Building a stronger, smarter portfolio with bonds

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Investing is littered with cautionary tales. After a 30-year fairytale run for global bond markets, there are signs that the story may be heading towards grimmer times. But that doesn’t mean the wolf is at the door for the quiet achiever in your portfolio.

The classic tale of the three little pigs features a swine who outsmarts the big bad wolf to succeed where others have failed. He builds a solid house out of bricks to keep the wolf at bay, then cleverly catches the wolf at his own game.

In these changing markets, investment strategies need to be both strong and smart. Bonds have a valuable role to play as a foundation that provides steady income and diversification. And, for investors who are prepared to put in some huff and puff of their own, the risks provide new opportunities for increased reward.

This paper outlines the key drivers currently shaping bond markets by focusing on key risks inherent in government and corporate bonds, and looks at how smart investors can use this knowledge as part of an active investment strategy.

What’s outside the door?

An unwelcome guest, or simply a wolf in sheep’s clothing? If you want to open the door to solid investment returns, take a look out the window first. Spotting the risks around us helps reduce the potential for a nasty surprise. When we can clearly identify the individual components of those risks and their different drivers, we are better able to evaluate the available investment opportunities and active management strategies.

A look back at the last major global financial crisis in 2008-09 shows how valuable this ability can be. The majority of investors believed the GFC was purely a credit crisis, but hindsight tells us it was predominately a crisis of liquidity.

Those investors who could identify the difference were able to act accordingly – buy the bonds that offered large certainty of repayment that many thought were default candidates and wait for market liquidity to normalise and profit.

Deconstructing the bond risk premium brick by brick

“Bond risk premium” is a very broad term and it can be misleading to throw it around loosely. Understanding the individual risks that the bond risk premium encompasses enables investors to more clearly assess opportunities and use active management to isolate certain risks that they want and rid themselves of the ones that are likely to cause pain.

While there are numerous drivers of risks in bond markets identified in the academic literature, we believe the components of bond risk can be grouped into six key categories (Figure 1). Some aren’t easy to observe and as a further complication, they can be highly correlated and vary through time. With analysis and experience, we can learn to distinguish them (Figure 2).

In this paper, we focus on the first four categories of bond premium. The term premium is most relevant to the government bond space, and after reaching its all time lows post last year’s Brexit vote, it’s now moving higher.

Ahead, we look at how it too can be better understood by breaking it into its key drivers. Credit bonds price off government bonds and they have extra risks (and return). We then examine the liquidity premium, default premium and downgrade premium in credit bonds and highlight how vital it is for active managers to differentiate between them.

Built to last: why investors are demanding their term premium

Key points

  • The drivers of the term premium are complex and change over time.
  • Since 2008, the term premium has been driven lower but we are now at an inflection point and the term premium is coming back.
  • The duration risk in bond indices has increased at a time when investors are being less well-rewarded given the steep fall in term premium.

Before the big bad wolf arrived on the scene, it didn’t matter to the three little pigs what they used to build their houses. Straw, sticks, or bricks – it was all the same to them. The world was nice and safe. Then, everything changed…

Changing the risk-reward paradigm takes an extraordinary set of circumstances, but that’s exactly what happened from the beginning of 2014. Investors stopped demanding higher compensation for the risk of holding longer-dated bonds relative to reinvesting daily for the same period of time.

This risk is captured in the term premium: the excess compensation reflects the level of uncertainty about several factors that can impact bonds over the longer term. These factors, summarised in Figure 3, are complex and change over time and they have all been important in recent years. This paper focuses on the effects of central bank intervention, inflation expectations and inflation uncertainty.

Investors haven’t been fairly rewarded for holding long dated bonds – but this is changing

We estimate that the “long term average” term premium is about 100 basis points for 10 year US Treasury bonds[1]. As illustrated in Figure 4, understanding the term premium is important to understanding bond yields.

We saw the term premium reach historically low levels in mid-2016 following the Brexit referendum. This was a meaningful signal for markets and it showed that investors were at an extreme point in not being rewarded for longer term maturity bonds.

This lack of reward for long-term risk has occurred just as many bond portfolios’ sensitivity to interest rates – a key risk – has been rising.

