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An Unconstrained Approach to Bond Market Investing

January 7th, 2013

by Sabrina Callin, Lisa Kim

of PIMCO

  • Unconstrained bond portfolio construction should be driven by an outcome-oriented goal, with strategies assessed on an individual risk/reward and correlation basis, and each investment in the portfolio evaluated rigorously for the expected risk and return as well as the potential impact of the correlation to other investments in the portfolio.
  • Not only is a skilled manager’s potential to achieve attractive returns across different market environments enhanced by the removal of benchmark-related constraints, the ability to proactively manage downside risk is an equally if not more important benefit.
  • When bond market returns are positive, an unconstrained approach should ideally deliver positive returns that hopefully capture a material percentage of this upside. However when bond market returns are negative an unconstrained strategy should seek to limit or avoid entirely the risk exposures that produce the negative returns.

Investors today are facing numerous headwinds. It is widely acknowledged that prospective returns from both bonds and equities likely will be well below historical averages for the foreseeable future. The current environment is still marked by uncertainties emanating from the European sovereign debt crisis, while in the U.S. anxiety related to ongoing drama from the persistent debt presents additional noteworthy risks. Indeed, downside risk to asset prices is a very legitimate concern – especially after the substantial losses sustained by many during the financial market crisis. And, investing at the risk-free rate today yields an effectively zero return – or negative returns when adjusted for inflation. With all of this in mind, it is not surprising that investors are increasingly focused on alternatives to traditional investment strategies and approaches to diversify risk and achieve a reasonable return on (and of!) capital.

A blank canvas

One such approach is unconstrained, absolute return oriented bond market investing. These approaches generally allow the portfolio management team a broader range of investment discretion than more traditional approaches. The primary components of many unconstrained strategies are:

  • the absence of a bond market benchmark
  • a goal of delivering positive “absolute” returns independent

    of the market environment

  • a focus on downside risk management
  • a very broad-based, global opportunity set
  • reliance on manager’s skill as the primary driver of performance

The absence of a bond market benchmark means that unconstrained approaches have a different starting point for portfolio construction – a blank canvas so to speak rather than the structural risks embedded in the bond market.

This allows the manager to make decisions in an absolute return framework, where success is measured by the absolute level of return on an investment over a period of time, as opposed to a relative return framework where success is measured by performance relative to a benchmark.

For these reasons we believe unconstrained bond portfolio construction should be driven by an outcome-oriented goal, with strategies assessed on an individual risk/reward and correlation basis, and each investment in the portfolio evaluated rigorously for the expected risk and return as well as the potential impact of the correlation to other investments in the portfolio. As such, rather than “underweighting” a less attractive market exposure, the portfolio manager can choose to forgo the unattractive risk altogether and position much more defensively as appropriate. Likewise, rather than limiting attractive market exposures – as traditional bond strategies may be required to do, particularly with “out-of-benchmark” exposures – in an absolute return oriented approach the positions and the scaling will solely be a function of the manager’s best ideas and degree of conviction together with downside risk management considerations, unconstrained by a specified bond index benchmark.

Managing interest rate risk

Not only is a skilled manager’s potential to achieve attractive returns across different market environments enhanced by the removal of benchmark-related constraints, the ability to proactively manage downside risk is an equally if not more important benefit. Take interest rate exposure, for example. While the Federal Reserve has communicated its intent to keep rates artificially low through 2015, with the yield on the 10-year U.S. Treasury at 1.6% as of November 30th, there is very little room for additional price appreciation and significant room for price depreciation. In fact, at current interest rate and duration levels it would only take a 0.18% increase in rates for a 10-year Treasury to deliver a negative return.

Given this very asymmetric risk/return profile, an unconstrained bond manager may choose to tactically limit interest rate risk, while most traditional bond strategies are required to maintain a level of positive interest rate exposure that is similar to their market index, even when interest rates are rising.

Another related reason that investors may find unconstrained bond approaches attractive is the potential value of allowing a manager with a demonstrated track record to dynamically adjust risk exposures over time – looking across a broad, global market place including all sectors of the fixed income market and global currencies for attractive investment opportunities. Contrast this with a traditional U.S. core fixed income mandate tied to the Barclays U.S. Aggregate Index.

