Fixed Income Panel (April 2007) - Delivering the goods

Chairman
Chris Helyar
Investment partner
Lane Clark & Peacock
Helyar joined LCP in 1994. He is responsible for a range of clients, helping them to set and implement investment strategy. Helyar is head of bond research at LCP and also specialises in building bond portfolios to match pensioner liabilities.

Stephen Hobbis
Client portfolio manager
Aberdeen Asset Management
Hobbis is a member of Aberdeen’s UK fixed income team that runs nearly £13bn of assets on behalf of UK institutions.
He joined Aberdeen via the acquisition of Deutsche’s fixed income businesses in 2005.

Scott Mather
Managing director and head of portfolio management, Europe
PIMCO
Mather is a managing director, member of PIMCO’s executive committee and investment committee and head of portfolio management Europe. He also manages euro and pan-European portfolios. Mather joined the firm in 1998 from Goldman Sachs in New York.

Jonathan Platt
Director, head of fixed interest
Royal London Asset Management
Platt joined the Royal London Group in 1985 and became head of fixed Interest in 1992.
He has managed aggregate bond funds for over 15 years. Platt has overseen the development of the fixed interest process and team, culminating in winning UK Pension Awards in 2005 and 2006.


Helyar: Many investment managers are using derivatives extensively in fixed income funds. How can trustees satisfy themselves that managers are using derivatives appropriately?

Hobbis: The use of derivatives by investment managers is becoming increasingly accepted by pension funds. The trends in fixed income management are towards higher performance and LDI solutions, and the use of derivatives is an integral part of delivering these solutions to clients.
It is important that trustees are aware that derivatives may be used to manage or hedge risk and can be more efficient tools for portfolio management than trading in physical securities.
Trustees should ensure that guideline limits for duration and tracking error, among other things, include derivatives exposure, so managers may not use derivatives to increase risk beyond levels that trustees are comfortable with.
It is also important trustees satisfy themselves that investment managers have sufficient in-house derivatives expertise, and that appropriate controls are in place for tracking and managing counter-party risk, including the exchange of collateral.

Mather: It is important to remember that derivatives can be used to target exposure to desired risks as well as to reduce or hedge exposure to unwanted risks.
Trustees can influence the use of derivatives in two ways: first, by imposing investment guidelines with risk-based factors that would limit exposure, whether it is obtained from cash positions or derivatives; second, through due diligence on a manager’s back-office operations to ensure proper procedures for trade and settlement process.

Platt: The first thing that a trustee should do is ensure that the fund manager has the necessary experience to use derivatives in a sensible fashion: with the sudden growth in their use, many managers are using derivatives without understanding the risks.
This, however, should only be seen as a necessary – not sufficient – means to ensure that derivatives are used appropriately. Trustees should also put restrictions on the use of derivatives, such as not allowing derivatives to be used to gear the fund, and limits on the exposures generated by different forms of derivatives. Initially, these restrictions should be reasonably strict, and can then be relaxed as trustees become more familiar with the different kinds of derivatives and their uses, and also how well the managers have made use of derivatives.


Helyar: Can high alpha managers realistically be expected to deliver their target returns when credit spreads are so low? What are the key areas of flexibility required for a successful high alpha fixed income mandate?

Hobbis: Credit spreads have been low for some time and that has made for a challenging environment for fixed income managers.
There remain opportunities for managers to add value through bottom-up security selection, particularly when cross-border comparisons may be employed. However, more demanding outperformance targets will require greater flexibility and a more diversified approach to fixed income management.
Our approach to higher performance is to broaden the opportunity set to ensure we are able to express negative views on markets, as well as positive views, and to take exposure to sub-investment grade debt when we feel there are opportunities to add value.
Within credit, the global market offers more scope to add value than the domestic market, and the credit default swaps market provides opportunities to express negative views on names, as well as exploiting pricing inefficiencies, between physical bonds and derivatives.

Mather: Managers with a diverse set of strategies should be able to deliver alpha even with low credit spreads.
However, this does require flexibility on the side of the investor, so an asset manager with appropriate risk management capabilities can use the “full fixed income toolkit” to help improve results in a low spread environment. These tools include derivatives, such as futures and swaps, that can boost alpha without increasing risk if used wisely.
Other tools are non-benchmark-hedged exposure, like non-euro securities and non-traditional sectors such as emerging markets, to offer a larger opportunity set.

Platt: There is a common misapprehension that credit spreads are abnormally low – this is not the case. Overall, investors are more than adequately compensated to take credit risk. There are two caveats here. Credit spreads have tightened over the last five years, although this reflects the wide level of credit spreads prevailing in 2001-02. Second, there has been spread compression – i.e. the yield differential between risk assets has narrowed. For credit managers dependent upon “beta” plays, this will present a problem.
Credit markets have become much more diverse in recent years. We find that this diversity offers a lot of opportunities to add value – but you have to look more widely than the usual index constituents. It means much more focus on those areas where analysis can make a difference. The growth of derivative markets, high yield, asset-backed and hybrids offer the active manager more than enough scope to outperform.