As yields fall, bond duration rises, increasing the sensitivity of bond prices to interest rate changes.

At the same time, issuers have taken advantage of the low-yield environment and issued longer-dated bonds. Therefore, the durations of key bond benchmarks have increased by almost two years, as shown in Figure 5, passively adding interest rate risk to many benchmarked funds.

The result is that a 1 basis point change in yields would have a 1.4x larger profit and loss impact on the portfolio today than it had in 2000.

Rebuilding demand for the term premium

Central bank asset buying programs skewed the bond markets’ supply-demand dynamic and weighed heavily on the term premium.

Demand for quality safe haven assets, such as US Treasuries and other sovereign bonds, naturally increased following the GFC. But as demand increased, the US Federal Reserve also began its quantitative easing program (QE1) in November 2008 after cutting short-term interest rates to near zero failed to revive the economy. Two more rounds of quantitative easing were introduced in November 2010 and September 2012 as robust economic growth proved elusive. Trillions of dollars remain on its balance sheet today.

Other central banks such as the Bank of England (BoE), European Central Bank (ECB) and Bank of Japan (BoJ) also bought their own domestic government bonds. This excess demand drove yields lower (and eroded the term premium), forcing domestic investors to look offshore for yield. Bonds with a positive yield such as US Treasuries and Australian Government Bonds were well bid.

The strong correlation between the term premium and year-on-year changes in G4 central bank balance sheets is illustrated in Figure 6.

However, there are several signs that the limits of monetary policy have now been fully explored and that central banks may have already passed the peak point of their asset buying programs.  For a start, the Brexit-induced QE program in the UK is likely to end in February 2017.

The ECB’s quantitative easing program is currently scooping up €80 billion in assets each month. From March 2017, this will wind back to €60 billion a month. While it’s likely that the December 2017 end date will be extended as inflation remains low, we believe the size of its asset buying program has peaked.

Market sentiment has already turned to whether the ECB may in fact begin further stepping down its bond purchases sooner rather than later. It may be too aggressive to call it a “taper” yet a la the Fed which began tapering its six-year bond buying program in December 2013 before finally turning off the tap in October 2014.

Meanwhile, the Bank of Japan recently acknowledged the potential side-effects of negative cash rates and flat yield curves, reducing long-end bond purchases in an effort to create a steeper yield curve.

Some in the market have interpreted this as a form of tapering. In fact, while the BoJ still have a technical target for increasing government bond holdings by ¥80 trillion per annum, their recent buying is closer to a ¥70 trillion rate.

The US Federal Reserve’s Federal Open Market Committee (FOMC) has been elevating its discussions about the size of its balance sheet in recent speeches and minutes.  This highlights a concerted effort to communicate that the debate about when to stop reinvestment of securities may be happening earlier than the market has expected.

If central bank balance sheet buying programs are at their peak, this will (at worst) influence the term premium from going any lower. On the up side, the term premium is expected to make a welcome return as this market intervention gradually scales back.

There’s now a growing realisation that quantitative easing policies have propelled many asset markets higher but not adequately revived economic growth or inflation. With the limits of monetary policy reached, governments are expected to begin turning back to fiscal policy.

Trumped: inflation expectations rising

The surprise election of Donald Trump as US president on November 8, 2016 was a key turning point for markets.

Since the GFC, we have lived through a world of low inflation and accommodative monetary policy. Holding longer-term bonds has been the right decision for investors as we have raced to the bottom in yields: the capital gain has offset the pain of the low coupon.

In this environment, many investors were more concerned about deflation than inflation. This has been another driver of demand as falling prices increase the real value of the fixed dollar payments that bondholders receive.

Figure 7 tracks declining inflation expectations against the term premium – this relationship was especially strong from the GFC until mid-2011 and then again from mid-2014 onwards, as highlighted below. The inflation expectations in this figure are measured with a 5-year/5-year forward inflation swap – a measure of market expectations of the average level of inflation over five years in five years from now.

Trump has revived inflation expectations with early indications that his administration will strongly apply fiscal levers.

While it’s too early to know how many of his pre-election promises will come to fruition, we know that President Trump has expressed a desire to increase defence and infrastructure spending and has a bias for home-grown industries rather than international trade.

