The bond market, undergoing its biggest restructuring in at least a generation, is forcing managers to overhaul their investment strategies and benchmarks.
"It's like another blowup of the valuation rules (just like) in the stock market," said James W. Paulsen, chief investment officer, Wells Capital Management in Minneapolis.
Changes in the fixed-income market, led by refunding of Treasury securities, are transforming the environment managers face:
* The supply of risk-free securities, so highly prized, is shrinking.
* New ways of pricing long-term debt, without the stability of the long-term government bond market, are needed.
* The refunding of sovereign debt in the United Kingdom is further shrinking the supply of relatively riskless securities.
* The Treasury yield curve is so inverted that 10-year bonds yield more than 30-year bonds. In the United Kingdom, shorter debt yields more than longer debt.
* Japan's weighting in world bond indexes is increasing as the United States' and United Kingdom's shares decline.
* High-yield bonds and emerging markets debt have become widely accepted.
Shortage not a new concept
"The idea of a Treasury shortage has been out there for a few years," noted Mr. Paulsen. "But it's interesting it hit the market all of a sudden," he said, as the Treasury Department announced the first of its refundings.
The decline in Treasury offerings will be offset by rising allocations in indexes to corporates and mortgage-backed securities, said Liaquat Ahamend, chief investment officer, Fischer Francis Trees & Watts Inc., New York.
"The problem is that mortgages are a large portion of the U.S. fixed-income universe. They have unattractive characteristics," he said.
They aren't well-suited to matching pension liabilities, making it more difficult for sponsors to find the right mix of fixed-income securities. When rates fall, people pay off mortgages. So the securities become a shorter duration instrument, he said.
"That's precisely what you don't want to happen because no one has liabilities like that," Mr. Ahamend said.
A second factor in the new bond market is that Japanese debt is increasing at 10% a year.
"That is causing dramatic changes in typical global indexes," he said.
Japan has a weighting of about 20% in major global bond indexes, compared with 35% for the U.S. component. But in two or three years, he said, the weighting will shift significantly, to 40% Japanese and 20% United States.
"So this will cause problems for those who follow global indexes" and don't want to be weighted so heavily in Japan.
The decline in Treasuries means "people will be searching for alternative risk-free assets," Mr. Ahamend said.
Kirk Hartman, chief investment officer-fixed income, Banc of America Capital Management Inc., Los Angeles, said: "Because government is borrowing less doesn't mean there will be no bond market. Others will step up to replace Treasuries. It's advantageous for (issuers of) corporates and (mortgage-backed securities) to do it because there will be demand."
Inflation less important?
The inverted yield curve may signal that investors regard inflation as less important. In a an era of zero inflation, there may be no need to factor as big an inflation-risk premium -- or any -- into long-term debt.
"We may see a flat or inverted yield curve for a long time to come," said Mr. Paulsen.
In this new environment, he said, there could be short-term trading opportunities on the long end of the yield curve.
"Will the distortion between the 30-year and 10-year yield correct?" Mr. Paulsen asked. "Do you play that effect?
"To the extent there is a Treasury class shortage, you could have more dramatic volatility because the market isn't as liquid. It could become more magnified in a crisis setting."
Looking for new indexes
The changes in bond market investing have managers looking to new indexes.
John C. Snyder, vice president, J.P. Morgan Investment Management Inc., New York, believes "the Lehman Universal is more reflective of what clients will own over time."
Steven Berkley, managing director-global head of Lehman indexes, Lehman Brothers Inc., New York, agreed: "In a few years' time I'd say the universal will supersede" the Lehman aggregate bond index, its flagship.
The universal index consists of 85% Lehman aggregate index plus 15% four new components, including high-yield and dollar-denominated emerging-markets debt.
At the end of 1998, the major components of the Lehman aggregate index were 38% Treasuries, 22% corporates and 31% mortgages.
A year earlier it was 43% Treasuries, 19% corporates and 30% mortgages.
Mr. Snyder said the Lehman universal index "validates a philosophy some money managers had for a long time: By investing more broadly than only with the assets in the Lehman aggregate bond index, they can achieve higher returns."
Barclays Global Investors, San Francisco, plans to offer an index fund based on the Lehman Universal bond index sometime in the third quarter, said Prahu Palani, product manager, fixed income.
"We think it is a step in the right direction," he said of the index, which covers market more broadly than does the widely used Lehman Aggregate index.
BGI manages $50 billion in Lehman index-related funds.
Of the $144 billion J.P. Morgan manages in institutional fixed income, only $1 billion is run against the Lehman universal.
Mr. Snyder said most clients are just beginning to consider its potential application.
"It's a difficult decision" for clients on whether to adopt the index as a benchmark, Mr. Snyder said. Their managers may not have the skills for investing in extended markets, he added. So to adopt a new broad benchmark would necessitate changing managers.
Thomas C. Marthaler, vice president and portfolio manager, Chicago Trust Co., which manages $7 billion in fixed income, said the changes in the market won't change its approach to investing, although it has affected how it values securities.
"We've never been overweight in Treasuries," he said. "We focus on corporates and mortgages.
"We're not going to extrapolate trends in the market beyond the next two years.
"Treasuries are not as reliable in pricing because the scarcity value overstates the true intrinsic value."
"We will look at alternative methods to compare one security to another," he said, mentioning spreads in swaps and agency securities. But "both of these have been more volatile."
"Because there will be fewer Treasuries doesn't mean we will change the way we will manage our portfolios" at Banc of America, which manages $50 billion in institutional fixed-income assets, Mr. Hartman said.
It prefers "spread products," non-Treasury investment-grade securities such as corporate and mortgage-backed issues.
"We aren't market timers," he said. "So we don't time interest rates." He figures "98% of volatility in fixed income comes from the movement in interest rates."
But the changing bond market could affect even managers who focus on a particular segment of the market, such as corporate bonds.
While their benchmark might not change, the bond market changes "will cause people to re-evaluate their use of particular strategies, because of broader opportunities to add value," said Michael Cembalest, managing director, J.P. Morgan Investment Management.
"As the market has gotten more efficient, the diversification benefits of corporates only has fallen," he said.
"High-yield debt introduces (into the fixed-income market) the notion of new ideas" from new-company issuers. Emerging-markets debt introduces over time the chance for a change in credit risk.
"These (two notions) are powerful sources of change to the market, uncorrelated to the U.S. economic cycle," Mr. Cembalest said.
"There is no doubt the Lehman universal index will be more difficult to beat over time," Mr. Snyder said.
`Here to stay'
The inclusion of high-yield and emerging-markets debt in the Lehman universal in particular signal their maturation as part of fixed-income investing.
"They are here to stay," Mr. Snyder said.
This new maturity likely will spread ownership among institutional investors previously uneasy about investing in them, Mr. Snyder added, and thus bring more stability in valuation and more liquidity to these securities.
"Having high-yield and emerging-markets debt (in the Lehman universal index) makes them more acceptable to clients," Mr. Snyder said.
"Many people think high-yield and emerging-market debt increase risk to a portfolio. But the total return volatility (in the Lehman universal) is lower in most cases than (in the Lehman aggregate). That's because the new assets aren't correlated (with the others in the index). So you can increase return without a commensurate increase in risk."
Mr. Snyder expects the share of high-yield and emerging-markets debt in the Lehman universal index to rise over time as their issuance grows and other debt, such as Treasuries, declines in relative share.
They "could double in five years, the pace growing as Treasuries decline," Mr. Snyder said.