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Multi-Asset Credit (MAC): 7th Anniversary Edition

Michael C. Buchanan
Deputy Chief Investment Officer

Western Asset’s Multi-Asset Credit (MAC) strategy is currently celebrating its seven-year anniversary. We sat down with Lead Portfolio Manager and Deputy Chief Investment Officer Michael Buchanan to discuss MAC’s key features and how the portfolio’s current position seeks to take advantage of today’s market environment.

What do investors find appealing about MAC?

In today’s low-interest-rate world, finding an attractive source of income remains a global challenge for individual investors, pension funds and institutions. The challenge is exacerbated by the complexities involved in asset allocation, market timing and risk management. MAC is our answer to this challenge.

MAC is a strategy that seeks to capture the income, return potential and diversification benefits offered by credit markets worldwide. These markets include corporate credit within the traditional high-yield and investment-grade spaces and a host of other sectors that offer compelling income and risk-adjusted returns, such as agency and non-agency debt, residential and commercial mortgage-backed securities (MBS), emerging market debt (EMD), bank loans, and USD and non-USD global sovereign credit. Unlike other multi-sector products that may have a bias toward a particular sector, geography or credit quality, our MAC strategy has none.

Some of the big worries most investors share involve concerns such as the potential loss of capital (drawdown risk), see-sawing returns (volatility) and the ability to quickly redeem funds when needed (liquidity risk). History has shown that these concerns are warranted. Market-jolting events may always lurk beyond the next bend. If we look at just the past couple of years, global financial markets have been roiled by Brexit, fears of a China slowdown, oil market volatility and US Federal Reserve rate hikes.

To help mitigate the downside associated with unforeseen negative events, our MAC strategy allocates an annual risk budget of 40–50 basis points (bps) for tail-risk hedges. These hedges may be relatively simple in form, such as taking long-duration positions in government bonds, or they may be a bit more complex, such as utilizing derivatives on credit indices or equity indices to reduce or remove credit risk. Sometimes the approach may involve implementing option strategies designed to hedge against potential negative events. More recently, we’ve preferred put option strategies and put spread option strategies on the S&P 500 Index given their meaningful correlation to the US high-yield market during market turbulence; high-yield constitutes a large portion of our portfolio’s credit exposure.

What has contributed to MAC’s success over the past seven years?

I think the key to MAC’s success is its ability to fully leverage Western Asset’s global investment capabilities. The Firm has over 40 years of fixed-income experience with a platform that spans seven investment offices across five continents. We have specialized sector teams including Global Investment-Grade Credit, High-Yield Credit and Bank Loans, Structured Products and Emerging Market Debt. Each team comprises battle-tested portfolio managers and traders, in addition to more than 100 research analysts with an average of 20+ years of experience covering their specific companies, industries and regions. Our expertise in the “macro” side of the equation has been the foundation for the success of our global credit teams and also stands on its own as an important alpha driver. Having a strong understanding of the drivers of yields, the forces shaping inflation and the trends influencing economic growth and currencies is of paramount importance for a true global fixed-income manager such as Western Asset. The views of our macro team not only impact credit allocation decisions, but also directly influence our duration and yield curve positioning across markets. This depth of global fixed-income coverage and resources across the credit space in “macro” enables us to feel confident that we can find appropriate investment opportunities and help our clients with their asset allocation decision across global fixed-income.

Another key factor contributing to MAC’s success has been the way risk management complements the management of the strategy. On a daily basis, we use models produced by the risk team to ensure the risks that we are actually taking in the portfolio are the ones we indeed intend to be taking. If a mismatch arises, then we can quickly make an adjustment. We run scenario analyses on both anticipated market events (e.g., Brexit, French elections) and historic events (e.g., a severe spread widening such as the Great Financial Crisis, or the taper tantrum) to get a picture of the possible impact on our holdings. While our risk team does not function as the “portfolio police” or anything like that, they help us elevate our game by keeping us quite aware of the “what-ifs” and making sure we are keeping our focus where it should be. Our high Sharpe ratio, which we discuss a bit more later, is a testament to the success of our partnership with the risk team.

Exhibits 1 and 2 show our MAC strategy’s strong annualized performance over various time periods and highlights its compelling risk and return profile relative to single-name asset classes.

Exhibit 1
Multi-Asset Credit Performance
Source: Western Asset. As of 31 Oct 17
Returns for periods greater than one year are annualized.
Please see the Performance Disclosure for more information.
Exhibit 2
Comparative Risk-Reward Profiles
Source: Bloomberg Barclays, JPMorgan, Merrill Lynch, S&P/LSTA, Western Asset.
As of 31 Oct 17
Performance shown is gross of fees. Returns for periods greater than one year are annualized. Please see the Performance Disclosure for more information. ¹Previously referenced as the Diversified High Income Composite, incepted 01 Oct 10. US Investment Grade Credit is represented by Bloomberg Barclays U.S. Credit Corporate Index. US High Yield is represented by Bloomberg Barclays U.S. High Yield Index. USD Emerging Markets is represented by JPM Emerging Markets Bond Index Plus(EMBI+).
Mike, why do you think this strategy is relevant in today’s environment and going forward?