Funding sources for new spending plans appear to be unclear, for now; they will likely require more debt and thus more issuance of Treasury bonds, although we think the blow-out in government debt implied by Trump’s pre-election tax cuts is not sustainable.

However, even if the new president doesn’t deliver on all of his pre-election promises, the very expectation of fiscal stimulus has proven to be important in boosting inflation expectations, with a positive effect on the term premium.

In Figures 8 and 9, we demonstrate the impact of a “Trump Lite” scenario which models implementation of a third of the administration’s pre-election fiscal policies, half of previously outlined tariff policies, and a quarter of known immigration proposals.

The road less travelled: getting rewarded for inflation uncertainty

For the three little pigs, uncertainty may lead to ending up as a wolf’s dinner. But for investors, there can be greater rewards when there are some unknown factors. When the market is unclear about the future path of inflation, the premium for exposure to it is higher.

As shown in Figure 10, inflation uncertainty was a particularly good indicator of the term premium from 2006-12 when the market was debating what level inflation would be. However, until just recently this relationship faded as there was strong consensus on low inflation forecasts.

Active investors should relish the current debates on “how much fiscal spend” and “exactly how will tariffs be implemented” as it means uncertainty is back and increased uncertainty offers greater reward and opportunities.

Trump’s unexpected election victory is unlikely to be the last surprise as a number of countries could elect politicians and political parties from outside the mainstream in 2017. This trend is being driven by disenfranchised populations still suffering despite a slow recovery from the GFC, and could result in a redistribution of wealth away from corporations and back towards lower socio-economic groups. This will require some fiscal loosening and budget deficits.

Longer-run structural trends which have kept inflation low, such as falling costs of production thanks to China and a potential move to peak globalisation, have run their course. Meanwhile, the worst of the supply-demand imbalance which weighed heavily on commodity prices has passed.

So instead of the deflation debate, strong global growth and the expectations of more fiscal stimulus are fuelling a reflation re-evaluation.

An opportunity – not a drag – for active investors

The last several years have seen a fairly consistent fall in term premium for good reasons. However, as discussed earlier, the case for a rise in term premium is finally gathering momentum.

The global bond sell-off in November 2016 was heavily influenced by the return of the term premium. While this means some short term capital losses – the return of the term premium is not a negative for bond investors – it means they are finally being rewarded for taking on risk.

However, performance won’t be indiscriminately distributed and, as we have seen, many investors who have followed traditional bond benchmarks will suffer in the short term as markets adjust. Taking advantage of these new opportunities will require an accurate assessment of key triggers such as changing inflation expectations, particularly in response to fiscal and monetary policy, and the skill and active mandate to move quickly.

There are various ways to exploit this regime change and the optimal method will vary depending upon a portfolio’s benchmark (or lack thereof) and investors’ risk tolerance. While shorting government bonds may be a simple and efficient way to profit from an increase in term premium, it’s not for everyone. If inflation expectations are at the heart of the move, being long break-even inflation spreads or, for investors that need government bond duration, being long real yields rather than nominal may be preferable.

While benchmarks have their place, it’s worth questioning flexibility around them in this time of “double whammy” risk (negative and rising yields). Recasting benchmarks to reduce the duration to government bonds or increase exposure to credit markets may be beneficial.

Many investors worry that if yields are rising, credit markets may experience more defaults and credit spreads will widen in anticipation of this - but the empirical evidence is to the contrary. If the rise in yields is proportionate to increases in growth expectations, credit spreads are likely to perform well. It’s typically only at the very end of an expansion that credit spreads suffer. We believe we are in a “mature phase” of this business cycle but are not yet “late cycle” as output gaps, at least in the US, are only likely to be closing now.

Building credit bonds into your portfolio involves more levels of construction. Ahead, we separate the sticks from the bricks and explore liquidity, default, and downgrade risks in more detail.

In the long term, the potential to be rewarded for active risk taking provides an opportunity to deliver stronger performance. A more flexible portfolio approach, including active hedging strategies, can manage interest rate risk.

Credit spreads – building a brick house  

Just as we can strip out the term premium from government bonds and formulate views on what is going to drive its direction over time, we can do the same for corporate bonds – or more specifically, for corporate bond spreads.

