An Unconstrained Approach to Global Bond Investing

The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2019 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 17–18 October.

Marilyn Watson, managing director and head of global fundamental bond product strategy at BlackRock, is optimistic about opportunities in global bond markets, despite significant challenges in the current interest rate environment.

Watson discussed a flexible, unconstrained approach to managing global bond portfolios that taps into the broadest opportunity set available and uses diversification to weather uncertainty, at the CFA Institute Fixed-Income Management Conference 2018.

“In this environment that we’re heading into now . . . being flexible is incredibly important,” she said. “If you can be flexible and dynamic in your portfolio positioning, then really I think it’s a very exciting time for fixed-income investors.”

The Changing Investment Landscape

Higher interest rate risk, the withdrawal of liquidity by the US Federal Reserve, idiosyncratic events, and increased volatility are changing global bond market dynamics, Watson noted. “For three decades, bond investors have benefited from loose monetary policies,” she said. “But with that, we’ve seen a massive decrease in bond yields and reduction in the carry that investors can get across bond markets.”

What does this mean for investors today? “A lot less carry per unit of duration,” she said.

Watson also warned about the inadvertent extension in duration for the major global bond benchmarks. Over the last 10 years, the duration on the Bloomberg Barclays Global Aggregate (Bond) Index has increased by about two years, from five to nearly seven years, and the yield on the index has halved from 4% to 2%. Watson wondered if investors are being fairly compensated for the increased risks with 80% of the Bloomberg Barclays Global Aggregate Index concentrated in interest rate risk.

Know Your ABCs (and Ds)

Global bond investors will need to be more nimble and well diversified as major bond market trends of the past reverse. Watson recommended positioning portfolios differently from the benchmarks to achieve a higher carry and a lower duration through diversification. “It’s the flexibility,” she said. “We can implement our best high conviction views across global fixed-income markets and still ensure the correlations between the different risk factors is very low.”

Watson and her team evaluate the objectives of each position in their unconstrained portfolios through the ABCs (and Ds) of diversification — alpha, beta, carry, and duration.

Alpha — Sources include leveraging relative mis-pricings of securities, positioning for idiosyncratic events, or just cheap valuations. When used in combination, these can produce low market directionality. Watson cautions that investors need to understand if they’re getting pure alpha or if beta is also mixed in.

Beta — Can be employed quickly to position for structural trends and capture broad market exposure. Investors should recognize the active decision behind when and how to employ beta and explore the risks behind their macro views. Beta can also be stripped out of investments to reduce risk.

Carry — One of the most important components bond investors seek for regular income to offset liabilities or diversify equity positions, Carry comes in many different forms. Investors need to make sure they’re getting paid for the risks taken — not just duration and credit risk, but also for volatility.

Duration — Can be managed to hedge against “risk on” or “risk off” environments. Watson uses duration in a controlled way to manage volatility and protect the portfolio in a rising rate environment.

Watson emphasized the importance of understanding correlations within the portfolio. “You might have three trades with very high conviction on each and they appear to be different — different geographies, sectors, etc.,” she said. “But if the underlying driving risk factor is the same, you could be doubling or tripling up on your risk. Conversely, you could also have two positions that actually cancel each other out.”

Stress Test for Success

Watson and her team rely heavily on stress tests to better understand different scenarios and to guide how they should change the portfolio if certain “stress events” unfold. “You can form a stress test around the price of oil or what might happen with tariffs or the Italian government’s budget deficit plan or around Brexit. Stress tests can help investors understand how they can quickly put on hedges or change positioning to protect returns, but also to make money in different environments,” Watson said.

Watson described a good example of the benefits of stress testing during the Brexit referendum. Her team performed numerous stress tests to look at the impact of Brexit outcomes on all asset classes across financial markets — not only for individual bonds or specific areas of the global bond markets, but also to look at the impact on currencies, commodities, and equities markets.

The firm’s core view was that the United Kingdom would vote to remain, but Watson’s team realized the risks were very asymmetric. That is, if the United Kingdom voted to remain in the EU, there was very little upside. If the United Kingdom voted to leave the EU, however, the performance of certain assets, particularly the UK assets and its currency, were very skewed to the downside.

Watson said they decided to put on a lot of hedges and increase the duration to about as high as it’s been in the last few years (approximately 3.25 years) to protect against significant “risk off” news. “If we hadn’t put hedges on, we could have had a significant draw down,” she explained.

Taking Advantage of Change

Watson provided examples of how investors can take advantage of some of the ongoing sources of change in bond market dynamics:

Structural Changes in the Yield Curve — Investors no longer need to take on as much duration risk today as they have in the past. Watson observed that investors can get a relatively decent amount of yield in the front end of the curve, particularly with a flat yield curve. Even in emerging markets, investors can get the attributes they like with lower duration risk.

Reduced Liquidity from Central Bank Policy — As the European Central Bank (ECB) steps back from its asset purchase program, for example, differences among the performance of individual issuers have surfaced. Investors can use a relative value approach to implement high conviction views and generate uncorrelated returns without market beta.

Increased volatility — For years as central banks suppressed interest rates, individual issues in many sectors traded in a very tight group, regardless of the fundamentals or valuations. Today, there are more opportunities to diversify, especially during times of greater volatility and with wider dispersion of performance among individual bond issues.

Rethink Fundamentals in Emerging Markets — Watson sees improving fundamentals over the medium to longer term in emerging markets. “At the moment our allocation to EM is relatively light, because we do still see quite a few risks in the shorter term,” she said. With this in mind, she said investors can continue to take advantage of their positive fundamental views by stripping out duration, FX, or beta risk. Liquid exchange-traded funds (ETFs) can be used to quickly adjust top-down allocations as emerging markets evolve.

The Allocation to Unconstrained Approaches

Where does an unconstrained global bond approach fit in the total portfolio? Investors ranging from pension funds to retail are using unconstrained approaches either as their sole fixed-income allocation, as a diversifier to other asset classes, or as protection against a rising-rate environment. With an unconstrained approach, investors can dynamically and actively express views, hedge positions, and manage duration through the cycle without being tethered to a benchmark that could have uncompensated risks.

Today, Watson and her team have built up duration to the higher end of its range, to about 2.5 years, and are gradually increasing exposure to the front end of the US Treasury curve to hedge their spread positions in emerging markets, high-yield, and corporate positions.

“The US is in a more mature place in the cycle than Europe or other countries, and we like that deliberate duration positioning,” Watson said.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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