- After the volatility seen in 2011, investors are understandably concerned about risk in portfolios. Rather than revert to a passive strategy, investors should consider ways to take advantage of trends that we expect to see in the new year.
- Investors concerned about interest rate risk should consider agency MBS—notably GNMAs—and opt for short duration strategies.
- 2012 should see a continuation of the trend toward globalization.
- Although it has long been a significant source of total return, income is even more important in the current low-rate environment; investors should therefore look at higher-yielding opportunities.
- Tail protection strategies provide an alternative to traditional risk-mitigation tools.
- Due to their strong balance sheets and greatly improved political stability, emerging markets will keep attracting investors in 2012.
2011 was certainly a historic year for investors. In addition to extremely high volatility, the year included an unprecedented downgrade of long-term US government debt, continued record-low yields in the US, the US debt-ceiling crisis, and questions about the future survival of the euro amid the sovereign crisis on the Continent. Investors, still reeling from those events, are understandably heavily focused on reducing risk in their fixed-income allocations as they move into 2012.
Last January, Western Asset produced a white paper, A New Year’s Resolution: Get Active, looking at key trends and strategies for the coming year, and explaining why we feel active management is even more important in these volatile environments. As we enter 2012, we want to again share with you our views on key trends and strategies for the upcoming year, and continue to lay out the case for active management.
Shorter Duration/Higher Yield
Many investors continue to focus on reducing risk in their fixed-income allocations as we enter the New Year. These investors are either focused on maintaining shorter duration (due to concerns about rising interest rates) or on maintaining liquidity in the event of another bout of volatility that will necessitate a rebalancing out of fixed-income and into equities. Some investors have turned to a passive aggregate-index strategy in response, but we feel that there are strong alternatives to this option.
As we expressed in A New Year’s Resolution: Get Active, we believe that agency MBS, notably GNMAs, can provide a shorter duration and higher yield than that produced by a move to a passive aggregate-index exposure.
While the duration of agency MBS is variable and dependent on the level of interest rates, it is currently lower than that of the Barclays Capital U.S. Aggregate Index benchmark, while the yield is higher.
Current conditions, including low rates and falling-to-stable home prices, should keep prepayment levels below rates that would otherwise be achieved if home prices were higher, as it is difficult to refinance a home whose value has declined below the purchase price and nearly impossible to refinance a home whose value is below the mortgage amount. GNMAs in particular tend to have low loan balances, reducing the efficacy of refinancing, as even significant rate declines do not amount to significant changes in the monthly cost.
The management of duration is critical in this sector.
In addition to agency MBS, investors should also look at short duration strategies, which, although not providing a higher yield than the Aggregate index, offer the potential of less interest rate exposure. At Western Asset, those Strategies include Enhanced Cash, Limited Duration and Intermediate Duration.
Importance of Income
Yields on US, German and Japanese government bonds are all very low in both absolute and historical terms. As yields in the US have fallen below inflation expectations (negative real yields from one to 10 years), investors who have flocked to the safe harbor of US Treasuries are committing to less income, more risk (higher durations) and less purchasing power in the future. The income part of that equation should not be ignored in this low-yielding environment. Total returns in fixed-income, and to some extent in equities, are a function of income.
At the same time, the governments that are offering the lowest yields are in the process of leveraging their balance sheets. This suggests another dangerous dynamic: Investors are receiving lower and lower yields as the leverage of the issuing institution increases, thus further amplifying risk.
A significant part of total return for fixed-income—even for US Treasuries—historically has come from income. Between September 30, 1988 and the end of December 2011, coupon income (including reinvestment) accounted for 101% of total return for US high-yield, 85% for US credit and 71% for US Treasuries (all values unhedged), according to Barclays Capital.
This income contribution is especially important in the current investment climate and is a strong argument for investors to focus on higher-yielding fixed-income investments, such as:
- High-yield debt
- Emerging markets debt
- Bank loans
- Middle-market loans
- Non-agency MBS
- Investment-grade debt of large US banks
These higher-yielding opportunities, while potentially more volatile and likely more correlated to equities than government debt, likely will provide higher returns over the intermediate investment horizon. In particular, high-yield and non-agency MBS are attractive. Although the latter sector has weak fundamentals, its future cash flows are reasonably certain. As a result, current market non-agency MBS pricing offers attractive yields and limited downside absent another dramatic downturn in the housing market.
Corporate balance sheets are strong. Corporations have become increasingly global, have improved their balance sheets and have reconstructed their business models to allow for more effective management of costs in the face of more volatile revenues.
We believe that these stronger balance sheets and higher yields will support returns in the coming years. Just as an investor looks to dividend-paying stocks to support returns in a slow growth environment, higher coupon rates from fundamentally sound issuers should support returns in the coming years.
