Thinking outside the index


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Dramatic policy interventions have produced massive distortions in the fixed income markets, reflected in overvaluations of most sectors in the Barclays Agg. Risk in fixed-income proceeds from four areas: term structure,
prepayments, credit, and liquidity. The Agg is currently biased toward term-structure risk. Active managers may be well positioned to target risks and opportunities outside the Agg.

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Thinking outside the index

  1. 1. PUTNAM INVESTMENTS | For several decades, the Barclays U.S. Aggregate Bond Index (known as the Lehman U.S. Aggregate Bond Index until November 2008) has been a central reference point for bond investors — a benchmark with widespread acceptance comparable to the S&P 500 or the Dow Jones Industrial Average in the equity world. The “Agg” comprises more than $17 trillion worth of bonds, based on current market value, and was designed to include the whole landscape of domestic, investment-grade fixed-income sectors, from U.S. Treasuries and agency issues to mortgage-backed and asset-backed securities. The Agg is the benchmark for multi-billion dollar institutional funds as well as scores of mutual funds that seek to gain exposure to the broad spectrum of the U.S. fixed-income universe. Many funds are designed to substantially track the performance of the Agg, with the manager seeking to add alpha — or outperformance of the index by virtue of skill — by overweighting or underweighting its sectors. Some passive index funds seek to replicate its performance as precisely as possible. Between passive exchange-traded funds and index funds, actively managed mutual funds and institutional mandates, many trillions of dollars are invested in strategies pegged to this benchmark, and too often, this fact alone results in a significant misallocation of risk for investors. In this paper, we explore how the Agg has come to represent a diminished set of risks for fixed-income investors — and, hence, a diminished set of opportunities. While the Agg is, of course, likely to remain a key touchstone in the bond market, we believe that the financial crisis of 2008 and its still- unfolding aftermath underscore why an approach to fixed-income investing that targets risks and opportunities outside the index can be of particular value to investors. Bonds or bond funds? Why a bond fund might be the better choice for most clients April 2013 » White paper Thinking outside the index D. William Kohli, Michael V. Salm, and Paul D. Scanlon, CFA Co-Heads of Fixed Income • Dramatic policy interventions have produced massive distortions in the fixed- income markets, reflected in overvaluations of most sectors in the Barclays Agg • Risk in fixed-income proceeds from four areas: term structure, prepayments, credit, and liquidity. The Agg is currently biased toward term-structure risk • Active managers may be well positioned to target risks and opportunities outside the Agg • Putnam’s team-based approach offers the depth of resources to exploit out-of-benchmark opportunities Keytakeaways
  2. 2. APRIL 2013 | Thinking outside the index 2 How the U.S. government came to support the largest sectors in the index The Barclays Agg was designed to reflect the broad U.S. bond market. It is a purely “passive” index; as long as a domestically issued bond meets criteria primarily based on issue size, maturity, and credit rating, it is incorporated into the index, and weighted according to its market capitalization. By extension, if an investor believes that the market as a whole is fairly valued, then a portfolio that mirrors the index may be a perfectly suitable invest- ment. However, our judgment today is that the U.S. market, as represented by the Barclays Agg, does not compensate investors for the risks it entails. We have just come through a period of government intervention in the bond market that was historic in size and scope. The U.S. Federal Reserve responded to an economic emergency with massive purchases aimed at adding liquidity and stabilizing the market. As the dust has settled, we now have an unprecedented fixed-income landscape: •Between November 2008 and March 2010, the Fed purchased $1.25 trillion of agency mortgage-backed securities (MBS), representing about 25% of the outstanding market. •Between October 2010 and June 2011, the Fed implemented a second round of quantitative easing, purchasing $600 billion in U.S. Treasuries, adding to the approximately $300 billion already on the government’s books. •Between October 2011 and December 2012, the Fed’s “Operation Twist” used proceeds from maturing holdings and the sales of short-term debt to purchase intermediate- and long-term Treasuries in an effort to drive down longer-term rates. •In September 2012, the Fed announced a third round of “QE,” this time targeting the mortgage-backed securities market, with monthly purchases of up to $40 billion. •In December 2012, the Fed replaced its expiring Operation Twist program with an additional round of easing authorized to purchase up to $45 billion a month in longer-term Treasury debt. •The federal funds rate currently hovers around zero, and Fed Chairman Ben Bernanke has indicated that the Fed would hold the rate down until there is substantial improvement in the labor market, with unemployment declining to 6.5%. From a public policy perspective, it is hard to argue that the Fed could have taken any