Fixed Income Management
Evolution or Revolution?
June 2008
Susan Buckley, Managing Director, Active Management Division
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Discussion Agenda
• The Traditional Approach to Fixed Interest
• Evolution or Revolution? – The separation of Alpha and Beta
• Accessing Fixed Interest Beta Risk and Return
• Meaningful Fixed Interest Alpha
2
The Heritage of Fixed Interest…..
• Traditional Approach was based on the concept of Strategic Asset Allocation (SAA)
• Fixed Income was mainly used as a risk reduction allocation within diversified
portfolios
• Active returns were low, and the weighted contribution of the assets to the total
portfolio return was negligible.
• Downweighting of the asset class, within portfolios, in order to search for
alternatives that added more meaningful return.
• This encouraged fixed interest managers to evolve and remain meaningful.
3
Traditional Fixed Interest Management
•
Fixed income portfolios were historically managed relative to a specific
benchmark. Eg. UBS Composite Bond Index, Lehman’s Global Aggregate
•
BUT, these benchmarks embody a number of complex issues.
•
The 2 major inefficiencies relate to:
– Duration problem – duration of benchmark comes from issuer preferences and
is not necessarily duration that a given investor should hold.
– “Bums” problem – the biggest debtors have the largest weight in the
benchmark.
•
4
The recent growth in size of the credit market has also caused a number of issues.
Bond returns have disappointed Australian Investors…..
1 Year Rolling Returns: Cash (Bank Bills) Versus Australian (UBS) and Global
Fixed Interest (LGA)
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
Dec-90
Dec-94
UBS Composite Bond Index
•
UBS Bank Bill Index
Dec-02
Dec-06
Lehman Bros Global Aggregate (AUD)
Fixed Interest market (beta) returns have disappointed in recent years
–
5
Dec-98
Australian Fixed Interest underperforming cash returns
Weaknesses of the Traditional Approach
• Pre-occupation with benchmarks and a reluctance to hold significant allocations to
assets which fall outside the benchmark.
• Strategic asset allocations tend to be static for long periods, even in the face of
significant changes in market valuations.
• Active mandates are allocated in accordance with SAA weights – possibility of
insignificant contributions.
• Active managers tend to be analysed by investors on an unweighted basis
6
Evolution or Revolution? – The Separation of Alpha and Beta
• Fixed Income portfolios can provide significantly different risk and return outcomes,
depending on composition and construction.
• Beta Policy
– Developed to provide market return stream from risk premia
– Allocations include sector exposures, country allocations, credit limits, inflation exposure
and overall duration.
– Structure of Beta portfolio should reflect investment objective and risk preference of client
• Alpha Policy
– Aimed at construction of absolute return portfolio that provides:
 Diversification (multiple alpha sources)
 Consistent return stream
 Outcome not tied to changes in Beta portfolio
7
Accessing Fixed Interest Beta Risk and Return
• Sources of Fixed Interest asset return are driven by four fundamental factors:
– Real Interest rate risk
- Credit Risk
– Inflation uncertainty
- Illiquidity Risk
• Exposure of traditional beta sources to conceptual risk premiums:
Beta Source
8
Real
Interest
Rate Risk
Inflation
Risk
Credit
Risk
Illiquidity Risk
Sovereign
X
X
Inflation Protected Securities
X
Investment Grade Credit
X
X
X
X
High Yield Credit
X
X
XXX
XX
Securitised
X
X
X
X
Emerging Market Credit
X
X
XX
X
X
• Some asset classes are more effective in accessing risk premia
Methods of Beta Replication
• Physical Index Replication
 Full replication is the lowest risk - but is highly complex.
– For example Lehman Global Aggregate Portfolio contains over 12,000 issues
 Enhanced indexing – investing in large sample of bonds such that portfolio risk factors
match index risk factors
• Synthetic Beta Replication
 Shown to be effective – achieved by utilising market inovations
 Instruments used include:
– Bond Futures
– Interest Rate Futures
– Interest Rate Swaps
– Mortgage Futures
– Credit Default Swaps / Indexes
9
Achieving Meaningful Alpha
Reasons why fixed income alpha can be meaningful
10
•
Improved diversification of alpha sources with switch to absolute return from
fixed interest benchmarks
•
Flexibility to adjust underlying betas without disrupting alpha sources
•
Low correlation to Beta
•
Greater capital capacity with use of derivatives and overlays
•
Alpha becomes more scaleable
Breadth – Improving the Opportunity Set
Fixed Interest Asset Spectrum
Distressed Debt
Emerging
Markets
Reward
High Yield
Investment
MortgagesGrade
Inflation
Sovereign
Risk
Fixed interest provides a BROAD opportunity set
11
•
Global
•
Access to the entire capital structure
•
Access to the entire risk curve
What Does Diversified Fixed Interest Alpha Look Like?
