An updated version of Q&A: Multi-Asset Credit was published August 2016.
In this Q&A, Western Asset Portfolio Manager Chris Orndorff and Product Manager Robert Abad discuss the Western Asset Multi-Asset Credit (MAC) Strategy. Since its inception in 2010, this unconstrained strategy has sought to maximize income and expected total return within a specified risk budget. Chris and Robert also explain how risk factor rotation and tail-risk protection strategies are utilized in an effort to mitigate drawdown risk stemming from periods of high market volatility in the global credit markets.
CO: Western Asset’s Multi-Asset Credit or MAC is an unconstrained strategy that, in a risk controlled manner, seeks to maximize the return from global credit. MAC has three key differentiating features. The first is its emphasis on providing high current income. The second is the use of risk factor rotation, rather than just sector rotation. The third and final differentiating feature of MAC is that it utilizes a portfolio of tail-risk hedges in an attempt to constrain overall portfolio volatility to 5% to 7%. This volatility range has generally been the historical experience of the Barclays U.S. Aggregate, Global Aggregate, UK Corporate, and Multiverse Indices.
CO: Western Asset has published extensively on the importance of income and this strategy seeks to achieve this goal.1 We use Western Asset’s global footprint and extensive investment experience in global credit markets to construct a diversified fixed-income portfolio that includes, but is not limited to, the following credit asset classes: high-yield and investment-grade corporate bonds, inflation-linked bonds, emerging market sovereign and corporate bonds, developed market sovereign bonds, residential and commercial mortgage-backed securities, preferred equity, and convertible bonds. It’s important to note that in addition to capturing the income potential across these various credit classes, a fully diversified portfolio is generally more stable than a portfolio focused on a single country.
CO: The portfolio consists of what could be termed a “nucleus” of bonds from the credit asset classes we believe represent the most attractive fundamental value. This nucleus is then augmented by the use of mostly derivative securities to help manage portfolio risk and factor exposures such as duration, yield curve, credit beta and currency. Derivatives, in this instance, help us to better calibrate the risk profile of the portfolio rather than trying to make sector- or issuer-specific adjustments in the cash markets during challenging times.2 For example, in 2013, after the “taper tantrum” induced selloff across risk assets, we added to exposure by buying credit default swap index (CDX) calls, thus adding to our credit beta. We also purchased a put spread on US interest rates to help protect against the risk of a significant rate rise. Having the flexibility to adjust macro risk factors using derivatives helped us to better position the MAC portfolio for a more dynamic environment in both the credit and rates space through the rest of the year.
CO: Tail-risk protection is not confined to one particular tool, as the strategy makes use of a wide range of hedging techniques in an effort to protect the portfolio from significant credit market sell-offs. For example, the portfolio manager can use duration and curve as a way to hedge out credit market risk at times when he is worried about a future event. The portfolio manager can also use currency as a way to alter exposures to certain markets as a method of hedging. Market volatility, interest rate exposure and credit beta can also be altered with the use of derivatives.
An example is the Greek referendum of July 2015. The referendum was an event known to the market in advance, with an unpredictable outcome, and potentially significant adverse scenarios. We used a combination of VIX futures, developed market yield curve flatteners, and interest rate and currency options to help protect the portfolio in a low cost way. To accomplish the same result without derivatives would have cost the portfolio over 100 basis points in transaction costs, reducing the return to our investors.
RA: When constructing MAC portfolios, the objective is to maximize the income and expected total return within our risk budget. Our Global Investment Strategy Committee establishes the broad, top-down themes that are found throughout all portfolios at Western Asset. The MAC Portfolio Management Team leverages those themes to assess relative value and then allocates a portion of the portfolio to each respective sector team, providing guidance on the characteristics of the sub-portfolio. Each sector team is responsible for issue selection. The MAC Portfolio Management Team also works closely with the Risk Management Team to monitor risk and correlation, but the MAC Portfolio Management Team will adjust overall portfolio risk factors as needed, generally relying on the Firm’s Derivatives Team for implementation.
CO: Our MAC product uses currency in one of two ways: as a risk hedge or as a way to capture income. During difficult markets, having certain currency pairs in place can play an effective role in reducing risk in a portfolio. For example, in 2013, it was beneficial to have a short position in the euro and the Japanese yen versus the US dollar. When currencies are used to capture income, income is generally maximized when buying a non-base currency bond if the currency is unhedged. If the currency remains steady, a zero return on the currency component of that investment is acceptable, because the portfolio earns the full amount of income from the higher yielding bond.
RA: MAC seeks to maximize return within a volatility risk budget of 5%-7% over the course of a market cycle. For a non-benchmark strategy, a Sharpe ratio of 1.0 is a reasonable performance objective.
CO: Successfully achieving the volatility target is a highly collaborative effort between the MAC Portfolio Management Team and the Risk Management Team. The volatilities of sectors and subsectors can change over time, and their relationship to each other also changes over time. For these reasons, portfolio constructions are tested with a variety of scenarios to reveal their behavior during times of stress. Adjustments to the portfolio are made as necessary until we believe we have produced the portfolio that is most likely to achieve our objective. This process is important because the volatilities of the individual sectors, such as US high-yield and emerging markets, are much greater than our 5% to 7% target. In our 5-plus years of experience in MAC, we have demonstrated our ability to achieve the objective of maximizing return in a risk-controlled setting.
CO: Yes. Our MAC framework allows for flexibility to adjust to higher volatility bands based on an investor’s level of risk tolerance. This can be accomplished by increasing or decreasing position concentrations, increasing or decreasing currency risk through more foreign bond income capture, utilizing more or less tail-risk hedges, and/or introducing leverage.
RA: A MAC portfolio will have much lower volatility than a sector-specific mandate, such as US High-Yield or Emerging Market Bonds, and as a diversified strategy it will capture less upside in a “risk-on” environment than a sector-specific mandate. Conversely, a MAC portfolio will generally excel in a “risk-off” environment when compared with a sector-specific mandate, as higher returns would come from both the diversified portfolio construction as well as the presence of tail-risk protection hedging strategies. Overall, the MAC strategy should behave well in both periods of high and low volatility because we adhere to our risk budget of 5% to 7% over a market cycle.
RA: We believe MAC’s three differentiating features emphasizing high current income, risk factor rotation and volatility management make this a very compelling product for investors looking for income, but who are also looking for some protection caused by sudden and sharp dislocations in the credit and rate markets.
RA: As global markets expand and more countries and corporations throughout the world issue bonds, the global bond market and the potential opportunities expand with it. As a firm emphasizing global breadth and local depth, Western Asset is well situated to take advantage of these changes and reflect them throughout our diversified suite of products, including MAC. Western Asset has over 40 years of fixed-income experience with a global platform that spans seven investment offices across five continents. The Firm has specialized sector teams including Emerging Market Debt, Global Credit (both investment-grade and high-yield), Inflation-Linked, Long Duration/LDI, Liquidity Management, Insurance, Sovereign, Structured Products (Agency MBS, Non-Agency MBS, and ABS), and US Municipal Securities. This depth of coverage and resources enables us to feel confident that appropriate investment opportunities can be found.
- “The Importance of Income,” Western Asset, February 2012, “The Importance of Income Part 2: The Rule of 72,” Western Asset, November 2012 and “Objective Driven Investing: Re-Thinking Asset Allocation,” Western Asset, June 2013
- “Liquidity in the Fixed-Income Market,” Western Asset, July 2015