other path in the wake of the financial crisis and through the economic uncer- tainty that has intermittently threatened to disrupt the global recovery. However, any such dramatic, one-sided market activity produces massive distortion, and we see that today in the relative overvaluations of Agg sectors that were targets of Fed purchases. Yields on govern- ment securities, agency debt, and agency MBS are at historically low levels, and spreads as of March 2013 have tightened to levels at or below their 10-year pre-crisis averages. Because the prices of these securities have been propped up by massive artificial demand, they offer little upside potential, in our view, but great downside potential as the Fed’s easy money policy is recalibrated in light of evolving expectations for economic growth and inflationary pressures. And as the era of easy money enters what may be its final phase, the potential for rising interest rates across developed markets is substantial. Rethinking fixed-income risk The traditional view of portfolio risk revolves around its divergence from a benchmark. For many fixed-income investors, therefore, risk has come to be understood as a portÂ�folio’s deviation from the Agg itself. On this view, the portfolio manager’s benchmark-relative decisions about which sectors or industries to overweight and underweight, and which securities to own or avoid, drive all meaningful metrics of risk and return, from standard deviation and alpha to information ratio. Because the bond markets, as proxied by the Barclays Aggregate indices, are generally thought to be efficient, conven- tional wisdom has it that outperforming the benchmark can only be achieved by assuming a greater degree of risk — risk reflected by a portfolio’s deviation from the allocations of the benchmark. This belief is flawed, however, because it oversimplifies the concept of risk. By conceiving risk as benchmark deviation, it ignores how individual securities, whether they are in or out of the benchmark, can represent different forms and intensities of risk. At Putnam, we find that fixed-income risks proceed from four areas: term structure, prepayments, credit, and liquidity (See sidebar on page 5).
  3. 3. PUTNAM INVESTMENTS | 3 Through this view of the major risk categories, we endeavor to quantify each of these risks at the secu- rity level and use that analysis as the basis for portfolio construction. When we filter the Agg through this understanding of risk, moreover, we find that the index is currently heavily tilted toward term-structure risk while the other three risk categories are less well represented or entirely absent. The upshot of this concept is that potential returns associated with the different sources of risk fluctuate over time and according to the characteristics of any given security. In other words, not all risks are — or should be — considered equal, and they are rarely static in terms of their potential negative or positive portfolio impact. Critically, the result for any investment strategy that uses the Agg as its starting point, we believe, is a signifiÂ�cant over-allocation to the sources of risk that offer the least potential for returns in today’s market. Underrepresented risks There are a number of areas we believe offer the potential for diversifying away from term-structure risk and also offer the opportunity for further spread tightening rela- tive to U.S. Treasuries (Figure 1). ImporÂ�tantly, these sectors all share a common characteristic: They represent tiny fractions of the Agg, and offer significant opportunities to active fixed-income managers ( Figure 2). At present, we see more value — and more worthwhile forms of risk — in the $4 trillion worth of securities that lie outside the Agg, along with some sectors in the Agg that have not been targets of government intervention. The key here is that the sources of risk inherent in these sectors are far more diverse and much less contingent on declining interest rates to fuel returns. Non-agency RMBS U.S. non-agency residential mortgage-backed securities (RMBS) represent a prime example of one of the opportunities available to active managers willing to look beyond the benchmark. As securities that lack any government support, U.S. non-agency RMBS returns are driven primarily by credit risks, making them sigÂ�nificantly less sensitive to changing interest rates than the vast majority of the securities in the Agg. In the wake of the financial crisis, prices of U.S. non- agency RMBS were “marked down” severely, often exceeding the declines in the value of the underÂ�lying collateral. As is frequently the case, the market had swung from extreme overvaluation initially to the under- valued condition in the aftermath of the crisis. Despite a strong rally in the sector and the fact that top-tier MBS are first to be paid, many continue to trade at 70 or 80 cents on the dollar. While those securiÂ�ties may never return to par value, we believe there remains an oppor- tunity for capital appreciation, even if housing prices decline and default rates increase. Figure 1. Spreads appear attractive in certain sectors outside the Agg Sector Average OAS* 12/31/97–12/31/07 Current OAS 3/31/13 Difference Agencies 34 30 -4 Agency MBS 56 60 +4 Investment-grade corporates 130 139 +9 High yield 511 457 -54 AAA CMBS 89 115 +26 Non-agency RMBS 123 200–450 +77–327 Agency IO 150 350–700 +200–550 EMD 425 287 -138 Sources: Barclays, Putnam. Data as of 3/31/13. * Option-adjusted spreads.
