Diane C. Nordin, William J. Hannigan and Justin G. Bullion offer a fixed income investor's review of three generations of securities.
Most insurers, as fixed income investors, can relate to the saying that “Change is the only constant in life”. The type of change we would like to discuss here is a generational one that has occurred in the fixed income markets over the last two decades. From the fixed income market environment in general, to an increasingly sophisticated bond investor base, there have been trends best described as evolutionary, for which “generations” are an appropriate analogy.Change does not usually occur without a cause or stimulus. In order to put into perspective changes in today's bond market, we review the historic macroeconomic environment to see how deeply rooted some of today's common bond practices really are.
We examine how three generations of bond investors have responded to this changing market in terms of:
• the investment strategies they developed;
• new fixed income securities created and the extent to which they are now in wide-spread use in bond portfolios; and
• the implications of each generational change for today's institutional bond investor.
Finally, we benefit from the accumulated wisdom handed down from generation to generation as we forecast the profile of the institutional bond portfolio of the future.
Changing macroeconomic environment
Most importantly for bondholders, nominal interest rates have fallen, in some cases dramatically, since 1980. This phenomenon has not been limited to the United States, as we can see from the benchmark 10-year government bond yields of three major industrialised nations (Figure 1).Of equal importance to bondholders has been the decline of inflation, again on a global basis. As inflation has come down, so too has the extra yield demanded by investors as protection from future inflation (Figure 2).
However, a bond's yield is a function of both demand (for extra yield or inflation protection) and supply. During the early 1980s, the major supplier of US bonds, the US Treasury, greatly expanded the supply of Treasury securities. This increase in supply was, in part, to finance the growing budget deficit.From the mid-1980s, however, the rate at which the US Treasury issued debt began to slow markedly (Figure 3). Meanwhile, since the early 1990s, the budget deficit itself has contracted sharply and may be in the process of vanishing altogether.
If these trends continue, it could mean no net new supply and fewer reinvestment opportunities in US government securities.
At the same time that global interest rates, inflation and the US Treasury supply were declining, the world bond markets experienced substantial growth. In 1980, the world bond markets represented $3.5 trillion in market capitalisation, of which US bonds accounted for more than half. The majority of bonds were publicly traded, and investors were concerned primarily with inflation, interest rates and credit risk.
When we compare 1980 to 1999, we see some dramatic changes. Not only has the size of the total investable universe increased more than sixfold, but non-US bond markets have grown at a faster rate than in the US. Today, the US share is less than 40% of the world's total.
The composition of this global market has also changed. In the US today, corporate bonds are no longer the only higher yielding alternative to Treasury securities. In addition to mortgage-backed securities, institutional investors consider high yield, foreign and even taxable municipals as ways to earn incremental yield. Outside the US, there has also been a trend toward private debt issuance. Currently, non-government debt issued outside the US accounts for more than one-third of the total world bond market.
Evolving risk management
Along the way, the risks involved with owning bonds have become more complicated. Risk is, of course, the flip side of this expanded set of return opportunities.For decades, interest rates and creditworthiness were the major factors of concern to bond investors. However, during the 1980s and 1990s, investors became increasingly aware of a wider array of risks. Mortgage-backed securities highlighted how the structure of a bond and a fluctuating cash flow pattern affect its performance. Further, the globalisation of the bond market introduced the issues of currency and sovereign risk.
More recently, bond investors have also discovered that volatility, or how fast interest rates and other variables change, can have a profound, short-term impact on portfolio values.
Investors needed tools and methodologies to assess and control these risks once identified. As awareness of risk led to identification, which in turn gave rise to ways of calculating, controlling and monitoring, so the science of risk management evolved. From duration to convexity and, more recently, to value at risk (VAR), risk analysis has become critical for bond investors.
How has investor behaviour changed over time to keep pace? One thing that has remained constant is the search for higher yields at a reasonable price. This is what defines us as fixed income investors. Where we do see a difference is in the nature of the investor response to change.
We can categorise the environment, the securities and risk measures used into three distinct periods, or generations, reviewed briefly below.
The older generation of fixed income strategies was tried-and-true. Faced with simple risks, bond investors relied on simple measures, like maturity, to understand the bonds in their portfolios.
In the early 1970s, mortgage-backed securities (with their prepayment characteristics) highlighted for the first time the difference between the bond's stated maturity and its average life.
Although high yield bonds had been around for some time, wider use by institutional investors gave rise to default probability as a measure of risk in the less-than-investment grade market during the early 1980s.
The mortgage-backed securities market led to the creation of other asset-backed securities. At the same time, duration became the preferred measure of interest rate risk.
The older generation formed the traditional foundation of fixed income strategies. Next came a generation that crossed those traditional boundaries, which we will call Generation X.
In the late 1980s and early 1990s, effective duration and convexity emerged as measures of interest rate risk. These calculations incorporate the optionality, or uncertainty, of cash flows, especially evident in the mortgage-backed securities sector.
During this period, it was not only risk measures that evolved but also the capital markets. Mortgage-backed securities gave rise to collateralised mortgage obligations (CMOs). Regulatory changes resulted in the creation of 144A securities. Also in 1990, Brady bonds “emerged” as the first, large part of what we now know as the emerging market bond sector.
These generation X strategies allowed us to boldly go where no bond investor had gone before. Unfortunately, some investors found that they did not want to go there. Whether unaware or unprepared, memories of toxic CMOs and “submerging” markets reminded investors that if something sounds too good to be true, it probably is.
Perhaps in response to these excesses, investors have recently taken a “back-to-basics” approach in which the analysis goes beyond static measures of risk. In today's mark-to-market environment, investors need to know the real-time value of their bond portfolios and how changes in any variable might affect that value (VAR analysis).
The new generation response can best be described as digging more deeply into the traditional sectors of government, corporate and mortgage-backed securities. In the mortgage-backed securities sector, commercial mortgage-backed securities (CMBSs) appeared on the institutional investor menu, adding an element of credit risk to this traditional, AAA-rated sector.
In investment grade corporates, a new breed of capital securities emerged in response to changes in the regulatory environment. Recently, investors have seen a flurry of collateralised bond obligations (CBOs), themselves an extension of the structuring found in the asset-backed securities market. Just this year we saw the debut of the latest addition to the US government bond sector in the form of Treasury inflation securities (TIPS). As a way to turn investment grade credits into high yield bond-like spreads, we see the development of a market for credit derivatives or default swaps.
Bond portfolio year 2000
With all that we have learned from generation to generation, what should bond investors expect their portfolios to look like over the next few years?As investors might expect, an all-weather portfolio for the future is likely to include securities and strategies chosen from each generation, with the resulting characteristics being more optimal in a risk-return sense, and with a majority in non-traditional securities. An interesting side note is that changes in portfolio composition usually lead to changes in index composition. So if more institutional bond portfolios look like this, we would expect index providers gradually to include these securities in their benchmark indices.
In summary, investors should look for these newer strategies and instruments to be found in core bond portfolios. But because newer is not always better, investors need to understand the nature of the securities and why you are earning the novelty premium. Put another way, make sure investors understand the risk-return profile under best and worst case scenarios, and make sure to “get with the times.”
Diane C. Nordin, is senior vice president and William J. Hannigan and Justin G. Bullion are vice presidents of Wellington Management Company, Boston, Mass. They are product managers in the Wellington Management's fixed income management area and work closely with the firm's insurance asset management group assisting in the design of custom-tailored investment portfolios for the general account assets of insurers around the world. Tel: +1 617 951 5000; fax: +1 617 443 4628; e-mail: email@example.com