MITON’S DAVID JANE: ARE FIXED INCOME INVESTORS TOO FIXATED ON BENCHMARKS?

• Fixed income benchmarks come with significant risk of negative returns
• Prevalence of very poor quality credits coming to the markets
• Investors need to be a genuinely active at times of heightened risk 

David Jane, manager of Miton’s multi-asset fund range, comments:

“It’s a simple but depressing fact that the vast majority of investors, or at least investment managers, are to some extent trying to beat an index. This isn’t necessarily a problem, until there’s too much money chasing too few good investments.

“This can be compounded in fixed income because the biggest components of the indices are those companies with the most debt. So supply creates its own demand. The same goes for equity, to a lesser degree, as the most expensive companies tend to have higher weights in the index.

“In favour of the index-plus approach is the argument that by selecting specialists for each asset class, and then charging them with beating that asset class, investors will get a superior return. This is a reasonable case, however, it of course ignores the most important decision of all – should you invest in the asset class in the first place?

“The index-plus investor never need make that decision, they must simply plough on investing the money as their clients have asked them to, into the asset class, irrespective of whether they think it offers the prospect of an attractive return.

“We raise this issue in the context of a very active fixed income issuance season. Very few investors in fixed income look upon the asset class as we do, i.e. from the context of being long only, unleveraged, and multi asset. Of those that do, few are outcome driven rather than benchmarked.

“For most investors, if they are worried about rising bond yields, they will have less duration than their benchmark. If they are worried about credit, they will carry less credit risk than their peers. This seems sensible until we consider what has happened to the benchmark, which has been consistently rising duration. So, a bond investor who runs a duration one year shorter than the benchmark duration today is taking more absolute duration risk than a neutral position only five years ago.

“The same goes for credit risk, although data is a little harder to come by as credit ratings are generally backward looking. New issuance defined as covenant light is now predominant in high yield, and the prevalence of very poor quality credits coming to the markets seems to move the risk all to the downside.

“When considering fixed income, we don’t consider any benchmark to be a proxy for our clients’ requirements and start from what might be termed first principles: what is the risk/reward of each investment we make and how does it fit within our overall portfolio.

“When looking at government bonds, conventional wisdom would say that long dated government bonds act as a good diversifier of equity risk in a mixed asset portfolio, as while they offer a lower total return they tend to rise when equities fall and vice versa. This would be a beautiful solution to the problem of running mixed asset portfolios, if only it were true.

“In fact, the correlation between gilts and equities is rather variable and while most often negative, not always so. Considering where we are today, one of the more probable causes of a setback for the economy, and hence equity markets, would be rapid rises in bond yields, then clearly gilts are not going to be a good diversifier. This, combined with the fact they are not offering an attractive income return, means they must be ruled out as the bedrock of a fixed income strategy. So we need to look elsewhere for diversification and return.

“A mainstream corporate bond strategy offers some of the same problems as gilts, yields are too low to offer an attractive risk/reward, particularly with credit spreads as low as they are, while interest rate risk is too high as the duration is too long. While the asset class offers slightly higher returns than gilts, overall downside appears to trump the upside.

“We need to look much deeper into the asset class to find the pockets of value which can offer a decent risk return profile. While the index for corporate bonds would suffer greatly from anything but the status quo, either growth is better, and hence yields rise, or growth deteriorates and spreads rise, leading to negative returns. Unless everything stays as is, we can find areas where the risk reward is more attractive, although to do so we must forego some potential upside.

“When we consider very short dated corporate bonds, particularly those issued many years ago when rates were higher we can find an attractive risk/reward profile. This type of bond can offer a decent yield pick up over cash while its total return is fairly independent of interest rates as its maturity is close at hand.

“While we must accept some credit risk, companies do not often fail completely without warning, so by avoiding industries and companies that are problematic, we can minimise, but not totally eliminate, this risk.

“So, our base case is dull, but steady returns, our downside is a smattering of defaults, reducing but not eliminating our return. But what of the upside? While not spectacular, there’s some upside from refinancing, as companies have a huge incentive to refinance higher coupon debt in order to reduce the interest cost to their profits and to do so they must pay holders a premium. So while we see little upside in buying the newly issued bonds we can see a little upside from owning those which get refinanced.

“In conclusion, we expect dull returns from fixed income, with the benchmarks offering a significant risk of negative returns either as monetary policy returns to normal as the economy grows and/or inflation rises, or from a weakening economy and hence credit spreads rising. This is a very poor risk reward profile, and a significant problem for benchmark hugging investors. It doesn’t however mean we must avoid the asset class altogether as we can find places where risk is much lower that offers a high probability of a positive, if low, return. At times of heightened risk you need to be genuinely active.”