  4. 4. APRIL 2013 | Thinking outside the index 4 CMO IOs If we step back and look at the broader universe of MBS outside of the Agg, we also find value in areas of the interest-only agency collateralized mortgage obligations (CMO IOs) market. Like an agency MBS pass-through, many CMOs have the backing of a federal agency — either Fannie Mae, Freddie Mac, or Ginnie Mae. CMOs are created from a portion of the cash flow of an agency MBS pass-through. Two of the most common CMO structures are interest-only (IO) and principal-only (PO). As their names suggest, CMO IOs receive the interest payments on an underlying pass-through, while the CMO POs receive principal payments. The value of an IO or a PO is influenced by mortgage payments and prepayments. CMO IOs can be attractive for two reasons. First, they currently offer yields at relatively attractive spreads over Treasuries. But they also offer the chance to add alpha by understanding the dynamics of prepayments. When a CMO IO is first sold, its price is calculated using an assumed rate of prepayments, based on model esti- mates. If prepayments proceed more slowly than the assumed rate, then the CMO IOs become more valuable, because the interest payments will be based on higher principal amounts than originally assumed and will be more numerous. (The slower prepayments would corre- spondingly lower the value of the CMO POs.) Prepayment rates can vary for a number of reasons. The most common factor is interest rates: as they fall, more homeowners typically are induced to refinance. However, today, even with interest rates low, many homeowners cannot refinance because the value of their homes has declined and bank lending standards remain tight. While we believe this will continue to be the case heading into 2013, an improving housing market and a healthier banking system will likely lead to an expansion of credit over the next 12 months, and for those reasons we have become more tactical in the CMO IO space. We prefer to focus on lower coupon IOs, which may benefit from higher interest rates, as well as IOs that may be less affected by recent government programs designed to spur refinancing activity. Figure 2. Opportunities beyond the Agg Barclays U.S. Aggregate Bond Index $17 trillion market value Average yield: 1.86% Out-of-index opportunities $4.6 trillion market value Average yield: 5.11% EMD Bank loans Global high yield CMOs (IO/PO) Non-agency RMBS CMBS/ABS IG corporate MBS Gov't related Treasuries Sources: Barclays, Putnam, as of 3/31/13.
  5. 5. PUTNAM INVESTMENTS | 5 The result for any investment strategy that uses the Agg as its starting point, we believe, is a signifiÂ�cant over-allocation to the sources of risk that offer the least potential for returns in today’s market. Pockets of value in term-structure risk Although we contend that the Agg represents a poor allocation of risks given today’s historically low interest rates and the massive government intervention in the bond markets, that is not to say that all term-structure risk is undesirable. But the key to unlocking the more worthwhile forms of term-structure risk, we believe, is active management. For example, there are ample opportunities for active managers to use discrepancies in interest rates and global growth rates to their advan- tage. Over the past five years, economic growth in select emerging markets — including India, Taiwan, and South Korea — has significantly eclipsed that of bellwether developed markets including Japan, France, and the United States. This divergent global economic growth is exploitable by managers who engage in the carry trade — i.e., who pay low rates on borrowed funds that they invest in longer-term securities with higher yields — or who establish cross-border relative-value positions. But again, these opportunity sets exist only outside the narrow context of the Agg, which has almost no exposure to below-investment-grade or emerging-market securities. Putnam’s team-based approach to fixed-income investing Putnam favors an approach to fixed-income investing that targets opportunities across the bond markets, both inside and outside broad indices like the Agg, while allocating assets toward those risks most likely to offer attractive returns. In today’s investment environment, with interest rates kept artificially low in a number of develÂ�oped markets, we believe the potential returns associated with most term-structure risk within the constraints of the government-heavy Agg are not commensurate with their downside risks and opportunity costs. Four types of fixed-income risk 1. Credit Exemplified by bank loans, corporate bonds, and emerging-market debt, as well as non-agency RMBS. To analyze credit risk, one must focus intensely on the issuers and their ability to meet their obligations under a wide variety of economic conditions, as well as the relative attractiveness of the yield on the issuer’s bonds. 2. Term structure Refers to the yield curves that exist in different markets around the world, and typically involves the relationship between short- and long-term rates, monetary policy, and currencies. Anticipating the changing shape of yield curves or the relative value of currencies can be an important source of alpha. 3. Prepayments Reflect the ability of a bond issuer or homeowner to pay off principal before the stated maturity date, typically done in a falling-rate environment. When principal is prepaid, bond owners have to find new investments — often with lower interest rates. Understanding prepayment dynamics is an important facet of active fixed-income investing, particularly with respect to different types of CMOs. 4. Liquidity Refers to the risk associated with the ability to trade a security in a reasonable amount of time. This risk can stem from either the security type (e.g., U.S. Treasury notes are highly liquid versus emerging- market bonds issued in local currencies) or market volatility.
