Fixed Income Portfolios What Do Managers Do to Outperform?
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1 Fixed Income Portfolios What Do Managers Do to Outperform? November 14, 2016 Presented by: John Mohr, Managing Director
2 Discussion Outline Fixed Income Introduction & Levers Fixed Income Portfolio Review Example Fixed Income Performance Attribution Fixed Income Performance Attribution Breakdown 2
3 FIXED INCOME INTRODUCTION & LEVERS 3
4 Fixed Income The Core of Your Portfolio Unlike other investor types such as pensions, foundations, etc., insurance companies and Government Risk Pooling organizations allocate the majority of their assets to fixed income investments. These allocations typically range from 70% to 100% of their portfolios depending on regulatory and other constraints (net position, business dynamics etc.) As such, investing these fixed income assets effectively is a primary objective for Risk Pooling clients. Effectively typically means you want your manager to generate a consistent, superior risk-adjusted return in excess of the applicable benchmark and better than those of other managers. Before we get into how managers actually look to add value, let s review the various levers they can utilize to do so. 4
5 Fixed Income The Main Levers Fixed income managers can utilize a number of tools within the portfolios they manage. These include the following: 1. Duration the big Kahuna! This is an approximation that measures the interest rate risk of the security or portfolio. The higher the number, the more risk from movement in rates. Example: if a security or portfolio has a duration of 10 years, a 1% increase in rates will result in a 10% instantaneous decrease in the market value of the security or portfolio. However, longer duration typically means higher yield. Duration * Change in rates = Change in market value 2. Convexity duration s little brother. We use duration to forecast the change in market value as a result of interest rate changes. But, it is an estimate. Convexity makes the estimate more accurate for bonds that have uncertain cash flows like mortgage backed securities (MBS) or callable securities. In a security or portfolio, positive convexity is better than negative convexity. How due you improve convexity? You could buy less MBS than the benchmark or focus on more stable types of MBS without as much cash flow variability. However, this improvement typically comes at a cost Less Yield! 5
6 Fixed Income Portfolio Book Yield & Duration Duration (Yrs) Book Yield (%) Max Min Median Average
7 Risk Asset Allocation & Fixed Income Portfolio Duration Duration (Yrs) RA % of Surplus Max % Median % Average % 7
8 Fixed Income The Main Levers 3. Yield Curve this is related to duration but focuses on how a portfolio s maturities are structured across the yield curve from short maturities (i.e. 3 months, 1 year) to long maturities (30 years). Different structures provide benefits in terms of additional yield or better return potential if rates rise or fall on that specific part of the curve. 4. Sector you ve all heard a manager tell you that they love the technology or consumer discretionary sector or hate the banking sector. Managers who use this lever allocate more assets than the benchmark does to sectors that they like. If they are correct, this will help them outperform the benchmark. If they are wrong, they may underperform. Commonly used sectors include: Treasuries, Agencies, Corporates, Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS), Asset Backed Securities (ABS), and Municipals. Within these overall sectors, there are numerous subsectors. 8
9 Fixed Income Allocation By Sector ST/MMF (%) UST & US Agency (%) Agency MBS (%) ABS/CMBS (%) Corporate & Taxable Muni (%) Max 54.7% 100.0% 45.3% 22.8% 59.4% Median 1.6% 18.3% 20.3% 11.6% 38.8% Average 6.3% 29.3% 18.7% 12.4% 33.3% Sorted by largest exposures to corporate and structured securities. 9
10 Fixed Income The Main Levers 5. Security Selection Related to sector selection, security selection is typically used by bottom up fixed income managers who find specific bonds they like or don t like and buy more or less of them than are contained in the benchmark. They may do this if the bond has better yield, structural or credit characteristics which will help the bond outperform. 6. Quality Some managers make an explicit bet on quality levels of the bonds they hold. Lower quality bonds typically pay higher yields to compensate for the additional credit risk (i.e. the risk that you won t get your money back at maturity). Some think that overall rating categories of bonds are over or undervalued and then structure their portfolios to take advantage of this. If they think BBB rated securities offer good value, they may own more of these than the benchmark. 10
11 Fixed Income Allocation By Credit Rating AAA-AA (%) A (%) BBB (%) Max 100.0% 29.5% 31.8% Median 63.7% 18.1% 14.7% Average 65.4% 16.5% 12.5% Sorted by largest exposures to corporate and structured securities. 11
