Sovereign bond boutique embraced by Asian clients

Historically low yields are denting investor demand for sovereign bonds, but some global bond managers are managing to swim against that tide.

Only the best managers in areas such as "macroeconomics, rates and FX," running global — including emerging markets — bond strategies are benefiting in the current environment, said Kate Hollis, a London-based senior investment consultant with Willis Towers Watson PLC, focused on fixed-income manager research.

If the ability to garner inflows is the test of whether a manager belongs to that fraternity, then Colchester Global Investors Ltd., a London-based investment boutique strictly focused on sovereign bonds, is in.

Colchester's numbers show net inflows of $2.6 billion over the first 10 months of the year which, together with valuation gains, have lifted the firm's global assets under management to $39.3 billion — a 16% boost from $33.9 billion at the close of 2016.

Asset owners based in the Asia-Pacific region have stood out this year, accounting for $2.8 billion of net inflows which have more than offset modest outflows elsewhere. Asset owners in Japan, moving out of zero-yielding domestic government bonds, and Australia, where investors are seeking managers with expertise, such as currency management, central to Colchester's offering, have powered those inflows said Paul Allen, managing director and head of marketing and client services for Colchester in Europe, Africa and Asia-Pacific.

With the current year's tally, the Asia-Pacific region now accounts for 30% of Colchester's $39.3 billion in global AUM, up from 18% of $31.7 billion at the close of 2014, according to company materials.

The firm — with its target of delivering returns over a market cycle 2 percentage points in excess of the Citi World Global Bond Index — has been able to appeal to asset owners seeking yield, but also to investors counting on sovereign bonds, even at current yields, to cushion portfolio losses in a risk-off environment.

The "huge fall in yields" under quantitative easing has led institutional investors to reduce their ​ exposure to government bonds, but they still see bonds "as a good diversifier to equities and other risk assets," said James Mitchell, a London-based senior portfolio manager, global fixed income, with Russell Investments.

Investors getting out of "expensive" sovereign bonds in recent years only to see those bonds become more expensive, as yield continued to drop, lost out on "extremely attractive" returns, noted Mr. Allen.

Some fear low yields now have compromised the "diversifying integrity of sovereign bonds vis-a-vis risk assets," but when the next equity market sell-off comes, those bonds are likely to prove a better preserve of the capital gains made since the financial crisis than equities, said Mr. Allen, who opened Colchester's first office in the region, in Singapore, five years ago. The takeaway should be "underweight duration at your peril," he added.

That's all the more true with U.S. Treasury yields edging higher now as the U.S. central bank unwinds its quantitative easing policies, Mr. Allen said. Should there be another market crisis, U.S. yields — "in positive territory and gradually drifting up now" — could fall a point or two, offering investors with average duration of six to eight years "a healthy 10% or so," he said.

Meanwhile, Russell's Mr. Mitchell said in the current market environment boutique managers that are capable of taking meaningful positions in smaller emerging markets offering better value now than major developed markets could have an advantage.

Analysts said firm's such as Colchester and Philadelphia-based Brandywine Global Investment Management LLC fit the bill.

Mr. Allen said Colchester's relatively small size — vis-a-vis the ranks of bulge-bracket fixed-income managers — gives it more room to diversify its portfolio by making material allocations to smaller markets. Currently, the firm's global sovereign bond strategy boasts allocations of 10% to New Zealand, 9% to Mexico, 7% to Singapore and 4% to Poland.

But Mr. Allen said it's the firm's broader investment process that has allowed Colchester to exceed its target of delivering 2 percentage points of alpha above the returns of the Citi World Government Bond index over market cycles.

The process ranks the 50 or so markets it covers for real yields, adjusted for both inflation and the balance sheet strength of the issuing government, with a separate ranking for currency exposures.

"When we're investing, we're using the adjusted real yield — for balance sheet strength — as a predictor of those bond markets that are going to have a better capital outcome on a relative basis," Mr. Allen said. "So it's the inflation differentials that are important for us, because that's going to largely drive the relative real yields, and therefore which markets we're going to pick."

As of Sept. 30, the strategy had less than a third of the benchmark's 32.8% allocation to "euroland" sovereigns and roughly half of its 34.3% allocation to U.S. Treasuries. Likewise, the strategy had no holdings of U.K. gilts, vs. a 5.6% benchmark weighting. Colchester's estimates of annualized returns for those three markets were -1.0%, -0.4% and -1.6%.

Conversely, with estimated real returns of 3.5% for Brazil and 0.8% for New Zealand, Colchester's strategy had respective allocations of 6% and 10% for those countries. Both countries have zero weightings in the Citi WGBI.

Colchester's presentation book shows its global bond strategy delivering annual returns of 7.52% over its 17-year life, topping the Citi WGBI's 4.77% return for that period.

Colchester looks to deliver roughly two-thirds of that alpha from active management of its bond portfolio and one-third from separately managing the portfolio's currency exposure, Mr. Allen said.

Meanwhile, the strategy has an attractive information ratio — a measure of the tracking error recorded in racking up those returns — of roughly 0.85%, he said.

Mr. Allen ventured that Colchester's single-minded focus on sovereign bonds and currencies — the most liquid markets in the world — counts in its favor in the eyes of consultants and clients.

All of the instruments Colchester invests in are "highly liquid and easy to understand … we're not invested in credit, our alpha is uncorrelated to credit and risk assets so there's no reason for us to structurally underperform at a time of market stress," he said.

Matthew Goldsack, the head of investment solutions at Auckland-based BT Funds Management (NZ), said Colchester's long track record of "delivering value," and its focus on inflation-adjusted "real yields" — "severely underweighting" European bonds with negative yields in favor of smaller but fundamentally strong markets such as Malaysia and New Zealand — were factors in BT-NZ's decision to award the firm an A$500 million global bond mandate in mid-October.

Russell's Mr. Mitchell said globally, managers running single-country government bond mandates in places where yields are low have seen outflows, while those with broad global mandates and proven skill in sidestepping the least attractive markets have gained.

Japan, where the benchmark 10-year government bond spent much of 2016 with negative yields and currently offers roughly three basis points, is a prime example. The shift by Japan's big public pension funds out of Japan government bonds has led to some mandates for Colchester's $25 billion global sovereign bond strategy, said Mr. Allen, who declined to name any clients.

Two Tokyo-based heavyweights — the ¥156.8 trillion ($1.4 trillion) Government Pension Investment Fund and the ¥22.8 trillion Pension Fund Association for Local Government Officials — included Colchester in separate announcements of their global bond manager lineups in the final quarter of 2015.

Mr. Allen said manager rotation is a bigger source of opportunities in the Australian market.

With credit spreads narrowing now, some managers that focused on less liquid market segments to boost global bond market returns for clients in Australia are asking asset owners for broader discretion in managing currencies, he said.

That, in turn, plays into Colchester's strengths, as "currency management, government bond management is the core of what we do," Mr. Allen said.

Of Colchester's roughly $11.8 billion in Asia-Pacific AUM, the firm manages about $6.5 billion for Japanese clients and $3.8 billion for Australian clients, with clients in Singapore accounting for much of the remainder, Mr. Allen said.