Unconstrained Investing: Not Running on Empty by Any Means

Robert O. Abad
Product Specialist

Executive Summary

  • While unconstrained investing has come under fire recently, we believe the attractiveness of unconstrained strategies will continue to grow for the following reasons: 1) global growth is facing stronger headwinds, 2) market volatility is on the rise, and 3) challenging markets require greater flexibility.
  • We define unconstrained fixed-income investing as strategies with no formal benchmark and that comprise exposures of various asset types, that have differing risk budgets emphasizing spread products or macro strategies, but that are ultimately managed within a pre-determined volatility range.
  • Western Asset’s unconstrained fixed-income program comprises five flagship strategies: Total Return Unconstrained, Global Total Return, Global Multi-Sector, Multi-Asset Credit and Macro Opportunities.
  • With more uncertainty around global risks and more volatility going forward, we encourage investors to take a closer look at the merits of unconstrained investing as it allows investors significant flexibility for navigating markets in the years ahead.

Introduction

Unconstrained investing is back in the spotlight. Once embraced by some investors and consultants as a magic bullet against rising US interest rates and as an opportunistic way to access new and growing segments of the global fixed-income universe, this approach is now generating some skepticism due to the recent performance of unconstrained products relative to traditional US and global benchmarks. With US and global rates now assumed to remain lower for longer in a post-Brexit world, there’s also a growing chorus that the popularity of unconstrained investing has perhaps peaked.

We believe these and similar views are misguided. Unconstrained investing not only helps protect investors from duration risk, which has become much more asymmetric for the long-only investor, it also offers investors a variety of additional benefits that will become increasingly relevant as market volatility is poised to remain elevated in the years ahead.

We see the attractiveness of unconstrained investing growing for the following reasons:

  1. Global Growth Facing Stronger Headwinds
  2. After decades of sustained growth, today’s global economy continues to sputter along, but feels increasingly vulnerable every step of the way. The impact of the Global Financial Crisis still weighs heavily on governments, markets and banking systems, and global central banks have gone to extraordinary lengths over the years to contain the damage. Yet, the underlying fault lines remain well in place, and new cracks are appearing with more frequency. The resulting uncertainty clouds the global economic outlook and inhibits the forward-looking thinking and the consequent spending and investment that ultimately underpins sustainable economic activity.

Exhibit 1
A Global Economic Snapshot
unconstrained-investing-not-running-on-empty-2016-07
Left Source: Bureau of Economic Analysis, Bloomberg, Eurostat, Western Asset. As of 31 Mar 16. Note: 2-quarter average growth. 1Q16 values forecasted.
Right Source: Bloomberg. As of 30 Apr 16.

    In the current context, policymakers need to rethink their positions and new mechanisms to spark global collective action are desperately needed. However, the recent referendum in the UK leading to a surprise vote in favor of Brexit seemingly pushes the world further down its current path, fueling uncertainty with respect to key macro questions, including the future shape of Europe’s economic and political landscape and the outlook for global growth.

    All of this suggests that central banks have no choice but to continue to deploy both conventional and unconventional monetary policies to keep deflationary and recessionary forces at bay. On one hand, the prospect of continued and more creative monetary policy accommodation can be viewed as a catalyst for buoying asset prices. On the other, the need for aggressive central bank action underscores their concern around global economic activity, financial market stability and now, social and political risk across developed-market and emerging market (EM) countries. This tug-of-war over the state of the world suggests a more skittish market environment going forward.

Exhibit 2
Central Banks in Action
unconstrained-investing-not-running-on-empty-2016-07
Left Source: Bloomberg. As of 31 Mar 16.
Right Source: Bloomberg, Western Asset, OECD. As of 31 Mar 16.

  1. Market Volatility on the Rise
  2. Global markets have benefited greatly from healthy doses of policy accommodation over the past 8 years, but policymakers’ inability to engineer economic recoveries to-date, and to stabilize markets when needed (China is one example), has as of late generated bouts of severe market anxiety. Indeed, broad market volatility, whether measured by the MOVE or VVIX indices1, has become more erratic over the past few years on rising headline risk and expectations of more “tail risk” events.

