- Having successfully dampened volatility across all asset classes through the multi-year implementation of near zero interest rates, liquidity injections and QE of various forms, the major global central banks now appear to be diverging in their policy stances.
- The major central banks are approaching a crossroads, with policy set to diverge for the first time since the global financial crisis. The scale and pace of this policy divergence is likely to have an impact on the level and shapes of global yield curves, the major currency exchange rates and the level of market volatility.
- The volatility of corporate bond spreads may approach their pre-crisis trends while government bond volatility could increase; investment-grade corporates’ risk premium should more closely reflect underlying fundamentals in the future, and the uncertainty of exiting unconventional monetary easing and divergent policies could result in higher levels of volatility for bond investors.
- Against this backdrop, we believe that a manager’s ability to deploy macro strategies in bond portfolios (alongside a fundamental value-driven allocation to selected risk assets and rigorous research-based bottom-up issue selection) will be the key to navigating this volatility, generating alpha and controlling overall portfolio risk.
The Name of the Game
As we approach a potentially significant crossroads where the divergence in monetary policy paths between the Federal Reserve (Fed) and other major developed market central banks—specifically the European Central Bank (ECB) and Bank of Japan (BoJ)—looks set to increase further over the coming years, we are revisiting the importance of macro investing as a key driver of future returns and risk management within fixed-income portfolios.
In a market commentary paper from early 2013, Western Asset’s CIO Ken Leech made reference to the importance of macro investing during the volatile interest rate cycles of the 1970s.1 While this decade will be best remembered (not always fondly) for giving us disco music, flared trousers and permed hair, it also heralded a development that was probably not on the radar of most ABBA fans: active bond management.
In contrast to the music and clothing of that decade, US core bond mandates were not as flamboyant, and typically restricted managers to take a limited amount of duration risk. A constraint of one year on either side of a benchmark’s duration was quite common and tight active duration limits remained a feature up until the recent global financial crisis. The reason for this was that if an investor was caught on the wrong side of a large swing in bond yields—changes of 400 basis points (bps) were common in the 1970s and 1980s—then long-term performance could be destroyed very quickly. Consequently, this volatile period was characterized by interest-rate, yield curve and convexity strategies as the main drivers of risk and return. It was therefore no coincidence that most large fixed-income firms employed investors with the requisite macro skills at senior levels.
By comparison, restrictions around exposure to corporate bonds in fixed-income mandates were very wide (or in many cases non-existent), reflecting the extremely low volatility in investment-grade corporate bond returns, which traded within very tight spread ranges over a long period.2 With spread volatility typically not having a meaningful impact on risk and return, the focus within corporate allocations centered around taking issue-specific risk and adding value through bottom-up credit analysis rather than by managing spread volatility risk.
The riskiness of adding one year of outright duration relative to adding one year of investment-grade credit spread duration is shown in Exhibit 1. In the 30 years leading up to the financial crisis, interest-rate risk dominated spread duration risk (over certain periods) by well over 10 times; this environment lent itself to an investment approach that combined a strong focus on macro strategies with rigorous company-specific research. Put differently, the ability to navigate the macro environment successfully was the key determinant of generating returns, while additional carry could be earned through credit research.
The Winner Takes It All
In the wake of the global financial crisis, the regime of macro volatility dominating credit spread volatility reversed spectacularly. What had been a rather dull asset class for several decades suddenly began to price in significant default risk as markets struggled to deal with a severe global recession and enormous systemic risks that threatened the entire global financial infrastructure. The scale of this reversal can be seen in Exhibit 2, which shows just how consistently low the volatility of excess returns in corporates was against the sharp swings in US Treasury (UST) returns.
It was only following unprecedented policy easing from the major global central banks combined with large scale balance sheet expansion through quantitative easing (QE) that normality returned to credit spreads and they started to again resemble previous benign periods. Having successfully dampened volatility across all asset classes through the multi-year implementation of near zero interest rates, liquidity injections and QE of various forms, the major global central banks now appear to be diverging in their policy stances. As Exhibit 3 shows, since the start of 2014, markets’ expectations for short-term rates by the end of 2016 have diverged significantly. In the US, the Fed has been clear that, with the US economy recovering, it now considers it appropriate to start gradually increasing interest rates and has signalled that this process is likely to start in the second half of this year.