Given the absolute low levels of interest rates globally, there’s going to be a greater reliance on income to drive return. For our MAC strategy, a main component of this will be the dynamic use of credit sectors. Exhibits 3 and 4 depict MAC’s historical allocation since inception and the historical ranges by sector since inception. We think global credit is going to be an important part of an investor portfolio in the years ahead, and active rotation across these sectors will remain vital. Bear in mind that credit sectors don’t necessarily move in tandem; they have different cycles, and they do well in different markets. The ability to tactically add emphasis to one sector and de-emphasize another to find value and drive alpha in a diversified portfolio is important.

Exhibit 3
MAC Sector Allocation Since Inception
Source: Western Asset. As of 31 Oct 17
Exhibit 4
Historical Ranges by Sector Since Inception
Source: Western Asset. As of 31 Oct 17
All percentages are relative to market value.
The information provided is supplemental to the Multi-Asset Credit Composite. Please see the Performance Disclosure for more information. A negative cash position may be reported, which is primarily due to the portfolio’s unsettled trade activity.

Also, not being benchmarked or tethered to the low levels of benchmark rates will be important going forward. I say that because strategies that look to beat a benchmark inherently have to be conscious of tracking error and, as a result, managers may own sectors that they have to live with rather than those for which they have a strong conviction. By measuring the performance of MAC through a Sharpe ratio, we’re able to manage the portfolio to express our highest-conviction ideas while still giving a clear sense of how we’re performing on a risk-adjusted basis. MAC’s Sharpe ratio of 2.45 over the past year and 1.52 since the strategy’s inception demonstrate our ability to generate strong risk-adjusted returns. We see MAC as an unconstrained strategy that can help investors navigate through different market environments.

What have been the key return drivers of MAC over the last year?

Our MAC composite has returned +8% over the one-year period ending October 30, 2017. At the beginning of the period, MAC portfolios held a 27% allocation to high-yield corporate bonds and a 16% allocation to investment-grade corporate bonds with most of the exposure in US-domiciled corporates. The portfolio benefited from the strong spread compression we observed in both sectors over the period. As high-yield valuations became less attractive coming into 2017, we migrated some of that exposure into bank loans, which are higher in the capital structure and generally less risky (i.e., exhibit less price volatility) than high-yield bonds. We currently hold about 10% of this type of exposure in our MAC portfolios.

Emerging markets (EMs) were the other large contributor to performance, where we currently hold about 25%. We added to EM local markets in countries such as Mexico, Brazil, Russia and Indonesia during the early part of 2016 and have been the beneficiary of the solid rebound in EMs over the past year. An improved global backdrop, receding concerns over a China slowdown, and a stabilization in oil prices precipitated a broad-based rally across EM local debt and currency markets, which we expect to continue.

Exposure to structured credit was another large contributor to performance over the period. We reduced our exposure slightly to legacy non-agency bonds as valuations improved and increased our exposure to the growth areas within non-agency residential mortgage-backed securities (NARMBS), such as the agency credit-risk transfer (CRT) bonds, which Fannie Mae and Freddie Mac use to reduce the mortgage risk on their balance sheets. This has been a growing segment of the market and returns have been strong. We currently hold roughly 8% in NARMBS and about 14% in commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS).

Both duration and curve positioning contributed positively to performance year-to-date. Is that normal in a credit-oriented strategy such as MAC?

This is an important element that needs to be explained regarding the MAC strategy. Traditionally, duration and yield-curve positioning are intended to serve as “ballast” against spread sector exposures, and this is something that we employ in the MAC strategy. With that said, there were opportunities during the year that—because of our fundamental assessment of growth prospects and inflation versus what was priced into the market—we added to the duration of our portfolio. First was US President Donald Trump’s reflation trade, which took US rates materially higher in the latter part of 2016. We felt that the market was too optimistic regarding the Trump agenda and used this period of euphoria as an opportunity to add duration. Rates moved lower throughout 2017 and we benefitted. We also benefitted from our short position in German bonds and long position in French bonds prior to the French elections. Throw in some opportunistic yield curve trades, which worked well, and we ended up with a large contribution from duration and curve. Being able to employ these macro-relative trades using duration and curve positioning can be a welcome source of return.

What keeps you awake at night on this strategy?

Like all portfolio managers, many things keep me awake. I constantly ask myself big “what if” questions and envision potential vulnerabilities in our portfolio positioning. One of the things that’s key to our unconstrained strategies, which includes MAC, is the relationship between duration and risk. At Western Asset, we tend to use developed market government duration as an offset to our spread product, as touched on earlier. Over time, this relationship has worked. However, there have been brief periods when it hasn’t (e.g., during the taper tantrum in 2013).

I also focus quite a bit on our tail-risk hedges. We recognize these tail hedges have to work in a hard “risk-off” environment; it’s one of the key features of our MAC strategy. However, we run the risk that there might be a breakdown in correlations that causes our tail hedge to underperform when needed. This might occur when we have most of our hedges in S&P puts or put spreads and equities are holding up, but the higher-beta segments of the fixed-income markets are selling off. It’s an unlikely scenario and we are continually examining those correlations, but this is the type of risk that we think about late at night.

How do you see MAC over the next seven years?

We believe MAC is a strategy with staying power. MAC’s emphasis on “making fixed-income work harder” makes it highly adaptable to evolving global credit markets. This brings us back to the importance of being properly resourced. Given the complexity of global credit and the numerous pitfalls associated with investing and managing risk in this market, we believe Western Asset has the global scale and resources to exploit the growing opportunities in credit markets for the benefit of our clients.

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