Global Fixed Interest Alpha Strategies
Interest Rate Country Spread
Duration
Yield curve
Inflation Linked
Volatility
Macro Credit
Micro Credit
Sector Credit Spreads
High Yield
Emerging Market
Swap Spreads
Structured Credit
12
Scaleable – Largest Global Markets - Currency and Fixed Interest
Fixed interest provides SCALEABILITY due to its broad opportunity set
•
Availability of fixed interest derivatives markets
•
Highly liquid
•
Economies of scale
QIC is using less than 2.0% of capital to generate 25bpts of fixed interest
alpha over $50bn ie. $125m pa target
•
13
Achieved via derivatives for strategy implementation and beta
hedging
Sourcing Alpha from Breadth of Opportunity Set
Market Exposures
• Global
government
bonds
GFI ALPHA
FUND
Investor
Margin Requirements
QIC Cash
Enhanced
Profit & Loss
Cash Flow
Maintenance
• Global credit
• Emerging
markets and
high yield
Macro Strategies
Yield
Curve
Volatility
Active Strategies
• Macro interest
rate and credit
• Micro credit
14
Duration
Country
Spreads
Inflation
Spreads
Global Credit Strategies
Swap
Strategies
Relative
Value
Sector/Industry Country Credit Credit Yield
Allocation
Curve
Spreads
Uncorrelated to Other Sources of Return
Fixed interest alpha can provide UNCORRELATED returns
Equity and Fixed Interest Correlations to QIC Global
Fixed Interest Alpha (2004-2008)
1.0
0.8
0.6
Correlation
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
vs Australian Equities
vs International Equities
vs Australian Fixed Interest
vs International Fixed Interest
The fixed interest alpha used in measuring correlation is taken from QIC Global
Fixed Interest overlays and the GFI Alpha Fund. The correlations are based on over
four years of data.
15
What’s So Good About Low Correlation?
Return
Impact of Allocating to Fixed Interest Alpha for Balanced Product
Risk
14.0%
12.00%
12.01%
12.03%
12.06%
12.11%
12.0%
10.0%
8.00%
8.20%
8.40%
8.60%
8.80%
8.0%
6.0%
4.0%
2.0%
0.0%
0%
0.20%
0.40%
0.60%
0.80%
Allocation to fixed interest alpha
16
The fixed interest alpha used in measuring correlation is taken from QIC Global
Fixed Interest overlays and the GFI Alpha Fund. The correlations are based on over
four years of data.
Achieving Meaningful Alpha Returns
To access fixed interest alpha successfully requires:
17
•
Global capability
•
Flexible mandates that allow derivatives
•
Strong risk systems and governance
•
Robust investment process
•
Absolute return focus
Derivatives and Risk Control
Global derivative capabilities requires:
•
Experienced fixed interest staff
•
Wide selection of counterparty contacts and ISDA agreements
•
Global coverage across the major financial centre (London, New York,
Tokyo, Hong Kong & Sydney).
Risk Control:
•
Understanding the risk factors attached to the derivative instruments
–
•
18
This is particularly important for new instruments such as credit
derivatives and inflation swaps
Stress testing, VAR analysis is crucial
Packaging Fixed Interest to be More Meaningful – Going Forward
- Explicit focus on Client’s total portfolio objectives
- Think about risk and adding value at fund level
- Get away from irrational capitalisation weighted debt indices
- Target fixed interest betas that meet client objectives
- Make fixed interest alpha meaningful
- Improve capital efficiency
19
Separating Fixed Income Beta and Alpha for Improved
Client Outcomes…
Beta
Alpha
Global Fixed Interest Beta Strategies
Cash
Global Fixed Interest Alpha Strategies
Nominal Short Duration
Interest Rate Country Spread
Nominal Long Duration
Yield curve
Nominal Country Allocation
Inflation Linked
Inflation
Macro Credit
Inflation Country Allocation
Volatility
Micro Credit
Sector Credit Spreads
Investment Grade Credit
High Yield
High Yield Credit
Swap Spreads
Emerging Market Credit
Swap Spread
• To achieve clients’ overall objectives
20
Duration
Emerging Market
Structured Credit