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June 19, 2020
Active Management in Fixed Income: Now More than Ever
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June 19, 2020

Active Management in Fixed Income: Now More than Ever


Market Pulse

Active Management in Fixed Income: Now More than Ever

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June 19, 2020

 
 

Global fixed income strategies that actively manage duration, sectors, credit and yield curve positioning are more important than ever given the post-pandemic low yield environment—where sitting by passively can lead to missed opportunities and potential losses.

 
 

A fundamental shift is underway in fixed income. Global central banks have responded to the economic fallout from CoVid19 by pushing interest rates to near zero in many countries, and actually going negative in others. Understandably, this has investors questioning whether bonds are useful diversifiers in portfolios, especially if bond yields have minimal airspace to fall.

Our solution is relatively simple: We focus on generating alpha in portfolios through active  management. Contrast our approach to constrained passive strategies that rely solely on declining interest rates, aka beta. We do not think that beta-reliant passive strategies will work in either the current environment or a future rising-rate environment. We believe investors need to consider truly committed active managers.

The pandemic sparked a financial crisis followed by an explosion of monetary and fiscal policy responses that require new thinking about how fixed income is deployed in a portfolio. As investors, we need to actively manage both the economic and policy fallout in the aftermath of the most recent crisis, and in our long-tenured experience, we apply a straightforward crisis framework to help anticipate the response from financial assets, as follows:

  1. Central bank policies move to support specific financial assets that are under stress, with an overriding goal of easing financial conditions
  2. We identify the assets that are being most strongly supported and buy those that may benefit most from policy and government support.
  3. Most importantly, we firmly believe “it’s never different this time,” in the sense that policy makers are always willing to scale up support for assets, as needed, in order to ensure a recovery in prices.
     

We dub this our crisis rule book, rough guidelines we follow as we try to anticipate the performance of the market in the months, perhaps years, after a given crisis. In short, policy makers act to effectively create a “fire break” to help prevent the immediate liquidity blaze from spreading into a full-out solvency inferno.

From an investment perspective this directs our thinking to which assets may perform better and which assets may lag. And this is ultimately the point. We believe one needs to engage investing with an active management style such that asset selection becomes the dominant source of potential return and alpha, while distancing from a passive approach that relies on perpetually falling interest rates and where the weighting of the index (beta) ultimately makes the asset selection decision for the investor.

The importance of active management

Over the past 12 years, sustained monetary stimulus — the lowering of interest rates aimed at keeping economies afloat after the global financial crisis of 2007-2008 (GFC) — made it easy for fixed income managers to earn returns. The systemic effect throughout the market, the beta, overwhelmed return contributions by idiosyncratic factors, alpha (Display 1). As yields fell bond prices rose across the board, such that simply being invested in the bond market was enough to earn decent returns.

 
 
 
Display 1: Shifting from beta to alpha
 

This chart is for illustrative purposes only.

 
 

That has all changed. Today, interest rates are hovering near zero (even negative in some countries), and it is no longer enough to just be “in the market.” Making active choices around duration, sectors, credit and yield curve positioning is more important than ever, where suboptimal decisions, or worse, no decision-making, can lead to missed opportunities and potential losses.

The beta avalanche is over

The stimulative policies that drove fixed income returns indiscriminately across entire markets, what we refer to as the beta avalanche, have returned to the point where “easy beta” is no longer a viable investment strategy. But ongoing policy decisions need to be watched assiduously, as the ripple effects across markets become tricky to predict with any assurance.

 
 

The era of beta dominance actually goes back much farther than the GFC of 2007-2008. For close to four decades, declining yields have been a primary support for fixed income returns. In fact, from 1989-2017, the Bloomberg Barclays U.S. Aggregate Bond Index averaged a 6.4% annual return. Of that, 95% was derived from duration, the beta effect of falling yields across fixed income markets.1

A few years prior to the 2020 pandemic, the shift from beta to alpha as the dominant driver of returns was well underway, and we thought truly marked the beginning of a new era in fixed income. By early 2018, most major central banks had either ended or were starting to end their stimulative monetary programs. By comparing index returns in 2018 and 2019 combined to those during the 10 years of monetary stimulus (2008-2017), we see a new era unfolding: The cessation of stimulus prior to the current crisis has slowed down the beta engine that had fueled returns in earlier years (Display 2).

 
 
 
Display 2: The beta engine is out of gas
 

Source: Morgan Stanley Investment Management. Data as of May 2020. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. Returns for less than one year are cumulative (not annualized). See Disclosure section for Risk Considerations and index definitions.