In Figure 12 we have estimated liquidity, default, downgrade and volatility[5] [6] [7] risks from the JPM Investment Grade index to illustrate how these risks are often correlated and they all change over time.

For example, we now know that liquidity risk was particularly high during the GFC, although many investors struggled to discern it from credit risk at the time. During the crisis, the flow of capital effectively dried up as major banks struggled under immense pressure. It wasn’t until steps were taken by the US Government and the Fed such as the Troubled Asset Relief Program (TARP) that inter-bank trust was re-established and liquidity started to return to the market.

The new illiquidity: higher credit risk or just an everyday occurrence?

Key points

  • A lack of liquidity has become a growing concern since the GFC. Those investors who don’t need immediate liquidity can use this to generate higher returns.
  • In a crisis, liquidity and credit risk can be challenging to untangle. The 2008 crisis was a liquidity crisis, although credit risk dominated discussion at the time.
  • The ability to distinguish between liquidity and credit risk can allow investors to hold onto quality bonds through future crises as times of extreme illiquidity are temporary.

While the GFC has passed, we are still living in its shadow – liquidity remains a major concern. And ironically, some of the measures taken in the wake of the GFC have further impaired liquidity.

In “Navigating Negative Interest Rates and Liquidity Challenges” we explored some of the challenges presented by less liquid markets. There are several reasons for the decrease in liquidity in markets including a wave of new regulations which stifle the traditional market-making capabilities of banks and other financial institutions, the impact of Central Banks’ monetary policy forcing investors into similar trade, and the impact of high frequency or algorithmic trading.

Shut the front door: new regulations put the squeeze on liquidity

However strong your house is, if you leave the door open there’s a good chance the wolves will just stroll on in. But boarding up the door entirely can lead to a new set of problems.

Before the GFC, banks held significant fixed income assets which provided liquidity to the market in times of volatility. However, regulations aimed at strengthening the balance sheets of financial institutions have forced many to withdraw from the market or curtail their trading activities.

Approximately 200 new regulations have been applied to US banks and broker dealers since 2010.  Key regulations include Basel III, which increased bank capital adequacy or leverage ratios, and Dodd-Frank, which stopped banks from proprietary trading and investing in hedge funds (both groups highly active in bond markets). Those regulations had the unintended consequence of taking liquidity out of the market.

The cost of leverage has also increased due to regulation. Banks running repos books were penalised and money market funds restricted from investing in longer maturity repos, making it harder for investors to cover short positions.

Corporate bonds in particular have been vulnerable to this issue as they are still traded on an over-the-counter (OTC) basis rather than via an exchange where many buyers and sellers place bids. The OTC market, where deals are negotiated directly between parties, is naturally less liquid than an exchange.

While this may seem a disadvantage, we would urge differently. For investors who don’t need frequent liquidity, such as those who simply require a fixed income portfolio to be steady and reward with a coupon, physical corporate bonds offer a higher premium than their credit default swap counterparts for similar credit risk. Physical bonds require capital thus are perceived to be less liquid and more heterogeneous given the differing maturity profiles than their credit default swap counterparts. This liquidity premium is valuable and warrants further exploration. 

It’s worth noting that we may be at the peak point for these costs. The Secretary of the Treasury, Steven Mnuchin, has vowed to overhaul Dodd-Frank legislation. He, along with other Trump advisers, believes it is overly complicated and impedes credit lending through the economy. Mnuchin has singled out the Volcker rule, which restricts proprietary trading, for special criticism.

Perhaps now is the time to unlock the door to the liquidity premium.

Why liquidity risk doesn’t always equal credit risk

While investors must adjust to a less liquid market, this is not necessarily a sign of increased credit risk.

In a crisis, liquidity risk and credit risk can be challenging to tell apart – but this also represents an opportunity for investors who can make the distinction.

An influx of new academic papers has attempted to disentangle the two risks by focusing on the extreme widening of the spread during the GFC. The studies find that while the risk of default may have been considered paramount during the GFC, the crisis was predominantly driven by illiquidity, just as it was during the earlier Ford/GM crisis[8].

