Scrutinizing the Fixed-Income Landscape

The fixed-income crisis that shook global markets from mid-2007 through early 2009 reverberated far and wide. During the worst of it, markets that were normally liquid froze. Even low-risk, stable investments, such as money market instruments, faced difficulty and raised investors’ fears. Terms such as “structured,” “securitized” and “leveraged,” which previously promised enhanced yield, became red flags, warning risk-averse investors to steer clear of securities that were too complex to understand fully.

The impact that all this will have on investment opportunities and risk perceptions is significant, according to Northern Trust investment executives. Among the changes they see are changing supply and demand dynamics, increased regulation, better risk management, a focus on liquidity and a return to more historical return levels following the extreme volatility of 2007 to 2009.

A Shift to Passive Investment Management

As economies recover from the broadest and deepest downturn in decades, one of the most profound changes the Northern Trust team sees is a shift in the composition of global fixed-income markets. “With governments deeply in debt, issuance of government securities is rising and is likely to remain high for years,” says Brad Adams, senior fixed income product manager at Northern Trust. “Governments have become heavy issuers of debt, running huge deficits. We expect that their outstanding debt — and, consequently, the weighting of government securities in fixed-income market benchmarks — will grow.”

Over the past year there also has been increased issuance of corporate debt. One factor contributing to the rise in the supply of these types of securities has been banks’ greater caution to engage in lending. Also, it has been much easier and less expensive for corporations to obtain funding in the capital markets. Investors leaving the securitized sectors perceive diversified corporate exposure as a decidedly better way to pick up yield with less volatility.

In addition to the expansion of debt issuance, there is a rising aversion to structured products, such as asset-backed and mortgage-backed securities. “Institutional investors now find simple, straightforward securities, such as government and corporate bonds, more appealing than complex products that may carry unknown risks,” notes Wayne Bowers, chief executive officer, Northern Trust Global Investments, London.

As a result of these supply and demand trends, the composition of fixed-income indexes is expected to shift toward government bonds and relatively high-quality corporate credit and away from structured products, which are out of favor with investors.

The move toward a more basic approach to debt management dovetails with another investor trend: a growing interest to shift from active to passive investment management. “With investors wanting less complicated investment solutions,” says David Rothon, director of cash and fixed income product development, Northern Trust, London, “the increased use of passive strategies will magnify the impact of shifts in issuance. And as the dynamic of rising government bond issuance changes the composition of fixed-income benchmarks, we will likely see a cycle that perpetuates further demand for government securities.”

This points to a concern investors have with index strategies tied to broad benchmarks such as the Barclays Capital Aggregate Index; index composition is driven by issuance. “In recent years, this meant that investors employing passive strategies held a higher weighting in mortgages than they might have wanted and less Treasury debt,” says Adams. “That decision was made for managers of indexed products by the composition of the overall market rather than the merit of the investments themselves, although the index concentrates on the best, most liquid securitized products.”

An additional risk facing investors using a passive fixed-income strategy is that the largest issuers of debt within an index universe typically will have a large weighting within the benchmark. Depending on the health of a bond issuer’s balance sheet, investors could be exposed to hidden risks. “One way that we have seen clients manage around that in a global fixed-income mandate,” Rothon says, “is to exclude a country that is considered particularly high risk from a passive portfolio in the design phase, and then work with us to manage the remaining market exposure passively.”

Uncover Hidden Risks

Whether pursuing passive or active strategies, investors must be aware of hidden risks. For instance, just as investors in passive strategies are subject to the benchmark’s default asset allocation, active investing has typical biases as well. “Active managers tend to be overweight spread product,” Adams says. “When spread products such as mortgage-backed or asset backed, and even corporate securities, perform handsomely, active managers generally do well. But when spread products falter, active managers have tended to underperform the benchmark, sometimes significantly.”

Active managers regularly invest in “out of benchmark” securities (e.g., emerging market debt and high yield securities), which is a key tool they use to generate excess return, but with added risk.

Another major risk associated with active management involves manager selection. Only a handful of active managers have consistently outperformed the market over long periods. Choosing the wrong manager could substantially affect returns.

When investing passively, investors must first decide on which index to track. For U.S. bonds, the Barclays Capital Aggregate Bond Index and the Government/Credit Index present material differences. The Aggregate Index holds a weight of more than 40% in asset-backed and mortgage-backed securities while the Government/Credit benchmark excludes these, Adams says. Investors should consider very carefully the type of risk exposure they prefer.

Corporate Bonds More Attractive Than Structured Debt

The unraveling of complex structured investments, and the ensuing negative impact on investors’ portfolios, has understandably fueled a back-to-basics movement. “In practical terms, it means that corporate bonds with a basic, plain vanilla flavor are more attractive than structured debt products, reflecting a growing distaste for risk,” notes Adams.

