Multi-asset global income investing

Take advantage of an unconstrained approach
Market Insights: November 9, 2017

Summary

  1. With Canadian investment grade bond yields near historic lows, investors may not be getting the income they need from traditional sources. This problem is compounded by the threat of continued interest rate increases and higher inflation.
  2. An active, unconstrained approach that invests in a wide range of geographical and asset class exposures has the potential for higher yields, better risk-adjusted performance and protection from interest rate risk.
  3. To be effective, an unconstrained approach should utilize both top-down and bottom-up analysis and be supported by a global network of on-the-ground investment professionals.

1. The new income reality

It wasn’t so long ago that investment grade Canadian government bonds offered yields in the high single digits or even double digits, with the added benefit of price appreciation from steadily falling interest rates. For many Canadians, this meant equity-like returns on effectively risk-free assets.

Investors today face a new and complex reality. The yield on the Government of Canada 10-year bond, like most developed market government bonds, is near historic lows, offering essentially no real yield once inflation is factored in. This contrasts with the experience of the better part of the last 30 years, which saw the yield on the Government of Canada 10-year bond meaningfully exceed inflation, giving investors a reasonable level of real returns (Figure 1).

Figure 1: Inflation vs. Government of Canada 10-year bond yield

Source: Federal Reserve Bank of St. Louis, as at September 30, 2017.

Recent economic strength in both Canada and the U.S. suggests potential for higher inflation, which, combined with low yields, does not bode well for traditional fixed income. This problem is compounded by monetary policy normalization – a priority for most developed market central banks, including the Bank of Canada. As central banks increase interest rates, bond yields will generally rise with them, resulting in price depreciation for current bond holders.

Home-biased Canadian investors are thus left with a perfect storm: low yields, potentially higher inflation and rising interest rates. The good news is that 95% of fixed-income opportunities reside outside of Canada. To generate meaningful income streams and mitigate the impact of rising interest rates and inflation, investors should consider an unconstrained approach that taps a wider range of geographic exposures and fixed-income asset classes.

2. Unconstrained, multi-asset global fixed income

An unconstrained approach to income investing makes it possible to nimbly adapt to constantly shifting market dynamics. Unconstrained investing is benchmark agnostic, which means the portfolio manager is not required to use external benchmarks as a point of reference. In the context of fixed income, this means the portfolio manager has no minimum or maximum allocation requirements for specific bond issuers, bond ratings, currencies or sectors. Instead, the portfolio manager has complete flexibility to pursue opportunities across the full spectrum of geographic regions, asset classes and issuing companies. This translates into potential for higher yields, better risk-adjusted performance and protection from rising rates.

a. Higher yields

Looking beyond our borders and traditional fixed-income asset classes presents an array of higher-yielding opportunities (Figure 2).

Figure 2: Yield advantage outside of Canada

Source: Bloomberg, PC Bond, PineBridge Investments, September 30, 2017. U.S. Government bonds represented by the Bloomberg Barclays US Treasury Total Return Index USD; Canadian Government bonds represented by the FTSE TMX Government Bond Index; Canadian bond universe represented by FTSE TMX Canada Universe Bond Index; Canadian IG corporate bonds represented by FTSE TMX Canada Universe Bond Index; U.S. IG bonds represented by Bloomberg Barclays US Corporate Total Return Index USD; EM corporate bonds represented by JPM CEMBI Diversified TR USD; EM sovereign hard currency bonds represented by JPM EMBI Global Diversified TR USD; senior loans represented by Credit Suisse Leveraged Loan Index (USD); EM sovereign local currency bonds represented by JPM GBI-EM Global Composite TR LCL; U.S. high-yield bonds represented by BofAML HY Master II.

Senior loans are especially appealing in the current rising rate environment. Because of their floating coupon, these investments usually benefit when central banks raise rates.

In addition to the above, collateralized loan obligations (CLOs) are an attractive example of a non-traditional, income-producing asset class. A CLO is a securitized pool of corporate loans; payments on these loans are the source of the income security holders receive. Importantly, no CLO tranche at the AAA or AA level has ever experienced a default loss.1

Currently, CLOs offer superior relative yields across the credit spectrum, outperforming the highest-quality investment grade bonds, B-rated high-yield issues and everything in between (Figure 3).