By contrast, the balance sheet of the BoJ is still expanding at a rapid pace and is projected to double in size (since the start of the asset purchase program) by the end of 2015. Similarly, the ECB has pledged to keep policy very accommodative for the foreseeable future and is targeting expanding the size of its balance sheet back to 2012 levels. Thus, the major central banks are approaching something of a crossroads, with policy set to diverge meaningfully for the first time since the global financial crisis. The scale and pace of this policy divergence is likely to have a meaningful impact on the level and shapes of global yield curves, the major currency exchange rates as well as the overall level of market volatility. The current geopolitical landscape and continued concerns around downside risks to global growth will also likely add to uncertainty.
It is not unreasonable to conclude from the above analysis that the volatility of corporate bond spreads may approach their pre-crisis trends while government bond volatility could increase. Investment-grade corporates’ risk premium should more closely reflect underlying fundamentals in the future, since a combination of conservative balance sheet management and regulatory pressure reduces the scope for increasing leverage in corporate balance sheets. At the same time, divergent policies by the world’s central banks could result in higher levels of volatility for bond investors. As can be observed in the final bar in Exhibit 1, macro volatility relative to credit spread volatility has already started to increase.
Moreover, as corporate risk premium declines, corporate bond returns are likely to become increasingly correlated to those of governments, further raising the asymmetric risks facing bond investors (Exhibit 4).
Against this backdrop, we believe that a manager’s ability to deploy macro strategies in bond portfolios (alongside a fundamental value-driven allocation to selected risk assets and rigorous research-based bottom-up issue selection) will be the key in seeking to navigate this volatility, generate alpha and control overall portfolio risk.
Knowing Me, Knowing You
At Western Asset we have had success employing macro strategies within dedicated sovereign, aggregate, multi-sector and absolute return strategies. Exhibit 5 below shows the three-year and five-year attribution history of benchmark relative returns within Western Asset’s global aggregate strategy and how these compare with our targeted attributions.
As the table highlights, macro strategies employed within global portfolios have generated positive outper- formance, contributing 50% or more of total excess returns using a diversified range of sources. In addition to alpha generation, macro strategies have also played an important role in dampening down the overall level of portfolio volatility, particularly during periods of significant credit spread widening.
To demonstrate this, Exhibit 6 shows our historical positioning across the UST curve in global aggregate strategies plotted against our historical active exposure to investment-grade credit. Western Asset has long held the view that, in addition to being consistent with our view on US economic fundamentals and expectations of Fed policy, an overweight to 30-year USTs can offer diversification and ballast to an investment-grade credit overweight during periods of corporate bonds stress. We relied heavily on this relationship in 2011 and again in 2012, and rather than sell less liquid credit holdings that we felt were mispriced below our assessment of fair value we instead increased 30-year UST duration meaningfully. As valuations have improved we have reduced our credit overweight accordingly, however, this has not deterred us from seeking alpha-generating strategies across the US yield curve. One such trade was to position our portfolios long 30-year UST bonds at the beginning of 2014 (a counter-consensus trade at the time) and this yield-curve-flattening trade has benefitted portfolios.
Take a Chance on Me
Western Asset’s management style emphasizes multiple strategies with macro positions combined with active sector rotation and issue selection achieved within a risk-controlled framework. Going forward we believe macro strategies will offer more opportunities to play an increasingly important role in generating alpha and in managing the volatility within portfolios. We believe that the macroeconomic research and idea generation from our investment teams around the world will allow our experienced Global Portfolios Team to identify many of these opportunities.
This paper was originally posted in October 2014, and updated in June 2015.
- Ken Leech, Market Commentary, January 2013
- Between 1984 and 1999, the average of the absolute (positive or negative) quarterly excess return of US investment-grade corporates was approximately 60 bps. Over the same period, the average quarterly return of USTs was approximately 300 bps