• Fixed income benchmarks come with significant risk of negative returns
• Prevalence of very poor quality credits coming to the markets
• Investors need to be a genuinely active at times of heightened risk 

David Jane, manager of Miton’s multi-asset fund range, comments:

“It’s a simple but depressing fact that the vast majority of investors, or at least investment managers, are to some extent trying to beat an index. This isn’t necessarily a problem, until there’s too much money chasing too few good investments.

“This can be compounded in fixed income because the biggest components of the indices are those companies with the most debt. So supply creates its own demand. The same goes for equity, to a lesser degree, as the most expensive companies tend to have higher weights in the index.

“In favour of the index-plus approach is the argument that by selecting specialists for each asset class, and then charging them with beating that asset class, investors will get a superior return. This is a reasonable case, however, it of course ignores the most important decision of all – should you invest in the asset class in the first place?

“The index-plus investor never need make that decision, they must simply plough on investing the money as their clients have asked them to, into the asset class, irrespective of whether they think it offers the prospect of an attractive return.

“We raise this issue in the context of a very active fixed income issuance season. Very few investors in fixed income look upon the asset class as we do, i.e. from the context of being long only, unleveraged, and multi asset. Of those that do, few are outcome driven rather than benchmarked.

“For most investors, if they are worried about rising bond yields, they will have less duration than their benchmark. If they are worried about credit, they will carry less credit risk than their peers. This seems sensible until we consider what has happened to the benchmark, which has been consistently rising duration. So, a bond investor who runs a duration one year shorter than the benchmark duration today is taking more absolute duration risk than a neutral position only five years ago.

“The same goes for credit risk, although data is a little harder to come by as credit ratings are generally backward looking. New issuance defined as covenant light is now predominant in high yield, and the prevalence of very poor quality credits coming to the markets seems to move the risk all to the downside.

“When considering fixed income, we don’t consider any benchmark to be a proxy for our clients’ requirements and start from what might be termed first principles: what is the risk/reward of each investment we make and how does it fit within our overall portfolio.

“When looking at government bonds, conventional wisdom would say that long dated government bonds act as a good diversifier of equity risk in a mixed asset portfolio, as while they offer a lower total return they tend to rise when equities fall and vice versa. This would be a beautiful solution to the problem of running mixed asset portfolios, if only it were true.

“In fact, the correlation between gilts and equities is rather variable and while most often negative, not always so. Considering where we are today, one of the more probable causes of a setback for the economy, and hence equity markets, would be rapid rises in bond yields, then clearly gilts are not going to be a good diversifier. This, combined with the fact they are not offering an attractive income return, means they must be ruled out as the bedrock of a fixed income strategy. So we need to look elsewhere for diversification and return.

“A mainstream corporate bond strategy offers some of the same problems as gilts, yields are too low to offer an attractive risk/reward, particularly with credit spreads as low as they are, while interest rate risk is too high as the duration is too long. While the asset class offers slightly higher returns than gilts, overall downside appears to trump the upside.

“We need to look much deeper into the asset class to find the pockets of value which can offer a decent risk return profile. While the index for corporate bonds would suffer greatly from anything but the status quo, either growth is better, and hence yields rise, or growth deteriorates and spreads rise, leading to negative returns. Unless everything stays as is, we can find areas where the risk reward is more attractive, although to do so we must forego some potential upside.

“When we consider very short dated corporate bonds, particularly those issued many years ago when rates were higher we can find an attractive risk/reward profile. This type of bond can offer a decent yield pick up over cash while its total return is fairly independent of interest rates as its maturity is close at hand.

“While we must accept some credit risk, companies do not often fail completely without warning, so by avoiding industries and companies that are problematic, we can minimise, but not totally eliminate, this risk.

“So, our base case is dull, but steady returns, our downside is a smattering of defaults, reducing but not eliminating our return. But what of the upside? While not spectacular, there’s some upside from refinancing, as companies have a huge incentive to refinance higher coupon debt in order to reduce the interest cost to their profits and to do so they must pay holders a premium. So while we see little upside in buying the newly issued bonds we can see a little upside from owning those which get refinanced.

“In conclusion, we expect dull returns from fixed income, with the benchmarks offering a significant risk of negative returns either as monetary policy returns to normal as the economy grows and/or inflation rises, or from a weakening economy and hence credit spreads rising. This is a very poor risk reward profile, and a significant problem for benchmark hugging investors. It doesn’t however mean we must avoid the asset class altogether as we can find places where risk is much lower that offers a high probability of a positive, if low, return. At times of heightened risk you need to be genuinely active.”