Boxing clever

Positioning across many investment-grade strategies is too often reliant on beta, the direction of the overall market, rather than alpha, the excess return achieved over the relevant benchmark.

During the post-global financial crisis years, low rates and low dispersion of returns encouraged a hunt for yield, with investors able to rely on the central bank backstop when markets stuttered and take a buy-the-dips approach. However, such approaches leave portfolios vulnerable to periods of market stress when BB and BBB-rated issuers generally underperform higher-quality names.

Behavioural biases may explain why investors chase beta. Our research has revealed it is unusual for credit analysts to recommend an investment idea where the issuer trades at a narrower spread than other issuers in the wider sector.² Instead, recommendations are invariably driven by an analyst’s expectation the issuer’s spread will compress relative to the sector.

This can lead analysts to favour lower-quality BBB-rated issuers or even off-benchmark BB-rated issuers (which probably accounts for the high BB exposure among many purportedly investment-grade funds within our fund’s universe — see Figure 2). Beta-led approaches may struggle in more volatile conditions when individual returns are more dispersed and aggressive movements in spreads are more common.

Our global investment-grade strategies do not typically look to generate outperformance from beta or duration positioning — we maintain a stable beta in line with the benchmark while typically managing duration at +/- 0.5 years versus the benchmark.

Furthermore, we have a limited allocation to high yield (up to five per cent of the global investment-grade portfolio), in contrast to others in our peer group. It is important for clients to have transparency on what a strategy invests in. Just as a flyweight boxer would never be matched to fight against a heavyweight, an investment-grade strategy should be exactly that and behave accordingly. 

We see this as a building-block approach. There may be complementary characteristics of a high-beta strategy that, when combined with our investment-grade strategy, can potentially provide positive and uncorrelated outcomes for clients.

The aim of our portfolio optimisation process is to maximise the expected excess return of our portfolios while maintaining the same level of volatility as the investment-grade benchmark.

Step one is to define the universe. The investment-grade universe is made up of around 15,000 securities and 2,000 issuers. No-one can have a view on every bond: you must bucket sectors to help risk allocation. The typical approach is to bucket the index using broad industry sectors, credit ratings and maturity buckets. This makes no allowance for the different risk and volatility characteristics of the securities over time and how they behave in different scenarios.

We go one step further. Using over 20 years of historic data, we have re-defined sectors of the credit universe to more effectively isolate securities into categories with similar risk and volatility characteristics, as depicted in Figure 3.

Figure 3: Our custom sector approach

For illustrative purposes only.
Source: Aviva Investors, March 2023

Step two is to calculate the return expectation of each customised sector using yields as a broad measure of the annual return expectation. We overlay this with our own forecast for spreads, tilting the portfolio to sectors we like from a fundamental perspective.

The carry element of the return – the regular income provided by the coupon – is crucial. It is difficult for portfolio managers to have a consistently strong view on the direction of bond markets. If you base your excess return on trying to predict the direction of spreads, you can fall into the beta traps mentioned above.

Carry is an underappreciated driver of returns, but it matters where you own it. Typically, it is more efficient to own riskier carry at the front end of the curve and higher-quality carry at the long end. History has shown this is the most efficient way to reduce volatility in the portfolio without giving up expected returns.

Now you have the expected return profiles and volatility characteristics of the universe, you can run an optimisation to maximise the expected return for a volatility equal to the benchmark. With the custom sectors as a guide, the output suggests where the most efficient areas are to allocate risk to outperform, as Figure 4 demonstrates.

Experience suggests isolating this strategy as an alpha source can deliver 30 basis points of excess returns through the cycle. It also provides an excellent tool for discussion with our global credit analysts and helps alleviate behavioural biases. In practice, it means the riskiest ideas compete with one another and higher-quality ideas compete for inclusion in the portfolio. It also means portfolio managers and portfolio construction specialists adhere to a structural allocation of risk that does not allow us just to be long beta.

