ATLANTA -- Bonds may be looking like a six-letter word -- equity -- to plan sponsors that are hankering to take bets on high-yield and emerging market debt in their fixed-income portfolios.
With the days of returns of 75 to 125 basis points above their benchmarks behind them, managers have been forced to sacrifice credit quality to sustain past portfolios yields, a research study by Brian Hersey, investment director for the consulting office of Watson Wyatt Worldwide in Atlanta, concludes.
The study focuses on his concern over the risk/return tradeoffs of enhanced core or core-plus bond portfolios, an area that is piquing interest among pension fund executives.
"We are in favor of core-plus portfolios, but plan sponsors need to be aware of the risk that is taken on in using these strategies," Mr. Hersey said.
The spreads between high-yield and emerging market debt over Treasuries continue to be attractive. High yield outperformed Treasuries by 658 basis points in January (the most recent data available) and emerging markets debt topped them by 959 basis points.
Shift in portfolios
This may account for the shift in bond managers' portfolios reflected in the study. In surveying 60 bond management firms from 1990 to 1997, Mr. Hersey noticed managers reduced their government sector exposure by 15% during the seven-year period and boosted corporate bonds 5%, specifically investment-grade and lower quality bond sectors offering higher yields. Allocations to non-dollar bonds, including emerging market debt, increased 3% during the same time period.
In total, "credit-sensitive" exposure represented 74% of managers' core bond holdings at the end of 1997, vs. the 51% weighting of the Lehman Aggregate bond index.
Watson Wyatt has been pushing for bond managers to adopt a universal sector rotation in order to drop or underweight sectors that are underperforming. Mr. Hersey said he is frustrated with managers that move into sectors not reflected in the benchmark index and just stay there. He argues such strategies pose a short-term threat to pension funds that expect their portfolios to be unscathed by global market turmoil.
Some dispute theory
Not all consultants agree with Mr. Hersey's strategy theories.
David Brief, principal at Chicago-based Ennis, Knupp & Associates, supports the use of "opportunistic active management" strategies and wrote a paper detailing his reasoning.
"We . . . believe that, for most investors, the risks associated with active fixed-income management become insignificant when viewed from a total fund perspective," he wrote.
Mr. Brief describes the trend in high-yield and emerging market debt being used to add spice to core portfolios as an evolutionary process.
He addresses the flaws in the benchmarks used by institutional investors, concluding that arbitrary sector weightings and a lack of global bonds leaves current benchmarks such as the Lehman Brothers Aggregate and the Salomon Brothers Broad Investment Grade bond indexes unable to produce "desirable investment characteristics."
Mr. Hersey agrees the benchmarks are flawed, allowing managers to "game" the index by investing outside of it. He expects that tactic to change now that Lehman has introduced the Lehman U.S. Universal index, which includes high-yield, emerging market and eurodollar-denominated issues.
No modest risk
He rebuts Mr. Brief's view that opportunistic strategies entail modest risk, citing last August's market turmoil as an example. With Treasury yields falling, corporate bond spreads widening and global markets declining, it was the worst of all scenarios for pension funds, which also saw an increase in their liabilities.
"You can't tell me that the bond portfolio wasn't a matter of focus," he added.
Some managers and consultants agree with Mr. Hersey.
"I think there is a lot of religion out there saying you're good if you mix enough scary stuff together," said Billy Williams, principal at STW Fixed Income Management.
In managing $10 billion exclusively in U.S. bonds, Mr. Williams' firm does not dabble in high-yield bonds, which behave too much like equities, he said.
'Everyone wants to tweak'
Dean Derby, president of Standard Valuations, a consulting firm in St. Paul, Minn., has heard many of his clients talk about adding high-yield bonds, but he doesn't encourage them to follow through.
"One of the problems is with the markets being very good, everyone wants to tweak," he said, adding fixed income is supposed to be a pension fund's anchor to the wind, while equities deliver the returns.
Watson Wyatt clients are encouraged to take this traditional outlook on bonds.
Mr. Hersey recommends plan sponsors stress test their current bond portfolios by simulating performance based on a number of market assumptions. Comparing the differences among these returns and the results of the same stress test applied to the benchmark index should reveal what's at stake in any particular portfolio.
The $5 billion Teachers' Retirement System of Oklahoma, Oklahoma City, is searching for domestic enhanced core fixed- income managers, but officials don't want to add too much risk to their portfolio.
Looking for credit plays
While Oklahoma trustees are looking for credit plays, they are not planning to put a great percentage of assets into high yield, according to Bill Puckett, investment officer. The two new managers, with mandates of approximately $250 million each, will be expected to match the returns of the Lehman Aggregate index.
Interviews are scheduled for the April 28 board meeting.
The search hopefully will end in a more aggressive portfolio, officials said. "We had a couple (bond) managers, but for whatever reason the cat ran away," said Mr. Puckett, referring to their performance.
Managers seem to be caught in the crossfire, but many continue to promote their core-plus capabilities.
At Boston-based Loomis, Sayles & Co., the idea is to be opportunistic while seeking relative value in the bond market, which might be found in BB-rated corporate bonds, or a bet on Korean debt.
Kathleen Gaffney, Loomis, Sayles vice president and portfolio manager, expects default risk to remain low and opportunities overseas to compensate for the volatility risk.
That market environment is expected to translate into success for three of Loomis' portfolios: a $1.9 billion core-plus portfolio; an $8.5 million medium-grade corporate bond portfolio; and a $5.7 billion dedicated high-yield portfolio. Clients are allowed to limit certain investments in their portfolio.
The dedicated high-yield bond portfolio, which includes an allocation of up to 35% to 40% to emerging markets, may seem the riskier option, while the core plus portfolio takes a position of up to 20% in those markets and up to 35% in below-investment-grade bonds.
