Bond benchmarks may be the source of structural flaws resulting from their very composition. With yields at unprecedented lows, we believe exploiting these flaws through active management techniques can potentially result in more attractive returns for fixed income investors.
Bonds and equities are investment staples, sitting side-by-side in all kinds of portfolio structures but clearly distinguishable by a number of attributes, not least their benchmark composition.
Commonly, equity indices may comprise several hundred stocks, which do not vary greatly over time. Conversely, fixed income benchmarks can comprise thousands of bonds. For example, the Bloomberg Barclays Global Aggregate Index is made up of some 30,000 securities.
When investing in fixed income, the greater number of securities makes benchmark replication more challenging in comparison to equities. In addition, there is near-constant issuance of new securities, given that the average maturity of the securities within it stands at approximately 7.5 years.
Aside from benchmark composition, another distinguishing element is the differing emphasis on returns. Whereas the overwhelming majority of equity investors are focused on maximising them, this does not necessarily apply to all fixed income investors – something becoming increasingly prevalent based on central bank bond buying in recent years.
Fixed income investor behaviour can seek to match assets to liabilities on a cashflow basis. Alternatively, there may be regulatory arbitrage based on individual credit ratings and capital charges that investors in some sectors face, but do not apply to others.
In this way, fixed income – unlike equities – does not need to represent a zero-sum game.
While both asset classes can be subject to information inefficiencies, as bonds don’t routinely trade on formal stock exchanges, price discovery can be opaque. Many securities also comprise complex features, such as callability, subordination or covenant protection, which are difficult to value.
This market structure may be seen to lead to pricing anomalies that can potentially be exploited through active management.
Utilising inefficiencies through active management
Studies have shown fixed income to be an inefficient asset class by means of the identification of observed premia attached to term structure, credit, volatility and liquidity. In our view, investors can enjoy a theoretical over-compensation by exploiting these premia.
At a security-specific level, it is also possible to make an argument with respect to fixed income market inefficiency. When investing in a corporate bond or any other credit, one is hoping to earn an attractive yield and to receive capital paid back at par at the point of maturity. The principal risk an investor is bearing is that the issuer can’t or won’t meet this repayment, meaning that prospective investor returns are subject to a left-tailed risk in the event of default.
In this context, there may be robust arguments to suggest that credit analysis can be undertaken by active investors to avoid those issuers whose credit metrics are on a deteriorating trajectory and are most likely to experience such ‘credit events’.
Capitalising on rebalancing distortions
Fixed income benchmarks are governed by rigid rules with respect to issue inclusion, which may often rely on assessments from third-party credit rating agencies. However, rules around inclusion and exclusion may be exploited by anticipating moves from these agencies, which will flag their intentions to the market in advance of making formal rating adjustments.
Arguably, the greater the volume of assets passively tracking such benchmarks, the greater the distortions around such index-rebalancing events will occur, creating potential market inefficiencies for active investors to exploit.
Fixed income benchmarks – structurally flawed
In equities, one rationale for tracking a market is that the benchmark is constructed to reward the success stories whose stock prices increase over time.
By contrast, bond benchmarks are constructed based on those entities that issue the largest volume of debt. This will skew country and sector composition and one could make the argument that this intrinsically favours struggling names rather than success stories.
At the heart of the fixed income asset class, there exists an interplay between debt issuers seeking to achieve the lowest-possible cost of capital and investors who are commonly seeking to earn the highest return. It can be argued that bond issuers can exploit their understanding of benchmarks to their benefit.
For example, this may see borrowers extending the duration of their issuance at times when interest rates are ultra-low due to the stage of the economic cycle (as is currently the case). Consequently, the composition of a fixed income benchmark can vary greatly over time with respect to its interest rate or credit sensitivity.
Put simply, bond issuers have the potential to exploit passive fixed income investors given the understanding of which bonds will be bought and at what times, based on index composition rules. This can be viewed as a further source of market inefficiency and one which active fixed income investors may also benefit from.
With today’s fixed income offering yields at unprecedented lows, we believe return generation needs to be maximised through proactive approaches that look to utilise the opportunities the asset class offers beyond simple benchmark tracking. We believe the future of fixed income investing needs to be active.
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