Investing involves risks including the possible loss of principal. In general, fixed income investments are subject to credit and interest rate risks. High yield investments may have a higher degree of credit and liquidity risk. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than investments in foreign developed countries. Investors should carefully review the risks of each asset class prior to investing.

 
 
"
We firmly believe in active management focused on asset selection, distancing from a passive approach that relies on perpetually falling interest rates."
 
 
 

Just being in the market and benefitting from “easy beta” was no longer enough and given the current stimulus programs is still not enough. We believe the one certainty post-pandemic is that asset valuations will eventually normalize, migrating to levels that are in line with their idiosyncratic fundamental merits. This return to normalcy ultimately means that, to earn competitive returns, managers will need to identify and capitalize on those merits.

In this new era, fixed income retains its role as a diversifier

As the shift to alpha-driven returns unfolds, investors may naturally be tempted to question the validity of bonds as diversifiers. Some research shows that negative stock-bond correlations, which are suggestive of strong diversification benefits, are associated with accommodative monetary policy.Given that the era of accommodative monetary policy will likely reverse at some point post-pandemic, it would be logical for investors to question the diversification benefits of fixed income in the future.

Our answer, unequivocally, is that bonds will continue to play a vital role in portfolio diversification—both in the new era and throughout changing market cycles for many years to come. In our view, though, skilled active management will be crucial to producing positive returns and creating those diversification benefits.

Challenge: There is little yield cushion

We believe it will be possible to earn competitive returns from fixed income, but it will require greater skill than in years past. One of the biggest challenges will be to manage interest-rate risk when there is virtually no yield cushion to buffer the effects of rising rates down the road.

A comparison here is useful. In the pre-GFC period when interest rates were higher—and even going back as far as the 1980s—a generic allocation to investment grade fixed income provided both return and diversification properties because bond yields were simply much higher. In the 1990s, for example, an investor could buy A-rated corporate bonds with yields averaging over 7%. Such bonds could absorb an approximately 130-basis point rise in U.S. Treasury yields before incurring an absolute return loss.

That sort of yield cushion does not exist today. In fact, a rise of just over 50 basis points in U.S. Treasury yields could trigger an absolute return loss in today’s market, all else being equal (Display 3).

 
 
 
Display 3: Not the same without a yield cushion
 

Source: Bloomberg Barclays A-rated Corporate Bond Index. Data as of June 2020. Data shown for the 1990s is an average from 1990–1999. This interest rate sensitivity analysis is spread neutral.

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions. Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.

 
 

In no way are we suggesting that yields are going to spike higher anytime soon. What we are suggesting, however, is that at some point post-pandemic we could be nearing an inflection point. As we see it, the secular decline in yields will eventually come to an end, and bond yields may bounce along the bottom and trend higher in the years to come.

 
 
"
We advocate owning an actively-managed bond fund over individual bonds because it can reduce concentration risk."
 
 
 

A shift toward alpha requires a change in strategy

In this environment, where market beta adds little value or even detracts from returns, it becomes fundamentally important to tap into alpha-based sources of return. This is where investors need to make choices, and there is a spectrum of strategies from which to choose.

On one end of the spectrum are popular passively-managed index strategies that rely solely on beta as a source of return. On the other end, non-indexed active strategies (like the ones we manage) have the potential to also generate alpha through in-depth analysis of duration, sectors, credit spreads and yield curve structure (Display 4).

 
 
 
Display 4: Adding alpha
 

Source: Morgan Stanley Investment Management, June 2020. This is for illustrative purposes only and is not exhaustive.

 
 

In our view, only by taking advantage of these more idiosyncratic opportunities in global markets can investors achieve alpha. Given today’s market conditions, we think that returns from alpha-oriented decisions have the potential to exceed returns from simple market exposure, beta. For this reason, we think it is time for investors to consider increasing their allocations to alpha-focused fixed income strategies.

The right alpha-producing conditions

Market beta is easy to manage to, but alpha is a scarce commodity that needs serious attention. Producing alpha is a delicate art and science: Managers need to have the right analytical resources and infrastructure to support their ability to find alpha.

Large asset managers may struggle to generate alpha because they may not be able to secure enough individual bonds to fill their needs. To compensate, they may frequently rely on derivatives to gain synthetic exposure.

