider more familiar alternatives. 

Endnotes

1 In Greek mythology, Scylla was a monster that lived on one side of a narrow channel of water, opposite its counterpart Charybdis. The two sides of the strait were within an arrow’s range of each other — so close that sailors attempting to avoid Charybdis would pass too close to Scylla, and vice versa. The strait has been associated with the Strait of Messina between mainland Italy and Sicily. The idiom “between Scylla and Charybdis” has come to mean being between two dangers, choosing either of which brings harm.

2 Volatility drain captures the negative relative impact volatility has on portfolio returns. An example illustrates this. Suppose an investor has a US$100,000 portfolio that experiences a minus 15% return this month and a 15% rebound next month. While the average return is zero, the painful math is that the portfolio went down to $85,000 with the 15% drop and then rebounded to $97,750 with the 15% rebound. The $2,250 loss incurred is the volatility drag.

Keep in mind that all investments, including mutual funds, carry a certain amount of risk, including the possible loss of the principal amount invested. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, industry, political, regulatory, geopolitical, and other conditions. 

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries. Issued in the United States by MFS Institutional Advisors, Inc. (“MFSI”) and MFS Investment Management. Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS International (U.K.) Limited (“MIL UK”), a private limited company registered in England and Wales with the company number 03062718, and authorized and regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered offi ce at One Carter Lane, London, EC4V 5ER UK and provides products and investment services to institutional investors globally. This material shall not be circulated or distributed to any person other than to professional investors (as permitted by local regulations) and should not be relied upon or distributed to persons where such reliance or distribution would be contrary to local regulation. Issued in Hong Kong by MFS International (Hong Kong) Limited (“MIL HK”), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the “SFC”). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and fund sponsor registered with the U.S. Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services to “professional investors” as defi ned in the Securities and Futures Ordinance (“SFO”). Issued in Singapore by MFS International Singapore Pte. Ltd., a private limited company registered in Singapore with the company number 201228809M, and further licensed and regulated by the Monetary Authority of Singapore. Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian fi nancial services license under the Corporations Act 2001 in respect of the fi nancial services they provide. In Australia and New Zealand: MFSI is regulated by the U.S. Securities and Exchange Commission under U.S. laws, and MIL UK is regulated by the U.K. Financial Conduct Authority under U.K. laws, which differ from Australian and New Zealand laws. 

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