A logical outcome of this move toward simpler solutions will directly affect the behavior of institutions such as banks. “Banks will act more like banks,” Bowers says. “They’ll have smaller balance sheets. They’ll take deposits and use that money to lend, rather than issue securitized products. And they’ll rely less on leverage or structure for the creation of lending products.”

Bowers also foresees more stringent capital reserve requirements against a business line that supports structured credit or securitized products. Should such requirements come into being, he sees basic profitability equations driving behavior. “Banks won’t sell asset-backed commercial paper to money market funds any more, and they won’t look to buy longer-dated, lower-rated, higher-yielding, securitized products on their balance sheet.”

In the United Kingdom, the Financial Services Authority (FSA) has proposed that all banks with a branch in the country will need to demonstrate that they have a liquidity buffer. “In essence, they’ll be required to own high-quality U.K.-issued government bonds,” observes Bowers. “The thinking is that this liquidity buffer is needed in order to protect the depositors, shareholders and the banks themselves in times of crisis.”

In some cases, a bank may have had a buffer during the recent liquidity crisis but couldn’t access it because it had invested in asset-backed commercial paper, floating rate notes or collateralized debt obligations. Although these products had attractive yields and contributed to bank profitability, they didn’t help when liquidity was needed. The regulatory proposals aim to prevent a repeat of that situation. “This also has the effect of increasing demand for government bonds, whilst reducing demand for structured and securitized bonds,” Bowers says.

Lower Return Expectations

In terms of fixed-income market performance, the unusually strong across-the-board market bounce in 2009 can’t be expected to last, Rothon says. “Rather than continue to be thirsty for yield, investors have to accept a changing scenario and reel in their expectations for higher returns because of the fundamental changes that are leading to greater government bond issuance.”

However, institutional investors must assess their organizations’ investment goals. A pension plan sponsor, for example, will need to weigh tradeoffs such as seeking higher returns –– and accepting more volatility –– through greater equities exposure or focusing on matching the pension plan’s liabilities with more fixed-income exposure. “An underfunded pension plan might be under pressure to seek additional return,” Rothon says. “That might lead it to take on more risk in an effort to reduce its deficit. In the big picture however, investors generally have to accept that the road to recovery will be bumpy and understand that we may not see double-digit returns in the fixed-income markets again for some time.”

Bowers observes that because emerging markets bonds made very significant gains last year, they’ve attracted a great deal of interest. However, he cautions that they comprise less than 1% of global bond issuance. “Before investors take on emerging markets exposure, they should be diversified in the major markets of the United States, Europe, Japan and the U.K.,” he says. “That provides exposure to four distinct economic, policy, fiscal stimulus and inflation cycles.”

Bowers also sees value in ramping up sovereign bond research capabilities to be able to understand the factors that affect the creditworthiness and risks of exposure to troubled countries, such as Greece and Ireland. With increasing government bond issuance, he says it makes sense to focus research “on the balance sheets of countries rather than just companies.”

A critical opportunity may arise when governments decide how to unwind their fiscal support based on their country’s specific economic circumstances. “What will be the impact on fixed-income markets when countries begin to withdraw some of these stimulative policies?” Rothon asks. “It’s like switching off a life support machine. We won’t know how robust any economy is until that happens.”

Updated Money Market Fund Proposals

Globally, regulatory bodies have been considering risk-limiting rules that are designed to further stabilize money market funds and increase the safety and liquidity for money market fund shareholders. In the United States the Securities and Exchange Commission recently approved rule changes to tighten existing requirements regarding the maturity, quality, liquidity and disclosure of money market fund portfolios. A dozen more organizations around the globe, including the Institutional Money Market Funds Association in Europe, have proposed similar changes designed to reduce credit, interest rate and liquidity risk.

The anticipated impact of these actions, Bowers says, would be to reduce demand for securitized asset-backed products by money market funds and force them to own safer, lower-yielding securities, from Treasury bills to short-dated government debt. “This will tighten the focus of money markets on preserving principal and providing liquidity, and limit the chasing of yield, which is how Northern Trust manages these pools,” he says.

Adapt and Move Forward

As the markets move forward from the credit crisis to the creation of a more normal and healthy market, it’s important to distinguish between any temporary market phenomena and longer-term or permanent changes. “The move to greater government bond issuance and away from structured product was prompted by the credit market disaster of 2008,” Adams says, “but these and other major trends, such as increased pension plan focus on matching liabilities, are long-term changes. We all need to move in step with the market as it evolves, adjust our expectations and capitalize on new developments.”

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