Exhibit 3
Broad Market Volatility Has Become More Erratic in the Past 2 years
unconstrained-investing-not-running-on-empty-2016-07
Source: Bloomberg. As of 30 Jun 16.

    The same applies to the resurgence of risk-on, risk-off markets. In the pre-crisis years, asset classes generally marched to the beat of their own drum and would swing in tandem for a short period of time during severe crisis periods. However, after the 2008-09 crisis, the correlation of major asset classes such as US high-yield, EM debt, EM equity and commodities versus the S&P 500 has remained elevated relative to historic norms. This is worrisome as idiosyncratic shocks to one asset class can now spill over with greater speed and force across other asset classes for reasons not justified by fundamentals. Unfortunately, we do not expect the forces driving this distortion—more frequent government intervention, deeper global financial market linkages, thinner market liquidity and greater use of derivatives—to abate anytime soon.
Exhibit 4
Correlations Among Major Asset Classes Have Risen Markedly Since 2010
unconstrained-investing-not-running-on-empty-2016-07
Source: IMF (Global Financial Stability Report), 2015.

  1. Challenging Markets Require Greater Flexibility
  2. Given the global macro backdrop and expectations of a more volatile market environment going forward, both investors and asset managers need to be more nimble than in years past with their asset allocation and risk management efforts. This only serves to reinforce the case for unconstrained investing. For investors currently assessing the merits of an unconstrained strategy over a traditional fixed-income option, here are several key points to consider:

    • Traditional fixed-income strategies have performed well as of late on the back of slower global growth and diminishing inflation pressures. However, given the absolute low levels of global government interest rates today, it’s difficult to see these traditional approaches producing anywhere near their long-term average returns in the coming years. Part of the challenge stems from the prevalence of negative interest rate policy across large parts of the developed world. Of the approximately $82 trillion in global debt, $60.7 trillion (or almost 75%) trades at a 1% yield or lower, including $18.9 trillion that trades at a negative yield. This technical provides a strong incentive for investors to be flexible and to gravitate to regions that offer the prospect of positive real returns.
Exhibit 5
Negative Sovereign Yields Worldwide
unconstrained-investing-not-running-on-empty-2016-07
Source: Barclays. As of 05 Jul 16.
Exhibit 6
Central Bank Policies May Spur Greater Demand for US-Dollar Assets
unconstrained-investing-not-running-on-empty-2016-07
Source: Barclays. As of 30 Jun 16.

    • Unconstrained investing continues to offer investors the flexibility to allocate capital based on an independent assessment of value rather than the formulaic issuance patterns of the major constituents of the benchmark indices. Today, these indices, such as the Barclays U.S. Aggregate and Barclays Global Aggregate, are dominated by issues with historically low yields and longer than average duration, resulting in more asymmetric risk for the long-only investor tied to such rule-based indices.
Exhibit 7
The Glide-Path of Global Yields
unconstrained-investing-not-running-on-empty-2016-07
Source: Bloomberg. As of 30 Jun 16.
Exhibit 8
Asymmetric Duration Risk on the Rise
unconstrained-investing-not-running-on-empty-2016-07
Source: Bloomberg. As of 30 Jun 16.

    • The widely-used Barclays U.S. Aggregate Index, highlighted below, excludes approximately 65% of the investable fixed-income universe such as floating-rate, inflation-linked, non-US, private and below-investment-grade securities. Each of these off-benchmark opportunities provides less interest rate sensitivity and many currently offer higher income and total return potential.
Exhibit 9
Fixed-Income Market Opportunities Beyond the Aggregate
unconstrained-investing-not-running-on-empty-2016-07
Source: Barclays. As of 31 May 16.
Exhibit 10
Fixed-Income Market Opportunities Beyond the Aggregate
unconstrained-investing-not-running-on-empty-2016-07
Source: Barclays, Citigroup, JPMorgan, S&P/LSTA, Western Asset. As of 30 Jun 16.
Indices are Barclays unless otherwise noted. 1Internal estimate of the non-agency universe. There is no official benchmark. Non-Agency yields are loss adjusted