Assuming a U.S. core fixed income manager is expected to exhibit relatively low tracking error relative to the index, the primary risk exposures are predetermined to be U.S. mortgage, investment grade corporate and government bond exposure – including U.S. interest rate exposure in all three cases – regardless of whether these risk exposures are more or less attractive at any given point in time.

Choice of manager is key

From an investor’s standpoint, unconstrained approaches clearly place a much greater reliance on the investment manager’s global fixed income relative value and risk management expertise, and the potential ability of the manager to translate this expertise into attractive risk-adjusted return, while also preserving capital via successful downside risk management during challenging market environments. So, in reviewing potential managers, there are certain attributes that generally should be non-negotiable, including but not limited to:

  • global footprint with deep expertise across a wide range of fixed income sectors (vs. a sector specific orientation)
  • strong risk management framework
  • demonstrated and successful track record in dynamically expressing active views and hedging using a wide range of tools
  • full transparency, with respect to risk exposures, and attribution of risk/return

In addition, given the downside risk management and positive absolute return objectives, investors should presumably have greater confidence in an unconstrained bond manager who has delivered on these objectives across different market environments. This would be exhibited by an asymmetrical return profile with a high degree of positive return capture (the proportion of returns realized during positive periods) a very limited degree of negative market return capture (the proportion of returns realized during negative return periods) and limited number and magnitude of drawdowns.

For instance, the hypothetical asymmetrical portfolio in Figure 3 has a very similar average monthly return to the Barclays U.S. Aggregate Index, yet achieves this result by capturing 80% of the returns of the benchmark portfolio in positive months but only 15% of the returns in negative months, with a lower magnitude of drawdowns, and lower volatility.

If a bond manager is able to accurately assess the market environment, this additional discretion can be quite valuable. When bond market returns are positive, an unconstrained approach should ideally also deliver positive returns that hopefully capture a material percentage of this upside. However when bond market returns are negative an unconstrained strategy should seek to limit or avoid entirely the risk exposures that produce the negative returns, thereby delivering a very different return profile that is substantially less negative and possibly positive. Other important attributes should include an attractive Sharpe ratio and bond market-like volatility (i.e. the returns are not simply a function of taking more risk), no significant embedded biases, and meaningful diversification benefits relative to the primary risks in an investor’s portfolio – in particular equity market risk which still represents the dominant risk exposure in most investment portfolios, even those with significant existing fixed income allocations.

Versatile roles in a portfolio

One area where there is not consistency – nor does there necessarily need to be – is in how investors incorporate unconstrained fixed income approaches into their portfolios. In some cases investors have created a new category within their fixed income allocation, while in other cases unconstrained bond approaches are used specifically as a substitute for a portion or all of the core bond allocation. Unconstrained bond mandates may also be segregated completely from the fixed income allocation in recognition of the fact that, by design, the performance results should vary substantially from traditional benchmark oriented fixed income approaches at times – and also due to the diversification properties that many such approaches provide relative to other portfolio risk exposures (including fixed income). Regardless of their specific role, however, allocations to unconstrained bond approaches should represent a longer-term strategic decision as opposed to a shorter term, tactical move in our view.

Most unconstrained bond approaches seek to retain the positive attributes associated with fixed income investing – including valuable risk diversification, capital preservation and relatively low volatility. At the same time, the absence of a fixed income benchmark allows an active manager a much greater ability to express their best investment ideas, and in doing so dynamically adjust market exposures over time in an effort to optimize returns and help protect investors against adverse outcomes. With attractive investment returns arguably harder to come by in a zero interest rate world fraught with tail risk and uncertain outcomes, it may be more important than ever to look beyond traditional fixed income approaches. In the hands of a skilled active manager with significant breadth and depth of expertise, an unconstrained approach offers a potential solution designed to help investors maximize the risk-adjusted return potential available in the global bond market.

The “risk free” rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation of the portfolio returns.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays Global Aggregate (USD Unhedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2013, PIMCO.

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