In addition to sector-specific products, Western Asset offers a number of multi-sector products that offer a higher level of income. These range from Core, which offers a yield advantage of 0.89% versus the Aggregate index, to Credit Opportunities, which offers a yield advantage of approximately 4.75% versus the Aggregate, as of January 31, 2012.
Investors have continued to globalize their portfolios, and this trend will carry over into 2012. The reasons are many, and include the recognition of a continuing trend toward globalization for corporations and commerce. As business opportunities expand around the globe, capital follows suit. Most people have globalized their equity portfolios either directly, by investing in non-US companies, or indirectly, by investing in US multinationals.
Fixed-income portfolios have also experienced an indirect trend toward globalization, as non-US issuers have increasingly appeared in the various fixed-income indices. In addition, emerging markets have drawn investor interest because of their higher growth rates and healthy debt positions relative to parts of the developed world, especially the debt-plagued eurozone. As emerging market (EM) sovereign and corporate issuers have increasingly attained investment-grade status, many of these are now included in the Aggregate as well as in credit indices. (Emerging markets will be discussed later in this paper).
When investors buy non-US equities, they are making a currency decision. The issues included in the domestic fixed-income indices are all denominated in dollars, so currency diversification in fixed-income portfolios requires an explicit decision by the investor to invest in non-dollar bonds.
Record-low US Treasury rates have presented investors with a dilemma beyond mere interest rate risk and low yields. Traditionally, Treasuries have provided investors with an offset to equity risk. As equity volatility increases, investors traditionally shift money to Treasuries, bidding up prices and reducing yields in the process. This yield decline benefits investors who had already purchased Treasury securities as a stock-market hedge.
But with US Treasury rates already near historically low levels, will Treasuries continue to be an effective offset if equity volatility increases from here? The five-year Treasury, with a yield of 0.81% (as of January 31, 2012) is unlikely to provide much protection simply because it has very little room to improve.
Because Treasury yields are expected to remain low in 2012, investors will need to consider alternatives, such as Western Asset’s Tail Protection strategy. In our strategy, we buy a series of put options on the S&P 500, thereby putting clients in the position to benefit should the index fall below the “strike price.” We attempt to mitigate the cost of this strategy by minimizing time decay, buying options that are out of the money and at least nine months from expiration. We also work with clients to determine how much they are willing to spend for protection, and when and if we should monetize any gains. This strategy can be effective as a hedge for portfolio risk, whether such risk comes from equities or spread-sensitive fixed-income issues.
Emerging nations’ fixed-income markets should continue to draw attention from investors in 2012. Fundamentally, developed-market (DM) bond yields currently are under downward pressure as governments/central banks look to support economic recoveries that are challenged by powerful headwinds (such as sovereign debt woes in Europe, continued developed-world financial sector deleveraging, unemployment, election-year risks globally, etc). Technically, investors are challenged to meet return objectives due to a shortage of traditional, “safe” assets. They are also challenged by investment constraints imposed by global benchmarks, which demand greater exposure to traditional “risk-free” countries that are now threatened by sovereign rating downgrades.
The emerging world, on the other hand, is reaping the benefits of its strong balance-sheet position and its greatly improved political stability following the 1980s–1990s era of defaults, devaluations, fixed exchange-rate regimes, shallow capital markets, and “hot money.” For example, the financial crisis of 2008 and the ensuing volatility have forced investors to recognize that the ability and willingness of EM sovereigns and corporates to meet their obligations, even during periods of extreme market stress, is much greater today than ever before. As such, we believe that the EM-versus-DM “relative balance-sheet story”—as opposed to the traditional “relative growth story”—will continue to be a key driver of EM versus DM spread convergence. With spreads within the EM asset class currently offering a premium over similarly rated DM equivalents, investors may want to take advantage of the fundamental and technical merits of emerging markets by considering products that meet their preferences for risk and return: EM corporates (for spread premiums and geographic/sector diversification over traditional EM sovereigns-only investments), EM Unconstrained (for value that is lost by relying on “old” sovereign-heavy benchmarks) and EM Short Duration (for potential FX appreciation and EM money market opportunities) are all examples of Western Asset strategies for EM product offerings.
After the volatility seen in 2011, investors are understandably concerned about risk in portfolios. Rather than revert to a passive strategy, investors should consider ways to take advantage of trends that we expect to see in the new year.
Investors concerned about interest rate risk should consider agency MBS —notably GNMAs—and opt for short duration strategies. In addition, 2012 should see a continuation of the trend toward globalization. Although it has long been a significant source of total return, income is even more important in the current low-rate environment; investors should therefore look at higher-yielding opportunities. Tail protection strategies provide an alternative to traditional risk-mitigation tools. Finally, due to their strong balance sheets and greatly improved political stability, emerging markets will keep attracting investors in 2012.