Is Core Fixed Income a

2017 Report | AAM

Scott Skowronski, CFA | Senior Portfolio Manager

In the investment industry, there is a widely-held belief that a Core Fixed Income strategy is a commodity.

There are variations among managers and styles of course, but over time those distinctions will offset and there will ultimately be an immaterial difference in returns. Further, with yields across the investment grade universe near historic lows, the distribution of returns across managers should be even less substantial on a relative basis.

The question necessarily becomes, is there evidence to support this belief? Or are there in fact significant differences in returns over longer periods of time?

If there are, the costs of assuming homogeneity could be more significant than investors realize.


Removing the Noise

We wanted to explore this concept further, but to do so objectively, it was essential to level the playing field. Return differences between core managers can most often be explained by two factors: managing to either different benchmarks or duration targets, and/or a measurable allocation to “non-core” or below investment grade securities.

With these factors in mind, we evaluated a universe of institutional core managers with the most comparable objectives and characteristics we could find. The Core managers in this peer group all list the Bloomberg Barclays Aggregate Index as their primary benchmark, share a common duration range, and have an inconsequential allocation to “non-core” bond sectors such as High Yield or Emerging Markets. Finally, all return statistics for these managers were viewed gross of fees to further eliminate any nuances caused by expenses. In other words, we constructed the most “commoditized” group of institutional core managers possible.

Below we show the distribution of returns for this peer group across 1, 3, 5, 7, and 10 year periods. As you can see, even over the longest time interval (10 years), the average annualized return difference between the 5th and 95th percentile is substantial at 1.58%.

In economic terms, that’s a difference of $15.8 million every year for a $1 billion core strategy.

Figure 1: US Core Fixed Income Distribution of Returns


Exploring the Differences

So if performance does in fact affect returns for investors, what is driving the differences in a low interest rate environment? When you dissect the core universe by size, there is a consistent pattern of manager returns relative to the benchmark Bloomberg Barclays Aggregate Index. Figure 2 shows a heat map of the average risk adjusted excess returns versus the benchmark by core managers within each size category.

The colors move gradually from dark green representing the highest (and therefore the best) returns to dark red representing the lowest. Noticeably, the mid-size managers with core assets ranging from $10 billion - $25 billion exhibited consistently superior performance, while both the largest and smallest managers uniformly trailed.

Figure 2: Risk Adjusted Excess Return* Dispersion Annualized (bps)

… CoreAssetsHover-01Size of Manager1 yr5 yrs3 yrs7 yrs10 yrs1.000.550.700.750.710.900.410.620.720.820.640.340.470.500.420.230.330.410.510.58Under $1 Bln$1 - 5 Bln$5-10 Bln0.970.580.790.950.91$10-25 Bln$25-50 Bln0.440.310.370.450.41Over $50 Bln
Source: Investworks, excludes some smaller sectors labeled as “other” in the Investworks database *Risk Adjusted Excess Return is defined as Alpha.  Alpha is the measure of the difference between the portfolio’s actual return versus its expected performance, given its level of risk as measured by beta.  It is a measure of the portfolio’s performance not explained by movements of the market.

One way to analyze this underperformance is to explore the managers’ average sector allocation along the same size segments we examined above. In Figure 3, the table highlights that larger managers had hefty allocations to liquidity sectors such as US Treasury and Agencies and the lowest allocation to credit related sectors that traditionally offer more yield. Green indicates the highest average allocation in the peer group while red indicates the lowest.

We can see that the $50 billion and over category had the lowest allocation to credit sectors and overall, the most benchmark-like allocations. This helps explain why the largest managers appear to have the most difficulty delivering excess returns as their positioning closely aligns them with the benchmark itself.

There is a 50 basis point difference between the alpha of a $10-25 billion manager relative to a $50+ billion manager.

For the smaller managers there is no specific explanation for their underperformance other than they lack the resources or scale to gain full access to bond dealer offerings.

