Three hidden drags on Fixed Income performance
Three hidden drags on Fixed Income performance
In today’s low-yield environment, it’s more important than ever to maximise performance within investment portfolios. Nowhere is this more the case than in fixed income.
Structural and behavioural changes in recent years have ushered in a range of conditions that can drain valuable returns from fixed income investments. One way to counteract this and increase alpha is by taking on more risk. An alternative approach is to look at the causes of performance leakage directly and address them head-on.
Here, we examine some of the key issues undermining returns.
Transaction costs have risen dramatically as a proportion of total yield
Since the global financial crisis, transaction costs in fixed income trading have increased dramatically, both in absolute and relative terms.
As yields have fallen, partly in response to ultra-loose monetary policy, the bid-ask spread has increased as a proportion of total yield. Ten years ago, transaction costs accounted for less than 10% of the overall yield. Today this is closer to 25%.
But it isn’t just lower yields that are causing pain for investors, transaction costs have risen in absolute terms over recent years. A key factor behind the rise in absolute cost is liquidity, or rather – a lack of it.
Bond markets have been drained of liquidity
Structural changes in the market following the global financial crisis in 2008 have had a significant impact on bond liquidity. Increased regulation has meaningfully reduced market making activity as it is now more expensive for banks to warehouse positions, which has in turn led to a material decline in inventory volumes, as the graph below shows. The lack of liquidity makes it much more difficult - and more costly - to trade in bond markets. This change is structural and long-term. There is no going back.
Forced selling eats into 25 basis points of performance
Given the higher costs associated with each trade, it is clear that being able to minimise the number of trades is advantageous. However, some ‘low cost’ solutions in the market, like index-trackers, engage in sub-optimally high levels of turnover by adhering to benchmark rules, such as having to automatically sell a bond if it is downgraded by a credit ratings agency.
Not only does this forced-selling create additional turnover costs, but it usually results in downgraded bonds being sold at precisely the worst moment. Generally, a bond’s price will fall as soon as it drops out of an index, but thereafter it tends to rise as the investor base shifts from those investing in investment grade bonds to those investing in high yield bonds.
We estimate that the global credit index turnover is close to 20% annually, due to rules such as selling downgraded bonds. Barclays estimates the US corporate bonds index (the largest in the world) faces an annual leakage cost of 25 basis points2 due to forced selling alone.
Combined, these three factors create an adverse environment for investors looking to trade regularly.
How to plug the hole and stop performance leakage?
One way of avoiding performance leakage from a fixed income portfolio is by adopting a Buy and Maintain approach. This does not follow the behaviour of passive funds, and it minimises transaction costs by populating the portfolio with what are considered names capable of performing well throughout the market cycle. It also avoids forced-selling, which enables it to be more cost-effective than a typical active bond fund.
The structural and behavioural changes outlined above are unlikely to disappear any time soon. The hunt for yield will continue and could become even more challenging. Coupled with this, is increasing political uncertainty. Buy and Maintain has been designed with a long term horizon in mind and we believe it is suited to the current market environment.
Diversified across regions, sectors and issuers, AXA Investment Managers invest in names that the team believes can perform well throughout the market cycle, with an overriding goal to more efficiently harvest yield from the credit market by minimising transaction costs whilst mitigating downside risk.”
1 Adjusted for the size of the bond market as measured by the sum of the BofA Merrill Lynch US Corporate Index (C0A0) and the BofA ML US High Yield Index (H0A0). US Corporate Bond Inventory is measured by the sum of Primary Dealer Positions Net Outright Total Corp Securities (PDPPCRP2), Primary Dealer Positions Net Outright Non-Agency Residential MBS (PDPPGCMB), Primary Dealer Positions Net Outright Other asset-backed securities (PDPPOABS) and Primary Dealer Positions Net Outright Other CMBS (PDPPOCMB)
2 Source: Barclays research as at January 2017 based on the US Corp IG Index, January 1990 – March 2016.
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