12 Fixed Income The Main Levers 7. Liquidity This has been a more important factor over the past several years as yields have fallen. In general, some managers will trade liquidity, or ease/cost of trading a security, for yield/total return. In general, more liquid bonds trade at a lower yield than do less liquid bonds of the same type. By owning less liquid securities, managers can boost yield/income. However, if they unexpectedly need to liquidate these securities, this strategy can backfire. Yield Liquidity 8. Structure In many cases this is related to liquidity. Some managers purchase bonds that have unique aspects that might not be understood by the market and thus the bonds yield more and may not be as liquid. For managers who understand these structures, this is a great way to add value. 12
13 FIXED INCOME PORTFOLIO REVIEW EXAMPLE 13
14 Fixed Income Portfolio - Example Overall Characteristics Portfolio Index Market Yield (YTW) 1.80% 1.71% Book Yield 2.64% N/A Duration Convexity (0.22) (0.36) Average Quality AA- AA What levers is this manager using? Duration the portfolio s duration is 10% shorter than the benchmark. Convexity maybe the portfolio holds less MBS or different MBS? Quality the portfolio s quality is a bit lower than the index. Let s take a closer look 14
15 Fixed Income Portfolio - Example Quality Distribution (% of Portfolio) Portfolio Index AAA 44.1% 57.7% AA 11.3% 14.0% A 25.5% 23.0% BBB 19.1% 5.3% What does the quality distribution tell you? This manager is underweighting AAA rated securities in favor of BBB securities. Why? Possibly to boost the overall yield, or take advantage of the fact that they think BBB rated securities are cheap. Or maybe this is unintentional and they like individual bonds that happen to be BBB rated. 15
16 Fixed Income Portfolio - Example Sector Distribution (%mkt val) Sector Portfolio Index Government Total 18.5% 28.8% Treasury 11.4% 12.5% Agency 4.7% 16.3% TIPS 2.4% 0.0% Credit Total 48.7% 34.2% Finance 21.4% 14.4% Industrial 23.3% 18.0% Utility 3.2% 1.8% Muni 0.8% 0.0% Other Credit non-corporate 0.0% 0.0% What does the sector distribution tell you? This manager is underweighting Government securities and overweighting corporates. Drilling down to the next level would provide you with further information. Does the manager like banks? Do they like insurers? Why? 16
17 Fixed Income Portfolio - Example Sector Portfolio Index Securitized Total 30.7% 30.0% MBS Passthroughs 18.8% 20.0% CMO 5.3% 0.0% CMBS 2.2% 5.0% ABS 4.4% 5.0% Foreign Gov Total 1.3% 7.0% Cash Total 0.9% 0.0% Grand Total 100.0% 100.0% What does the Securitized and Non-US sector allocation tell you? This manager likes the CMO structure in lieu of other MBS. This manager has a significant underweight to Non-US issues vs. the benchmark. Why? Guideline constraints, other reasons? 17
18 Fixed Income Portfolio Performance Attribution How do you know how and why a manager outperformed/underperformed? ATTRIBUTION ANALYSIS! All investment managers should provide you with quarterly attribution analysis. This should be a proof statement that they do what they say they do. If a manager says they don t make duration bets, their attribution report should show this If a manager says they add the most value by bottom up security selection, the attribution analysis should prove this Fixed income attribution is part science, part art, but is an important ingredient in fixed income manager evaluation 18
19 Fixed Income Portfolio Performance Attribution Portfolio Attribution Example Return Portfolio 5.00% Benchmark 4.25% Excess Return 0.75% Manager added 0.75% over the benchmark Attribution of Excess Return Category % Duration -0.01% Yield Curve 0.05% Sector Allocation 0.21% Security Selection 0.70% Other* -0.20% Total 0.75% Manager added most of excess return from security selection * Other denotes impact of quality & convexity 19
20 Fixed Income Portfolio Performance Attribution So, how do managers say they add value? To answer this question, we used information in SAA s Manager Select database. We looked at 40 fixed income managers with AUM of over $5.6 Trillion who provided a breakdown of how they anticipate they will add value over their performance benchmarks. On the next page, we show you what we found 20
21 Fixed Income Portfolio Attribution Breakdown Anticipated Percentage of Value Added Statistics Duration Yield Curve Sector Security Other Total Average Max Min Standard Deviation What does this tell us? 1. Most managers focus on sector allocation and security selection these tools combined should represent 75% of managers value added 2. Though some managers use duration as a tool, none use it exclusively 3. On the contrary, some managers do exclusively use security selection as a tool 21
22 Fixed Income Takeaways We covered a lot of ground but what does it all mean? 1. Fixed income managers have many tools at their disposal and it is important to have an understanding of these tools and the benefits and risks involved in using each of them 2. It is important to know what tools your manager is using, why they are using them, and how these tools will help them outperform 3. Use the reports that managers provide to help you understand what they are doing. If the manager doesn t provide this information, ask for it. 4. Does your fixed income manager provide performance attribution? Are they doing what they said they would do when you hired them? Or are they making bets that you aren t aware of. Attribution will help answer this question. 22
23 Fixed Income - Questions Questions? 23
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