    • Traditional fixed-income strategies cannot stray far from benchmark sector allocations due to both guideline restrictions and the worry of increasing tracking error. However, unconstrained strategies are not constrained by benchmark sector allocations, allowing investors to place more (or less) emphasis on sectors that they prefer (or dislike). For example, adding structured products such as commercial mortgage-backed securities and floating-rate student loans into an unconstrained portfolio introduces other less-correlated risks (versus other asset classes) without sacrificing yield or expected return.
Exhibit 11
Opportunities in the Structured Product Space
unconstrained-investing-not-running-on-empty-2016-07
Source: BofA Merrill Lynch Global Research, Markit Partners. As of 30 Jun 16.

    • Unconstrained investing should not be viewed as a one-dimensional approach focused solely on avoiding the undesirable characteristics of fixed-income—relatively long duration and highly correlated to government rates—but, rather, one that seeks to exploit its most desirable characteristics: high income, diversification and risk reduction. Looking across the fixed-income spectrum in Exhibit 12, yields are currently low, but spreads in sectors such as US high-yield and EM debt are wide and do offer a degree of protection if benchmark rates slowly move higher.
Exhibit 12
The Global Fixed-Income Spectrum
unconstrained-investing-not-running-on-empty-2016-07
Source: Morgan Stanley, Citigroup Index LLC, S&P LCD, iBoxx, Bloomberg. As of 03 Jun 16.
Note: The minimum, maximum and percentile rank is based on the following assumptions: US HY, US IG, US Mortgage, US Agency, US Treasury based on data since February 1989. Europe investment-grade yields and spreads since 1999 and 2004, respectively. Europe high-yield yields and spreads since 2002. Leveraged loan data since 1997. EM spread data since 2000.

Western Asset’s Place in the Unconstrained Space

Unconstrained investing is not a new concept in the marketplace, but still lacks a common definition. Throughout the industry, the term unconstrained is used to describe various strategies that are managed without a benchmark or are targeting a total rate of return. Generally, the strategies will have broad guidelines and very different risk profiles.

At Western Asset, we define unconstrained fixed-income investing as strategies with no formal benchmark and that comprise exposures of various asset types, that have differing risk budgets emphasizing spread products or macro strategies, but that are ultimately managed within a pre-determined volatility range. These ranges are used to help keep these strategies within a client’s desired risk and return profile. Because a volatility range is central to how we position and size our unconstrained portfolios every day, risk estimation and management are fully integrated and within the investment process.

As highlighted in the conceptual graphic in Exhibit 13, on one end of the spectrum are less aggressive strategies that target bond-like volatilities and thus, more moderate returns. These strategies tend to have a longer-term investment bias and generally make gradual changes to allocations. On the other end of the spectrum are more aggressive strategies that target larger returns and a higher level of volatility. These strategies may employ active trading and may make frequent and/or significant allocation shifts.

Exhibit 13
Western Asset's Unconstrained Strategies
unconstrained-investing-not-running-on-empty-2016-07
Source: Western Asset

At Western Asset, our unconstrained fixed-income program comprises five flagship strategies:

Total Return Unconstrained (TRU)

This strategy, which launched in 2004, seeks to maximize total return within a volatility range of 3% to 5%. TRU fits squarely into the category of targeting a lower level of volatility and moderate returns. To a large degree, TRU can be thought of as an unconstrained version of a traditional fixed-income strategy. Whereas traditional fixed-income is usually benchmarked against the Barclays U.S. Aggregate Index, which also serves as the main guidepost in portfolio construction, TRU does not have a benchmark, so it has significantly more flexibility in terms of duration, curve, sector and quality considerations. That said, the strategy is US-centric and must have at least 50% of its holdings in investment-grade securities. TRU can be appropriate in all market environments, but may be particularly attractive in the current environment. With rates moving to historic lows, the duration flexibility of the strategy can provide a significant advantage.