Helyar: How will the increased prevalence of collateralised debt obligations affect fixed income markets?

Hobbis: CDOs have already affected fixed income markets. The demand for yield through CDOs has been one factor that has tightened credit spreads and flattened credit curves. Producers of CDOs have increasingly used credit derivatives, which has contributed to increasing size and scope of the credit default swaps market.
The CDO market relies on low correlations between individual names and a continuation of historically low default rates.
The major risk, therefore, would be a credit event that has a systematic (rather than name-specific) impact on the credit market which could result in losses in some CDO tranches, and wider spreads for physical bonds as well as derivatives. However, if volatility remains low, CDOs will probably continue to underpin tight credit spreads.

Mather: CDOs had an impact on fixed income markets in two ways: through credit spreads and relative value relationships.
First, the technical effects of strong demand for CDOs led to tighter spreads of cash bonds as well as CDS positions. Second, the demand for CDOs – and namely for new structures such as synthetic CDOs, CPPI and CPDO structured products – have affected relative value relationships between cash and CDS as well as the various ratings quality buckets.
The narrowing of spreads on CDS relative to cash bonds, for example, was influenced by the recent issuance of synthetic CDOs and the new CPDO structures, which increased the demand for single name CDS and CDS index products such as the DJ CDX and iTraxx.
We have examples today of “negative basis”, where the CDS spread is below the cash bond spread for a similar maturity position. This has presented opportunities for managers, such as PIMCO, where we can go long the cash bond, short the similar maturity CDS, and pick up the difference in basis points with minimal risk.
We would expect future product innovations in this segment to create further opportunities.

Platt: The rapid evolution of the structured credit market, of which the CDO is one product, provides both new solutions and problems for the credit investor. Synthetic CDOs spur demand for credit default swaps, and we expect this market to grow in depth and liquidity as a result. Increased choice is beneficial, but CDO issuance may result in a greater number of protection sellers than buyers, such that pricing reflects technical factors as much as any perception of credit risk.
It is not yet clear whether the market has fully understood that many CDO tranches will suffer poorer recovery prospects than a normal corporate bond with the same rating, or grasped that ratings on CDO tranches will be more volatile. AAA corporate bonds tend not to be downgraded to sub-investment grade overnight, whereas examples of this have already been observed in the CDO market. If default rates increase, we believe subordinated tranches of CDOs will underperform corporate bonds in similar rating categories.
CDOs can play a valuable role in dispersing risk across the market, supplying “super-senior” AAA issues to the risk-averse while feeding the appetite of hedge funds seeking more volatile instruments. This should make bond markets more resilient, but at the expense of transparency – CDOs make it even more difficult to trace who is bearing the losses, and this opacity can breed fear when the tide turns. It is not difficult to envisage the perverse scenario where CDOs contribute to increased price volatility, whilst reinforcing the market’s ability to absorb losses.


Helyar: Are leveraged loans an asset class that trustees should pay more attention to?

Hobbis: For pension schemes that are comfortable taking exposure to high yield corporate debt, leveraged loans would be worth looking at.
Leveraged loans can offer a more favourable position in the capital structure of companies. In addition, allowing scope to invest in loans provides opportunities to take advantage of inefficiencies in the relative pricing of bank loans and high yield bonds.
As with high yield bonds, the major risk associated with loans is default risk. However, the historical recovery rate for loans has been higher than for bonds in the same companies and a disciplined bottom-up approach to valuation can generate opportunities for investors.

Mather: Leveraged loans, or below-investment-grade-rated bank loans, are an attractive asset class that warrants more attention from trustees.
These loans are typically senior in the capital structure, secured by hard assets and have protective covenants. Historically, leveraged loans have exhibited very attractive risk-adjusted returns, especially with the use of modest leverage.

Platt: Yes, for two reasons: first, the distinction between the leveraged loan market and the bond market is primarily one of market practice rather than fundamental, and the difference is narrowing quickly.
Historically, the leveraged loan market was dominated by banks as investors; the debt was primarily floating rate and senior in the company’s financing structure. The recent issue by Eco-Bat, the world’s largest recycler of lead, illustrates how things are changing. While the e600m (£409m) deal was originally structured as a loan, enthusiasm from bond investors was so great that the whole issue was repackaged, through a special purpose vehicle, into a bond format to accommodate demand.
Second, collateralised loan obligations which invest in leveraged loans provide a mechanism which, for investors in a particular tranche of the CLO, can either dilute or concentrate credit risk. The burgeoning supply of such structures has the power to influence the pricing of credit risk within markets generally. Trustees need to be well informed of such developments, in order to understand fully the risks they are contemplating in setting their asset class benchmarks and outperformance targets.