Total Return Unconstrained

Mark Lindbloom
Portfolio Manager

In this Q&A, Portfolio Manager Mark Lindbloom outlines the investment approach taken by the Total Return Unconstrained (TRU) strategy and its relevance in today’s market environment. The increased opportunity set of fixed-income sectors offers the opportunity for a manager to add alpha while using the increased duration latitude to potentially guard against a rising rate environment.

Q: TRU was launched in 2004. What was the driver behind the concept?

A: The interest rate environment today is similar to what it was in 2003. Rates were very low, short-term rates were very low, and the concern at the time was—as it is now—that rates only had one way to go, and that was up. Those are the same concerns that we see with investors today.

Q: How would you say TRU differs from a Core Full strategy?

A: One of the most significant differences between TRU and Core Full is the flexibility that TRU has from a rate and sector perspective. With TRU, we include each and every sector that we have expertise in, and fortunately that includes all global debt sectors. We also have more latitude to differentiate ourselves relative to benchmarked portfolios. We have much more flexibility in TRU, which we think plays to our advantage in adapting to the various interest-rate and sector environments that we’re operating within.

That said, I want to acknowledge that there are clients who choose durations based upon other considerations, like a longer liability for example, and they specifically want to have a core full or a long duration strategy against those liabilities. So we have to acknowledge that there are some clients that have a very good reason for being in intermediate or long duration rather than a more flexible TRU strategy.

Q: Where would you expect the main sources of performance to come from?

A: As you might imagine, the market environment has a big influence on where performance is generated. Generally, if you look historically at Western Asset’s attribution of returns in the various products, most of the outperformance comes from sector rotation and issue selection. We are active managers. We are looking to select global sectors and weight them accordingly depending upon how we think they stack up in terms of attractiveness and relative value.

Sector specialists are responsible for issue selection. The sector teams will populate common issues across different mandates given the views of our bottom-up analysts. In today’s environment, all sectors have a credit component. It doesn’t matter if it’s corporates, high-yield, investment-grade, mortgages, emerging markets, municipals or developed markets. Everything’s a credit, and the depth of our global sector teams is key in analyzing the issues and structures in which we invest.

I would put rates at the lower end in terms of their contribution to performance and attribution. That of course could be very different depending on the environment that we’re in and how stretched rates are. In that case, the ability to have duration flexibility could be advantageous in a rising rate environment, and consequently, the contribution to performance could be greater.

Q: What would you say the main themes are today within the TRU portfolio?

A: Overall we are defensive, not only in terms of overall duration, but also in terms of the risk allocation when it comes to sectors. The abrupt changes we saw to the market in May and June did cause some shifts. We extended duration modestly, from two years to 2.75 years, by adding US Treasuries. We also added a few percent in agency mortgages. We added 1% to non-agency mortgages. This sector has been one of our favorite trades at Western Asset given the fundamentals of the housing market as well as the valuations that still exist. These were small additions as we are being very incremental and deliberate about our additions to risk given the uncertainty of the environment we are in.

Since last summer we have reduced duration as rates have fallen. We’ve also modestly reduced spread sector exposure as spreads have tightened.

Q: Can you talk about the process by which ideas from the global team of sector specialists get included within the portfolio?

A: What we’re trying to achieve is a broad global consensus view in terms of economic cycles, monetary authorities, interest rates, currencies and yield curves in multiple countries. We then drill down from there using our country and sector expertise to build themes across all of our global portfolios. These ultimately end up in a specific allocation, or what I call risk budgeting, either against the benchmark (if there is a benchmark) or in the case of TRU, absolute levels in terms of the percentages or contributions to duration that we want to employ in an unconstrained product.

What is important to point out is that the themes will be the similar, but the concentrations can be much different. For example, if we don’t like a particular sector, whether it be investment-grade corporates or mortgage-backed securities, we’re not bound to the benchmark. In TRU, we could own 5% or 10% or 0%. It can be significantly different.

Q: From an interest rate perspective, TRU has been defensively positioned for some time. What is the duration range and are there environments in which you would be at the extremes?

A: The advantage of the TRU product is its flexibility. TRU has a broad duration range of -3 years to 8 years. Overall the portfolio has been defensively positioned with this being mainly on the rates side as the duration has been in the 1.5 to 2.5 years range since late 2010. Portfolio duration today is over 2.5 years, which is up slightly given the abrupt backup in rates experienced in the earlier part of 2013.

When would we go to -3 or 8 is a good question. It would have to be some very obvious and extreme events that would lead us to be that aggressive. Realistically, 80% of the time we are going to be well within the 2- to 4-year range and it would be unusual that we would have the conviction to go to -3 or to 8 years.

Q: How do you think about risk in an unconstrained mandate?

A: We are often asked this question as the strategy is not managed to a benchmark. So for TRU we would position for a volatility target of around 3% to 5% over a market cycle.

Q: What kind of investor would be interested in the TRU strategy?

A: There have been lots of discussions going on with consultants and investors over recent months, quarters and years, and I think what sparked interest in unconstrained strategies broadly is the potential for rising rates and a desire to increase diversification globally.

Global debt markets have developed over the past decade and the Barclays Aggregate represents approximately one third of the total size. Clients and consultants are recognizing that there is a world of opportunity to take advantage of.

In terms of rates, unless I have a longer duration liability that I’m managing against, there’s no real reason to be confined to a benchmark. The reason that we’ve done that historically is that it’s been a fairly liquid sector to look at. It’s also been very popular, like the S&P of the bond world, and it’s what a lot of clients and consultants default to when they talk about the US debt markets. We acknowledge that many investors also define that benchmark as a high-quality benchmark. We also agree with that over time. For many clients that hire Western Asset, their fixed-income allocation is a high-quality, anchor-to-windward sort of strategy. They want that allocation, because elsewhere they’ve got equities, they’ve got high-yield, they’ve got emerging markets. But if they don’t have those allocations, and they don’t have a defined liability stream, I think a lot of investors and consultants have come around to thinking: why not be more flexible as debt markets around the globe have advanced and become more liquid?

Our portfolio managers, sector teams and bottom-up analysts argue that there are far more attractive valuations that we see in markets outside of the US for comparable qualities in terms of industries, issuers and corporations, but for wider spreads and better valuations. Similarly on interest rates, something we’ve already talked about is that if rates are going up, we don’t have to be 5.0 duration versus 5.5. We could be at 2, we could be at 0. And we could potentially have the advantage as rates are going up of having a much lower duration or less interest-rate sensitivity relative to those benchmarks. We can have higher duration as well, if we feel the environment is such that we want to have higher interest-rate sensitivity. So I think those are the types of investors that are finding our TRU strategy appealing.

Related White Paper(s)

Unconstrained Investing: Unleash Your Bonds

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