Global Total Return (GTR)

This strategy, which launched in 2006, is an investment-grade-only solution which seeks to maximize total return within a targeted volatility range of 4% to 6%. Returns are generated through active macro strategies and tactical asset allocation across the global investment-grade fixed-income opportunity set. By excluding sub-investment-grade securities, the strategy can offer investors better diversification to risk assets such as equities. GTR has the flexibility to adjust duration and rotate country and sector allocations as opportunities arise or valuations change. There’s also the flexibility to be long or short in any investment-grade currency. To ensure the currency strategy does not dominate overall portfolio risk, however, the aggregate currency exposure is limited to a maximum of 50% with a maximum of 25% long or short currency exposures versus the base currency.

Global Multi-Sector (GMS)

This strategy, which launched in 1996, seeks to maximize total return through income and capital appreciation within a volatility range of 5% to 7%. GMS effectively combines some of the higher yielding, more volatile asset classes such as high-yield and EMs (typically between 30% and 70% exposure) with some of the less-correlated, lower-volatility asset classes such as investment-grade corporate bonds, government bonds and agency mortgages. This gives investors access to a significant portion of the global fixed-income universe, but also a portfolio with an overall investment-grade-rated profile. Similar to our other unconstrained strategies, we have a flexible approach to duration management in GMS and also use active currency overlays to add to returns or hedge various risks within the portfolio, such as those arising from credit, peripheral markets, declining commodity prices, etc. GMS offers clients an opportunity to gain access to a diversified fixed-income portfolio away from traditional core market bonds, or for those who do not wish to make an outright allocation to high-yield or EM debt separately.

Multi-Asset Credit (MAC)

This strategy, which launched in 2010, emphasizes income primarily and seeks to maximize total return within a mid-level volatility range of 5% to 7%. MAC’s investable universe spans the whole global fixed-income spectrum: investment-grade and high-yield corporate bonds, non-dollar debt, bank loans, EM debt and structured securities. Unlike GMS, MAC has no credit quality, sector or regional biases. One of the key differentiators of the strategy is the inclusion of a portfolio of tail-risk protection strategies, which look to protect a client’s portfolio against significant drawdowns when credit markets come under pressure. These strategies may include taking long duration positions in government bonds, utilizing derivatives on credit indices or equity indices to remove credit risk or implementing option strategies that look to provide protection in the case of certain negative events.

Macro Opportunities (Macro Opps)

This strategy, which launched in 2012, seeks to maximize total return within a higher volatility range of 8% to 10%. This approach is purely opportunistic and is more alpha-oriented than the strategies described previously. Macro Opps allows for active trading of key fixed-income factor exposures. These include rates, curve, volatility and currency exposures. These positions are taken primarily through derivative exposures and can vary significantly in both size and direction over short periods of time. The strategy’s ability to use active management as well as to be long, short or neutral in risk positions helps reduce the correlation to broad financial markets. Ex-post, the correlation profile to equity and bond markets has been quite favorable. This gives clients flexibility when they need it most, and in the end, flexibility is what unconstrained investing is all about.

Conclusion

Unconstrained strategies are not always perfect substitutes for traditional bond strategies. They cannot always meet client needs. But we believe the inherent flaws of fixed-income benchmarks require consideration of an unconstrained approach as a viable complement to traditional strategies or as an alternative investing option in all market environments. With more uncertainty around global risk and expectation of a more volatile market going forward, we encourage investors to take a closer look at the merits of unconstrained investing; it allows investors significant flexibility for navigating markets in the years ahead.

Endnotes

  1. The Merrill Lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10 and 30-year contracts. The VVIX Index, known as the “volatility of the VIX,” is an indicator of the expected volatility of the 30-day forward price of the VIX Index. The VIX Index itself is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
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