Figure 3: CLO spreads vs. comparably rated corporate bonds
Source: JP Morgan, Bloomberg, Barclays, as at May 17, 2017.

b. Enhanced risk-adjusted performance

An unconstrained approach enables the portfolio manager to focus on asset classes and regions that offer opportunity and avoid those that pose excessive risk. This means that under some conditions, the portfolio manager may have a 0% allocation to one or more parts of the market – an option that is typically not available in conventional approaches to global fixed income.

The experience of the last decade shows that an active, unconstrained approach has the potential to deliver a level of performance that conventional approaches would be too limited to match. Looking at calendar year returns for select fixed-income asset classes (Figure 4), it’s clear that no single asset class is a consistent winner. Moreover, the average return discrepancy between the top-performing and bottom-performing asset classes was almost 25%. The largest discrepancy occurred in 2009 (60.4%) and the smallest in 2007 (16.2%). This wide dispersion of returns shows that not all income-generating asset classes behave the same way, which means that a nimble, unconstrained approach can capitalize on virtually any market.


Figure 4: Annual returns (%) for select asset classes

As at December 31, 2016. Index returns derived from the following: 3M U.S. T-Bill (Bloomberg Barclays US Treasury Bills TR USD; U.S. government bond (Bloomberg Barclays US Government TR USD); U.S. TIPS (Bloomberg Barclays US Treasury US TIPS TR USD); U.S. municipal (Bloomberg Barclays Municipal TR USD); U.S. inter credit (Bloomberg Barclays US Intermediate Credit TR USD); U.S. long credit (Bloomberg Barclays US Long Credit TR USD); CMBS (Bloomberg Barclays CMBS TR); MBS (Bloomberg Barclays US MBS TR USD); ABS (Bloomberg Barclays ABS TR USD); High-yield (Bloomberg Barclays US Corporate High Yield TR USD); Bank loans (S&P/LSTA Leveraged Loan TR); EM sovereign (JPM EMBI Global Diversified TR USD); EM corporate (JPM CEMBI Broad Diversified TR USD); and EM local currency debt (JPM GBI-EM Global Diversified TR USD).

 

In addition to potential for stronger performance, unconstrained multi-asset investing offers enhanced risk mitigation in a world where diversification may not be as effective as it once was. The rationale for diversification is that uncorrelated – or minimally correlated – assets will behave differently during a downturn, providing protection for portfolios. While broad diversification is a cornerstone of risk management, it is no longer enough to protect portfolios during periods of significant market stress. In recent years we have seen that correlations between diverse asset types tend to spike during major market stress – precisely when the benefits investors expect from diversification are needed most.

Figure 5 illustrates asset class correlations under normal market conditions.


Figure 5: Correlations in normal markets

Source: PineBridge Investments.2

 

Figure 6 shows how correlations can move to the extremes during periods of severe market stress.

Figure 6: Correlations in stressed markets

Source: PineBridge Investments.3

 

Compared to normal market conditions, periods of extreme stress result in a marked increase in overall correlations. Some asset class relationships shift from uncorrelated to extreme positive correlations. For example, ABS and European equities are generally uncorrelated in normal market conditions (Figure 5). During periods of market stress, these assets classes have an almost perfect positive correlation (Figure 6). The same is true when comparing ABS with U.S. equities, Japan equities and emerging market equities.

The flexibility of an unconstrained approach can help reduce the impact of higher correlations in stressed markets by dynamically selecting asset classes that offer opportunity – while avoiding regions and asset classes that may be most directly impacted by a broad downturn.

c. Protection against rising rates

An unconstrained, multi-asset approach to global fixed income offers investors a variety of ways to mitigate one of the main headwinds to conventional fixed-income investing: rising interest rates.

Some non-traditional fixed-income asset classes, including high-yield bonds, emerging market bonds and senior loans, not only aren’t negatively impacted by monetary policy normalization, they can actually benefit from it (Figure 7).


Figure 7: Fixed-income asset class performance amid rising interest rates

As at September 30, 2017. High-yield bonds represented by Barclays Capital U.S. Corporate High Yield; emerging market bonds represented by JPM EMBI Global Diversified; bank loans represented by Credit Suisse Leveraged Loan; investment grade credit represented by Barclays Capital U.S. Intermediate Credit; core fixed income represented by Barclays Capital U.S. Aggregate Bond; U.S. Treasuries represented by Barclays Capital U.S. Treasury

3. Active unconstrained approach

Investing across a wide range of geographic regions and multiple fixed-income asset classes can offer higher yields, a more attractive risk/return profile and protection against rising interest rates. As we’ve seen, this more diverse opportunity set introduces risks that make an active, unconstrained approach especially critical.

