It's not your father's fixed-income shop.
Quantitative shops, such as Barclays Global Investors, San Francisco, and The Clifton Group, Minneapolis, have turbo-charged bond investing, holding out the promise of superior and consistent risk-adjusted returns.
"I think consultants and clients are taking a much harder look, because the old days - when you looked at bonds as something sleepy and you could ignore - are over," said Perry Vieth, director and head of fixed-income investments at PanAgora Asset Management Inc., Boston.
The timing might be right. Many core-plus strategies - which became wildly popular in the 1990s - were pummeled during the past two years, dragged down by bonds issued by WorldCom Inc. and a host of telecommunications companies. The result: Leading core-plus managers have seen their performance tumble, and the dispersion of returns between the best and worst bond managers has hit an all-time high (Pensions & Investments, Sept. 16).
Here's how four bond managers have applied new investment technology to the oft-ignored area of fixed-income investing.
PanAgora's core fixed-income strategy is based on finding inefficiencies on the yield curve. In particular, the manager has found that shorter maturities offer higher returns relative to their risk than longer maturities do.
This pattern of declining Sharpe ratios (a measure of excess return relative to the standard deviation of those returns) only varies when the Federal Reserve shifts interest-rate policy and during extended periods of deflation, PanAgora research shows.
So, instead of buying the 30-year Treasury, PanAgora can take positions in the 10-year Treasury, which has the same long-term rate of return but significantly less volatility, and lever up its duration, explained Edgar Peters, chief investment officer.
And by using futures contracts along the yield curve to take overweight and underweight positions, PanAgora avoids issuer-specific credit risk, Mr. Vieth said. PanAgora's credit exposure is to government futures and eurodollar contracts from the Chicago Board of Trade and the Chicago Mercantile Exchange, giving the portfolio an overall AA rated quality.
Since PanAgora started running the fixed-income strategy on July 1, 1998, it has attracted $1.2 billion in institutional assets under management, plus nearly another $400 million employing the approach in portable-alpha type strategies.
PanAgora's fixed-income approach has produced excess annualized returns of 197 basis points over the benchmark Lehman Brothers Government/Credit index from inception through Dec. 31. Returns were buoyed by its return of 15.05% in 2001, or 654 basis points in excess returns.
One rarely finds officials at indexer BGI trashing passive strategies, but in the case of credit issues, they make an exception. Unlike the Standard & Poor's 500 stock index, where the companies with the biggest market capitalization rule the roost, it's the biggest debtors that dominate the Lehman U.S. Credit index.
Last year, the top 15 corporate bond issuers underperformed the index by 470 basis points. "So you really got hurt last year by trying to match the index," said Brian Zalaznick, head of U.S. fixed-income product strategy.
So BGI tried something different. Finding that a company's stocks and bonds are much more tightly correlated now than in the past, the manager has its 58 bond and stock analysts sharing insights on the 760 issuers in the Lehman U.S. Credit index.
The result is a new strategy, dubbed AlphaCredit, that makes lots of small bets on hundreds of issues in the index, trying to weed out the losers that drag down performance. Portfolio managers are allowed to underweight BBB bonds by 50 basis points, A bonds by 100 basis points, and AA and AAA bonds by 150 basis points.
"We're not making enormous bets, but by the end of the day, we will generate significant alpha if we get it right 75% to 80% of the time," Mr. Zalaznick said.
Since launching the AlphaCredit strategy six months ago, BGI has $1.4 billion in institutional assets under management from external clients, including the pension funds of SBC Communications Inc., San Antonio, Texas, and Texas Instruments Inc., Dallas,and the State of Wisconsin Investment Board, Madison.
"With the process they use to screen securities for bad credit, you have an efficient way to build a long credit portfolio in a quasi-passive manner," said Phil Schneider, director of advanced investment solutions at Watson Wyatt Worldwide, Chicago.
Smith Breeden Associates, Chapel Hill, N.C., makes measured bets in its risk-controlled investment-grade core strategy.
The strategy, under which $2.5 billion is managed, has paid off: It landed in the second decile of PIPER's broad market fixed-income portfolios for one-, three- and five-year periods ended Dec. 31. In 2002, a brutal year for many bond managers, the strategy returned 11.35%, outperforming the Lehman Brothers Government/ Credit index by 32 basis points.
Smith Breeden focuses on high-quality issues and return on unit of risk, explained Daniel C. Dektar, senior vice president and CIO. "There may be risky assets that have apparently (high) relative returns, but relative to the risk, the returns aren't attractive," Mr. Dektar said.
For example, using option-pricing models, Smith Breeden officials compare the relative riskiness of interest-only strips on mortgage-backed securities with those of Treasury securities. "We were able to use option pricing to quantify the risk in those mortgage securities, and determine where we were being best compensated for taking that risk, and hedge out the worst risks," he said.
For the past couple of years, Smith Breeden has placed its biggest bet on AAA commercial mortgage-backed securities, finding these high-quality issues avoid the event risk of AAA and AA corporate bonds while offering better returns. Typically, the strategy also has underweighted Treasuries.
Now, however, the firm has reduced CMBS to its index weight of about 2%, from 10%, while boosting Treasuries. The incremental return for agencies and both residential and commercial mortgage-backed securities is the lowest it has been against Treasuries for the past four years, Mr. Dektar said.
The Clifton Group, Minneapolis, long had been running synthetic equity portfolios, overlaying an S&P 500 index futures contract on top of a cash portfolio.
In 1991, it sought to adopt the same methodology to fixed income. The problem: There was no equivalent futures contract covering the Lehman Aggregate index, said Thomas Lee, senior portfolio manager and principal.
Instead, the manager had to buy contracts on different parts of the yield curve to mimic the Lehman Aggregate's duration characteristics, he said. Those contracts then were combined with a high-grade money market portfolio.
The strategy works particularly well during periods of stress in the credit market. During the 1998 Russian debt default, the strategy soared, returning 6.2% in the third quarter while credit spreads were exploding.
Conversely, the strategy tends to underperform when credit spreads are tightening. In the fourth quarter of 2002, as spreads narrowed, the strategy produced a meager 0.2% return, placing it in the last decile of PIPER's broad market universe. The fourth quarter also dragged down returns for the year to 10.1%, placing it in the fifth decile.
But long-term results are far stronger. For the three-year period ended Dec. 31, Clifton's portfolio ranked in the second decile, returning an annualized 10.9%. And for five- and 10-year periods, it was in the first decile.
Still, Clifton has pulled in only $200 million in assets for the strategy. Clients include the Laborers' International Union of North American pension fund, Washington; the University of Minnesota Foundation, Minneapolis; and the Boart Longyear Co. pension fund, Salt Lake City, Utah.
The relatively small amount of assets invested in the strategy makes it "hard to compete for larger assignments of $50 million to $100 million," Mr. Lee said.