Figure 3: Investment Grade Sector Allocation (%)

Source: Investworks, excludes some smaller sectors labeled as “other” in the Investworks database

Identification vs. Execution

It stands to reason that the largest managers have more difficulty allocating to credit sectors simply because these sectors make up a much smaller portion of the investment grade universe. And even if you successfully allocate to these sectors, it is even more challenging to accumulate an overweight position in a particular credit that offers value. To illustrate this point, the figure below shows the percentage of the US Corporate Universe that is eligible to accumulate a 0.5% position, again segmented by asset size. 0.5% indicates an overweight level of conviction for a corporate bond relative to the index, yet also ensures a prudent level of diversification in a portfolio. We define eligible issuers as those large enough to accumulate a 0.5% position without exceeding 10% of the corporation’s total bonds outstanding.

As you can see in the chart below, the corporate issuers eligible to purchase an overweight position shrinks dramatically for managers with assets above $25 billion. Less than half of the index is eligible at $50 billion and only one-third of issuers are large enough at $100 billion. This indicates that acting on recommendations from credit teams becomes increasingly difficult for strategies above $25 billion given the limited size and scale of credit related markets. These managers have the ability to purchase the issues, but it is much more difficult to accumulate more than a market weight position. This makes it challenging to outperform the index. While this example addresses issues related to purchasing, it also pertains to the potential difficulties these same firms encounter when selling large positions as credit or valuation concerns arise.

Figure 4: % of US Corporate Issuers Eligible to Overweight

Source: US Corporate Universe = Bloomberg Barclays US Corporate Index US Issuers as of 6/30/2017.
* As of 6/30/17 JPM is the largest US Corporate Issuer Representing 0.53% of the Bloomberg Barclays Aggregate Index. The average largest holder in the Us Corporate Index is 9%

Additionally, even the ability to trade substantial amounts of bonds has declined significantly. Bond dealer corporate inventories have withered as a regulatory consequence of the financial crisis. Because dealers have less capital to make markets buying and selling bonds from their customers, trading volumes overall, especially in larger sizes, have contracted. For example, only 6% of the trades that occurred for the 10 largest bonds in the index were $5 million or greater. To put that in perspective, $5 million represents a 0.50% position for a $1 billion portfolio.

Figure 5: % of Largest Corporate Bond Trades Based on Size

… Source: AAM, TRACE Data. Average trade stats for 10 largest US Corporate Issuers 3/31/17-6/30/17.

Figure 6: Corporate Dealer Inventories

… charts

Key Takeaways

This analysis has focused on the corporate universe because it is the largest credit related sector. A similar evaluation of the ABS and CMBS sectors would show even less flexibility given the smaller size of these markets. The industry can sometimes assume that larger managers provide superior returns given their size and market influence. However, it can be demonstrated that size potentially limits the ability to implement relative value views across investment grade sectors or individual credits. Scale and trading limitations can result in portfolios with heavy allocations to Treasury and Agency related securities that are not desirable for income oriented insurance investors.

Ultimately, we have shown a connection between the size of a manager’s assets and their portfolio characteristics, which is then reflected in their investment performance. Managers need size to provide the expertise to successfully navigate the market, but being too large can limit execution of investment ideas.

"Is Fixed Income a Commodity?" is featured in Insurance Asset Risk as a featured post.

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Scott A. Skowronski, CFA | Principal, Vice President and Senior Portfolio Manager

Scott A. Skowronski, CFA is a Principal, Vice President and Senior Portfolio Manager at AAM. He has 21 years of investment experience with 18 years dedicated to fixed income. Prior to joining AAM, Scott worked as a Portfolio Manager and Senior Analyst at Brandes Investment Partners. And prior to that, he worked as a Fixed Income Portfolio Manager at Country Financial. Scott is a member of the CFA Institute. Scott earned a B.A. in Risk Management from Illinois Wesleyan University.