We complement our portfolio construction process with high-conviction stock selection, underpinned by fundamental credit research.  Our team of global analysts are aligned to our customised sector framework and tasked with populating these sectors with their best ideas. This leads to fewer holdings, less turnover and lower correlation with our peers.

In our view, portfolio construction should drive about one third of a strategy’s alpha and security selection. Our portfolio construction process gives portfolio managers a more thoughtful way to harness the ideas from our credit analysts.

The investment-grade benchmark is not the most efficient allocation of risk

Our benchmark, the widely used Bloomberg Global Aggregate Corporates Index, does not capture risk efficiently. In our view, it should be possible to deliver higher returns for the same level of volatility or the same return for a lower level of volatility.

This can be achieved by exploiting carry and roll. These are the main drivers of credit returns, but their importance is often overlooked by beta-driven investors more focused on the direction of spreads. As an aside, we would rather leave spread forecasting to others; we do not profess to have any additional insight and believe it is difficult, if not impossible, to predict the next economic downturn or recession and therefore when spreads may widen.

Many experienced investors will be familiar with the term carry. Fewer are familiar with roll. This is the capital gain generated by the natural fall in a bond’s yield as it approaches maturity — the bond “rolls” down the yield curve. For example, roll accrues when, as time passes, a three-year bond becomes a two-year bond, leading to a lower yield (and higher price) that reflects the reduced term risk.

However, successful credit investing is not as simple as just picking up carry and roll indiscriminately. Where on the yield curve a manager obtains that carry and roll is crucial. For instance, when yield curves are flat, as they are today, an investor can buy a two-year bond yielding five per cent and a 30-year bond yielding the same. Clearly, the latter exposes the bondholder to materially more duration risk without additional compensation. Yield curve positioning matters.

In essence, we seek to earn excess carry from riskier lower-quality issuers (e.g., BBB-rated) at the short end of the curve while allocating to more defensive sectors and higher-quality issuers at the long end. We believe the asset class’s historic performance has shown this represents the most efficient method of reducing volatility without sacrificing returns.

This approach, with its limited spread duration, provides downside protection during periods of widening credit spreads and market stress, while the excess carry we collect at the front end of the curve ensures we typically at least keep pace with the index if not outperform it.

When allocating risk, we believe it is more relevant to focus on a bond’s beta and volatility than on which sector it sits in. However, index providers group issuers based on their business activity rather than the investment characteristics of their bonds.

This leads investors to compare bonds and issuers with very different qualities just because they are in the same sector. Consequently, simply choosing a preferred credit within that sector may not lead to the most desirable risk-adjusted investment outcome, as shown in Figure 5.

For that reason, we have developed customised sectors to compare credits based on their fundamentals, not their industry category. Our approach to sector classification, employed since we launched the strategy two decades ago, enables us to slice and dice the index in a far more efficient and meaningful way.

A dedicated credit analyst is assigned to each customised sector and identifies the best opportunities for consideration. Having dedicated sector specialists located in the same regions as the credits they cover facilitates better one-on-one company access and engagement. Furthermore, collaboration with our equity, environmental, social and governance, liability-driven investment, high-yield and buy-and-maintain credit teams provides more enriched, longer-term company and sector outlooks.

Rather than being afraid of changing market regimes, we seek to build a portfolio with the efficiency and resilience to cope with varying outcomes. Portfolio construction is an invaluable tool in preparing for such uncertainty.

For investors unaccustomed to high interest rates and inflation, the potential to receive a knockout blow has risen sharply. However, by placing downside protection at the heart of our portfolio construction process, we believe our strategy is well-placed to go the distance.

• The asymmetric nature of credit as an asset class means spread-widening events can undermine long-term portfolio performance
• In more challenging market regimes, credit investors should be wary of beta-led approaches and focus on strategies designed for all weathers
• Our robust portfolio construction process has historically delivered downside protection in tougher market conditions