Aggregate illiquidity doubled from its pre-crisis average in August 2007, before climbing more than five times beyond its pre-crisis average in late-2008 as Lehman Brothers defaulted and AIG was bailed out.

In our own mapping of these risks, the proxy for credit illiquidity risk is the basis between credit default swaps (considered to be more liquid) and physical bonds. We recognise this proxy assumes credit default swap are bastions of liquidity – a contentious assumption at best – but the basis relationship allows for transparency and ease of modelling.

Liquidity appears to be the most important factor in explaining investment grade (AAA through BBB) spread moves and that liquidity risk remains higher now than before the GFC (Figure 13).

Making illiquidity work for investors

Like other risk factors, there is a price for liquidity which differs by region and over time.

While the price of liquidity has risen substantially across markets since the GFC, the Australian liquidity premium is higher than in the US and Europe, reflecting the smaller size of our market. We estimate that the Australian Investment Grade Liquidity Premium is 50 basis points higher than pre-crisis.

The impact of central bank quantitative easing policies can also be seen in Figure 14. The US liquidity premium tightened during the QE period and has been rising slowly through 2014 and 2015. We can still see the impact of QE in Europe, where credit spreads remain tighter.

This lack of liquidity can be a problem for many investors – but it also presents an opportunity for some. Credit investors who are not under pressure to rapidly sell their holdings can be well rewarded in these market conditions. This may require a careful assessment of a portfolio’s true objectives and moving away from benchmarks.

Credit risk: weathering the storm of a downgrade can pay off

Key points

  • Credit downgrades, particularly from investment grade to high yield, are often a mandate-imposed trigger for institutional investors to sell.
  • However, automatically selling on a downgrade is irrational because it leads to a larger loss than from defaults.
  • Investors who can take a more flexible approach can generate higher returns.

Credit risk – the potential that an issuer will default on repayments – is readily understood by the naturally conservative bond market. The risk is so significant that many institutional investors will automatically sell on a downgrade from investment grade to high-yield rather than risk the impact of a default on their portfolio.

But are downgrades as dire as the market’s response suggests, or just a lot of hot air? If the underlying investment is sound, there might not be an urgent need to duck for cover at the first sign of strong winds. In fact, long-term data suggests that this is an irrational way to manage default risk and can act as a significant drag on portfolio returns. What appears to be protecting a portfolio may in fact damage it. This should prompt investors to reconsider the circumstances in which they sell “fallen angel” bonds, given the ability of credit spreads to indicate when downgrades will lead to defaults.

Moodys[9] recently analysed the performance of single five-year bonds over a five-year time horizon and found AAA-rated debt had a 0.02 per cent chance of default compared to 0.93 per cent for a BAA-rated security. As shown in Figure 15, this extra risk is over-compensated for in credit spreads, we believe largely due to the smaller investor base for high yield.

To add insult to injury, Barclays have also found that the “forced sell” discipline that many investors have to face upon the downgrade of a bond to high yield actually incurs an extra premium rather than simply the pickup from BBB to BB names[10].

They found a “fallen angel” penalty of 78 basis points immediately upon downgrade of a bond. Investors that have the flexibility to hold the security as a BB security, on average saved themselves a 40 basis point loss on the bond.

Once again, the wise investor is one that can distinguish between these risks. Downgrade risk is related to default risk but is far smaller than many investors assume when looking at credit spreads, as shown in Figure 16.

Here, we model investment grade default risk by using QIC’s forward looking model for speculative grade defaults[11] and applying the historical ratio for investment grade defaults relative to high yield ones. Downgrade risk is proxied by calculating the index’s exposure to BBB bonds and applying the cost of downgrade to BB multiplied by the probability that a downgrade may occur[12].

Downgrades are clearly related to default risk but a deeper analysis suggests a flexible decision-making approach in response to downgrades is far more effective.

For example, in 2013 Qantas lost its investment-grade rating as the airline struggled. Bond investors who automatically sold on the initial downgrade were stung with a sizeable penalty. However, investors who viewed this as a temporary setback and believed in management’s commitment to a rating upgrade were equally rewarded. Management revived the company’s performance and won back its investment-grade credit rating in late 2015, which provided bond investors with substantial outperformance. The downgrade penalty became a reward for those that could capitalise on it.