These derivatives usually behave like indexes and thus are largely beta-driven, effectively defeating the purpose of active alpha-seeking strategies. Reliance on derivatives can also be costly, and it is no substitute for a durable portfolio of actual securities.

In general we advocate owning an actively-managed bond fund over individual bonds because it can reduce concentration risk. The fund can have a measurable advantage by providing diversification across a wide range of sectors. It is difficult to replicate these diversification benefits by merely owning a series of individual bonds, even in a laddered strategy (which holds individual bonds of different maturities).

Conclusion: A new era requires a focus on alpha

Today, fixed income markets will likely live in a low interest rate environment for the foreseeable future. The beta engine is out of gas, where the falling interest rate environment of the past 40 years has disappeared. For rates to fall further, the U.S. would have to “go negative,” which we do not see as a viable or likely option. In our opinion, the diversification benefits of fixed income remain intact, but investors can no longer count on passive strategies reliant on beta to earn competitive returns.

This new era, post-GFC and post-pandemic, requires a new mindset in our opinion. Now, more than-ever, investors will need to explore actively managed alpha-focused strategies in an effort to achieve competitive performance. These strategies should be overseen by skilled, experienced managers who have the latitude to dynamically adjust their portfolios in an effort to extract value from duration positioning, credit and sector analysis, yield curve exposure and security selection. We believe the choices fixed income investors make today will have significant implications for performance and diversification well into the future.

 
 

1 Data from Bloomberg Barclays U.S. Aggregate Bond Index (1989-2017)

2 Systemic Risk and Systematic Value: “The correlation of equity and bond returns” http://www.sr-sv.com/the-correlation-of-equity-and-bond-returns/


 
 

Risk Considerations

Diversification neither assures a profit nor guarantees against loss in a declining market. There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging-market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

 
jim.caron
Portfolio Manager
Global Fixed Income
 
 
 
 

INDEX DEFINITIONS

The Bloomberg Barclays Euro Aggregate Corporate Index (European Investment Grade) is an index designed to reflect the performance of the euro-denominated investment-grade corporate bond market.

Bloomberg Barclays Global Aggregate Hedged USD Index provides a broad-based measure of the global investment grade fixed-rate debt markets. Total Returns shown is hedged USD.

The Bloomberg Barclays Global High Yield Corporate Index (Global High Yield) is a multi-currency measure of the global high yield corporate debt market. The benchmark name changed from Barclays Global High Yield – Corporate Index to Bloomberg Barclays Global High Yield – Corporate Index on 24 August 2016.

The Bloomberg Barclays U.S. Corporate Index (U.S. Investment Grade) is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market.

The Bloomberg Barclays U.S. Mortgage-Backed Securities Index (Asset- Backed Securities) tracks agency mortgage-backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage. Introduced in 1985, the GNMA, FHLMC and FNMA fixed-rate indexes for 30- and 15-year securities were backdated to January 1976, May 1977 and November 1982, respectively. In April 2007, agency hybrid adjustable-rate mortgage (ARM) pass-through securities were added to the index.

EM Debt – Represented by a Blended Index of equal-weighted (1/3%) of JP Morgan EMBI Global, JP Morgan CEMBI Broad Diversified and JP Morgan GBI-EM Global Diversified Index. The JP Morgan Emerging Markets Bond Index Global tracks total returns for traded external debt instruments in the emerging markets and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans and eurobonds with an outstanding face value of at least $500 million. The JP Morgan Corporate Emerging Markets Bond Index Broad Diversified Index is a global, liquid corporate emerging markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging markets entities. The JP Morgan Government Bond Index-Emerging Markets Global Diversified Index is a market-capitalisation-weighted, liquid global benchmark for U.S.-dollar corporate emerging market bonds representing Asia, Latin America, Europe and the Middle East/Africa.

JP Morgan Global Government Bond Index (Global Government Bonds) is a market value weighted fixed income index comprised of government bonds in developed countries.

DEFINITIONS

Alpha (Jensen's) is a risk-adjusted performance measure that represents the average return on a portfolio or investment above or below that predicted by the capital asset pricing model (CAPM) given the portfolio's or investment's beta and the average market return. Prior to 6/30/2018 Alpha was calculated as the excess return of the fund versus benchmark. Beta is a measure of the relative volatility of a security or portfolio to the market's upward or downward movements.

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Past performance is no guarantee of future results. The returns referred to in the commentary are those of representative indices and are not meant to depict the performance of a specific investment.

The views, opinions, forecasts and estimates expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market, economic or other conditions. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

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