Unconstrained investing across the full spectrum of fixed-income opportunities is a highly complex undertaking that requires:

  • An expansive team of area experts
  • Top-down analysis of macroeconomic trends
  • Research-intensive bottom-up credit analysis
  • An on-the-ground, global support network to better perceive opportunities and risks

For an actively managed, unconstrained approach to global fixed income, retail investors can look to IA Clarington Global Bond Fund.

Dealer use only.1 As at August 31, 2017. 2 For illustrative purposes only. The “normal markets” correlation chart is PineBridge’s 5-year forward-looking view on correlations, derived as a forecast of average correlations for the upcoming 5-year period. To arrive at this forward-looking view, PineBridge looks at long time series of rolling 1-, 3-, and 5-year correlations (at least 10 years of rolling correlations and up to 20 years in some instances) as a starting point. PineBridge then layers in its view on the relationship on a forward-looking basis. The forward-looking correlations are closer to current levels than historical averages, since the asset class today has changed in this respect. 3 For illustrative purposes only. The “stressed markets” correlation chart uses the historical correlations as of 2008 as indicative of how asset classes behave in fundamentally inspired, longer-lasting market downturns. While this is only one period of fundamental stress, PineBridge believes the extreme case of 2008 positions the analysis conservatively. PineBridge also looks at long-term rolling 1-year averages, since these are more revealing of the extremes. The sheer number of correlation pairs involved requires an extensive period of time and careful attention. The last evaluation was based on historical data as of March 31, 2017 and how that shaped PineBridge’s forward views at the time. Definition of terms: Asset-backed security – A security backed by assets such as loans or a company’s receivables. Bank loan – See Senior loans, below. Bottom-up investing – The process of analyzing and selecting securities based on their fundamental characteristics. Collateralized loan obligation (CLO) – A collection or ‘bundle’ of corporate loans that are offered as an income-generating security. Payments on these loans are the source of the income investors receive. Commercial mortgage-backed securities (CMBS) – Securities backed by mortgages on commercial properties. Corporate bonds – A fixed-income offering from a company, as opposed to a government. Correlation – A measure of how two investments perform in relation to each another. A high positive correlation means the two investments perform very similar to each other (when one goes up, the other goes up to a similar degree, and vice versa), while a high negative correlation means they perform very differently (when one goes up, the other goes down to a similar degree, and vice versa). Credit rating – Issuer credit quality is assigned a rating by rating agencies such as Standard & Poor’s and Moody’s, usually taking the form of a series of letters (e.g., A, BBB, BBB-, BB+). Please see the definitions of Investment grade and High-yield bond, below. Fundamentals – Refers to the characteristics of a company (or economy) that are analyzed when valuing its worth (or strength). Hard currency debt – Bonds issued by emerging market governments that are denominated in a liquid developed market currency, most commonly the U.S. dollar. Hedge fund of funds (HFOF) – An investment fund whose holdings consist of hedge funds. High-yield bond – A fixed-income security with higher risk and higher yield than investment grade bonds. High-yield bonds are rated below BBB (S&P) or Baa (Moodys). Interest rate risk – The risk that an investment’s value will change due to a change in the absolute level of interest rates. Investment grade – A high-quality issue with a low risk of default. Ratings for investment grade bonds are BBB and above. Local currency debt – Bonds issued by emerging market governments that are denominated in the local country’s currency. Mortgage-backed security (MBS) – A security backed by mortgages on residential properties. Monetary policy normalization – An effort by central banks to return interest rates to their normalized level. Private equity – An investment in privately held assets, as opposed to publicly traded securities. Risk-adjusted – The amount of return generated by an investment per unit of risk. Senior loan – In a senior loan arrangement, the lender has first claim on the borrower’s assets in the event of bankruptcy. These loans have floating rates that are reset at regular intervals. Sovereign bond – Bonds issued by a government. Top-down investing – An approach to investing that bases asset allocation decisions fully or partly on macroeconomic analysis and analysis of the broader markets. Tranche – A portion or ‘slice’ of a debt offering. Higher (senior) tranches generally offer less risk and lower returns, while lower tranches offer potential for greater income but with elevated levels of risk. Yield – The amount earned from a fixed-income security. This is generally the sum of interest payments plus the difference between the purchase price and the amount received on the maturity date. 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