Discerning the true underlying risks at play requires experience, research and skill, but can lead to a better risk-return trade-off and stronger portfolios.

Exploiting risks to create more effective portfolios

The term premium in government bonds and the liquidity, downgrade, and default premia in corporate spreads vary through time and can be correlated at times of stress, as shown in Figures 17 and 18.

It is only by understanding the individual drivers of returns at any point in time that active investors can harness greater decision making power. This enables them to more effectively shape their portfolios and the risk-return trade-offs they offer.

The term premium may be unobservable in the market but it can be inferred. Understanding what is driving it and where it is being driven aids asset allocation decisions such as whether to have exposure to real vs nominal yields, short rates vs long rates, or credit spreads versus credit yield.

It was naive in the GFC to muddy liquidity risk and credit risk. The former was temporary; the latter resulted in realised losses. However, these risks may play out differently during the next major downturn given the structural changes which have taken place, such as banks being required to hold significantly more capital.

Build your own adventure

Taking a more active approach to investing in bonds can help you become the architect of your own success. But you don’t have to go it alone. Just as building a house takes a team with different skills, a strong manager with experience through market cycles can help you demystify the different components of the risk premium. With a better understanding of these drivers, the risk-reward trade-off of apparent contrarian trades can then be viewed in a new light.

For example, there are often rational reasons to hold a corporate bond when liquidity risk is high, but a closer examination of the underlying drivers may reveal that the market has simply misidentified risk (such as credit risk).

In these circumstances, long-term investors may be better served by absorbing the illiquidity (or taking advantage of other pricing anomalies during times of stress) than by attempting to manage a mis-labelled risk by selling at the wrong time.

We have also seen the strong relationship that exists between downgrade and default risks. However, automatically selling on a credit downgrade can lock in losses that outweigh probable default losses, particularly at the threshold between investment grade and high yield.

A closer examination of the issuer can also reveal opportunities that are not immediately apparent in the ratings of credit agencies. This is where credit experience plays a vital role to discern the true difference between default and downgrade risks.

Similarly, informed investors can manipulate other components of the risk premium, such as volatility or complexity.

Taking advantage of these opportunities also requires strong trading experience, which has become far more important since the GFC.

With this knowledge, active investors can make informed decisions that take advantage of the different components of the risk premium. This can build stronger portfolios that deliver on their long-term goals, so that investors can live happily ever after.

[1] Using the ACM model; see Which term premium model should I use? on page X for more information.

[2] “The Determinants of Real Long-Term Interest Rates: 17 Country Pooled-Time-Series Evidence” A. Orr, M. Edey and M. Kennedy. 1995 

[3] “An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates”, D. Kim and J. Wright, 2005
[4] “Pricing the Term Structure with Linear Regressions”, T. Adrian, R. Crump and E. Moench, 2008

[5] Volatility is calculated as total spread – (default spread + downgrade spread + liquidity spread) regressed against the VIX index and the coefficient from this relationship is used as a proxy for the volatility spread. The remaining spread is called “residual”5 and represents a relatively systemic component of credit spread risk.

[6] A note on “residual” risk: We acknowledge our proxies for the premium aren’t perfect but we do note a systemic residual spread. This spread has been relatively constant since 2010 but has certainly grown since the GFC. We believe a good portion of this could also be liquidity risk (see details of our proxy below) but also highlight research6 which finds corporate spreads have a significant systemic component.

[7] Collin-Dufresne, P., Goldstein, R. and Martin, J. (2001), The Determinants of Credit Spreads. The Journal of Finance, [online] 56(6), pp.2177-2181.

[8] Bao, J., Pan, J., & Wang, J. (2011). The Illiquidity of Corporate Bonds. Journal of Finance, 66(3), 911-946.

[9] Moodys, Annual Global Corporate Default Study and Rating Transitions 2015

[10] “Try and Hold” Credit Investing research paper published by Barclays. January 14, 2014.

[11] Based on GDP and Senior Fed Lending Survey responses from banks regarding availability of corporate loans.

[12] We took the percentage of the index that is BBB and ascribe the cost of downgrade from BBB to BB (BBB price – BB price – fallen angel penalty) x probability of downgrade according to Moody’s.


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