  6. 6. APRIL 2013 | Thinking outside the index 6 Figure 3. Putnam’s integrated fixed-income investment process Analysts uncover attractive opportunities in their markets Sector teams promote strategies and allocate risk within subsectors Portfolio construction team allocates risk based on return expectations Portfolio managers direct trades within their risk budget Bank Loans Euro High Yield U.S. High Yield Investment- Grade Corporates Emerging- Market Debt ABS/ CMBS Non- Agency RMBS MBS PT, CMO, Derivatives Agency/ Govt/Swaps Macro Research Term Structure Money Market Currency Country Convertible Bonds Volatility Paul D. Scanlon, CFA D. William Kohli Michael V. Salm 1 2 3 4 Global Strategies Liquid Markets Securitized Products Global Credit Portfolio Construction
  7. 7. PUTNAM INVESTMENTS | 7 The 2007–2008 credit crisis, in particular, demon- strated the important role of professional research independent of ratings agencies as the bond market has become ever more varied, complex, and global. The ultimate source of an investor’s interest and principal may be a homeowner, a pool of credit card receivables, a mortgage on commercial property, a corporate borrower, a bank loan, or an emerging-market country. The 2008–2009 environment underscored how badly things can go when those factors are ignored or misunderstood. The good news is that the variety and complexity of global markets also provide a broad range of opportu- nities for those with the skills and resources to discern them. It requires a multidimensional approach that goes beyond the traditional notion of “diversification by sector” that is embodied in the Agg. That is why Putnam has more than 70 fixed-income professionals focusing on key areas such as global rates, securitized vehicles, credit, emerging markets, currency, and portfolio construction. We do not believe there are any shortcuts that work in today’s fixed-income world, especially for investments outside of the index. A broad approach is needed with the flexibility to exploit all sectors and opportunities, and with a grasp of the complex global interrelationships that drive the market. Under the leadership of a professional investment group that has been working together for more than 10 years, Putnam has developed comprehensive coverage of every aspect of the fixed-income world. The circle in Figure 3 captures sectors as well as the four broad sources of risk that we believe are most likely to drive returns. The inner core of portfolio construction knits together Putnam’s fixed-income investment process in a fashion that balances risk factors and maximizes the opportunity for consistent income and positive return. This is as much art as science, reflecting the portfolio managers’ deep experience and understanding of which sectors may be worth overweighting or under- weighting over a particular period. Putnam funds are positioned outside the index Putnam funds pursue diversification across sectors outside the index, while balancing credit, term structure, prepayment, and liquidity risk. For example, Putnam Diversified Income Trust in March 2013 had broad weightings in high-yield corporates, non-agency RMBS, and CMBS, along with smaller exposures to emerging markets, investment- grade corporates, and bank loans. All of Putnam’s fixed-income funds share the advantage of being relatively nimble, which is key to capitalizing on out-of-index issues. Sectors outside the index tend to be small, making it difficult to establish meaningful portfolio weightings unless a fund has a relatively modest level of assets under management. Conclusion Fixed-income markets today continue to ride out historic changes relative to central bank policy, global economic recovery, and financial market transforma- tion. The emergency market intervention by the U.S. government has resulted, in our view, in significant overvaluation of the Barclays Agg and a concentration of term-structure risk that reinforces the desirability of diversifying the sources of risk in a portfolio. Out- of-index sectors have not undergone the same buying pressure, and, in our analysis, continue to present value-add opportunities. Further, even as bond markets evolve from the current post-crisis condition, we are convinced that out-of-index investing will become increasingly important to investors seeking the traditional goals of steady income while minimizing risk to principal.
  8. 8. APRIL 2013 | Thinking outside the index Putnam Retail Management | One Post Office Square | Boston, MA 02109 | II891 280912 4/13 Fund returns and benchmark returns reflect security valuations and currency translations as of March 28, 2013. Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio. Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities. Barclays Global Aggregate Bond Index is an unmanaged index of global investment-grade fixed-income securities. You cannot invest directly in an index. Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. The use of derivatives involves additional risks, such as the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. You can lose money by investing in a fund. Request a prospectus, or a summary prospectus if available, from your financial representative or by calling Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.