In a previous article, I described the dislocation in the credit markets and suggested a few “plays” to help you navigate this uncertain market environment. The conversation focused mostly on high-yielding, non-investment grade, and alternative credit investment vehicles.
While below investment grade and alternative credit is more complex and offers more sizzle, it’s important to also focus on the less interesting but equally important role of investment grade credit bonds and Treasuries, which for many of us represents a larger weighting in our portfolios.
Many institutional investors obtain investment grade credit and Treasury exposure as part of a “core bond” portfolio, which is typically benchmarked to the Barclays Aggregate Index. This core bond composite is intended to provide portfolio diversification and protection against a large drawdown in risk assets.
However, this seemingly simple strategy can expose investors to greater risk than what is modeled or expected. Let’s examine the issue.
The Aggregate Index is comprised of Treasury, securitized, and high-grade corporate bonds. However, a common “beat the benchmark” strategy for many of the core bond managers is to overweight credit and underweight Treasuries. Bond managers expect that the overweighted credit allocation will outperform the underweighted Treasury allocation, which will fuel returns that beat the benchmark. Over the long term, this approach of taking more credit risk than the benchmark has generally worked.
However, during periods of dislocation, just when downside protection is needed the most, credit-biased core bond portfolios do not provide the expected or needed downside protection. During a risk-off environment, Treasuries often rally, but credit-biased core bond portfolios often succumb to negative returns as losses from spread widening offset gains from a decline in rates.
This issue is typically pronounced during periods of market stress. Take, for example, the returns of the Barclays Aggregate Index and its underlying components during the current market crisis. Month-to-date (through March 23) the Barclays Aggregate Index has returned -2.3%, with the credit component returning -13.2% and the Treasury component returning +2.5%. Securitized credit returned -0.2% during this period, according to data provided by Cardinal Investment Advisors.
And therein lies the shortfall of the AGG approach. Allocators using core bonds (AGG mandate) as a defensive hedge or a deflation hedge, often do not achieve the desired downside protection during periods of distress. The positive returns of the Treasury allocation are overcome by the negative returns from the credit exposure (the credit risk factor overtakes the duration risk factor).
To avoid this unexpected outcome, I encourage allocators to disaggregate their core bond composite. Rather than hold a single composite inclusive of Treasury, securitized and investment grade corporates, create separate composites for Treasuries and securitized + investment grade corporate bonds.
By implementing this simple portfolio structure, an allocator can establish the target weight to and control the exposure to the defensive Treasury sector in accordance with the needs and objectives of their respective institution. In doing so, the allocator will have greater assurances that liquidity needs can be met (without selling impaired assets), downside risk budgets will not be breached, and the portfolio will have a reliable source of capital ready for rebalancing and opportunistic investing.
The separation of core bonds into Treasuries and credit also enables better implementation for allocators using the Inflation/Deflation/Growth asset allocation framework. The Treasury allocation will naturally be aligned with the deflation objective while the credit allocation should be aligned with the growth objective. Although IG bonds benefit from declining interest rates (a duration risk factor), the bigger risk factor of and return driver for IG corporate bonds is the credit spread (or the credit risk factor, which is a growth risk factor, albeit a very conservative one).
Because the Barclays Aggregate Index combines Treasuries (deflation protection) and credit (a growth factor), allocators investing in a combined core bond mandate benchmarked to the Aggregate Index face a tricky classification issue. Most notably, a core bond mandate classified as a deflation protection allocation understates the credit risk inherent in the portfolio and, therefore, could simultaneously overestimate the downside risk protection expected by the portfolio allocation.
While this disaggregation approach is not common to E&F and health care investors, it is an approach used in the insurance community. Ed Jacobs of St. Louis-based Cardinal Investment Advisors consults to a wide variety of insurance companies. He often counsels his insurance clients to rethink the sector weightings within the Barclays Aggregate Index by separating Treasuries (liquidity and defensive) from spread sectors (higher yields).
He explains that, “Cardinal’s fixed income team sees many core bond strategies which rely on underweighting Treasuries and overweighting credit risk as a means to beat an aggregate benchmark. Although the corporate bond accounting treatment means that insurance companies do not have to be as concerned with the day-to-day price moves of their credit portfolio, we help our clients understand the economic effect of the credit overweight. Some clients aggressively seek the higher income from spread sectors and are comfortable with the higher risk. Other clients are more conservative or have higher liquidity needs, and Treasuries play a larger role in their portfolios. Therefore, we prefer that our clients consider customized benchmarks or dedicated sector allocations that address each organization’s specific liquidity and income needs, regardless of the accounting treatment.”
This thoughtful approach would work well for the E&F and health care allocator too.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.