In the current investment environment we have to deal with several constraints such as low interest rates, decreasing equity returns and volatile credit markets. Going forward stock and bond returns will not be as attractive as they have been over the past ten years. Under such circumstances the need for alternative ways to increase portfolio total returns is raising.
In recent years a variety of new asset class alternatives can be considered as valuable investments in the area of fixed income. Among these asset classes high yield and emerging market debt are the most important ones. One has to compare the risk/return features of alternative asset classes in question. Before including one of these new asset classes into a standard investment portfolio, the following questions have to be answered: (1) Is there a diversification benefit? (2) Does the asset class have low correlations with other asset classes in the portfolio? and (3) Does the asset class add sufficient opportunities to add value in terms of total return? If we look at a traditional bond portfolio and look at the alternative assets classes in the fixed income area we can see that the diversification benefit form the alternative asset classes is very good.
The general trend especially among institutional investors to include more “performance enhancing” investments is not necessarily inappropriate but needs to be congruent with each investor’s investment time horizon and preference for risk and liquidity. This leads us to the core-plus concept. What is it all about? Core plus is more than traditional active bond management. It starts with a somewhat different investment universe. Out of this universe core-plus portfolios are constructed.
The core portfolio is the traditionally defined set of bonds, which consists of investment-grade fixed income securities and government bonds. In such a portfolio the most important risk parameters are linked to pure interest rate risk and moderate credit risk. The core portfolio’s objective is to outperform the defined benchmark with a clear emphasize on preservation of principal. The added value is created through moderate duration adjustments, yield curve strategies and security selection.
On the other hand, the plus components are the non-traditional fixed-income asset classes such as high-yield, non-base currency hedged or un-hedged fixed income instruments, emerging market debt and convertible debt instruments. The plus components should all significantly out-perform a broadly based traditional fixed income benchmark. The plus components are included into a portfolio tactically when risk-return prospects are considered attractive for the specific plus asset class. Core-plus portfolios are expected to have an average excess return much greater than the range usually targeted for core mandates. The most important feature of the core-plus is its potential — to deliver improved risk adjusted excess returns. In a core-plus portfolio there are three main points we want to highlight: (1) you can realize higher returns from existing market inefficiencies outside the traditional investment universe; (2) more opportunities exist for asset class rotation and security selection; and (3) there are additional correlation benefits at the total portfolio level.
The core-plus strategy opens the door for another important decision: How to allocate the “plus” part of the portfolio? We want to explain two asset classes of the “plus” portion in more detail. The first one is high yield bonds.
High yield bonds are an independent fixed income class with unique characteristics that should always be considered in any asset class decision for the “plus” part of such a portfolio. High yield bonds offer high absolute returns and have a very low correlation with other asset classes. The diversification benefit of this asset class increases the efficiency of a portfolio significantly. The power of the high coupons is worth looking at; the high coupons earned by these bonds offset much of the principal losses. The 10 year annualized return in the US high yield market is about the average coupon of the whole high yield sector.
The above points make the high-yield market a valuable addition in a fixed income portfolio. One last important point is the management of high-yield portfolios; it has to be done by a dedicated and experienced management team, which has enough experience in the market and is familiar with all the specialities of this market.
The second sub asset class we want to highlight is emerging market debt. In recent years, emerging market debt has provided strong risk-adjusted performance, outperforming even US large-capitalized stocks. Obtaining the benefits of emerging market debt requires intensive analysis of default, macroeconomic and political risk and the ability to implement a strategy dependent on timing of entry and issuer analysis. A dedicated manager should have lengthy experience in the market and a specialized knowledge. It is not recommended to invest in single positions. Again, the knowledge and experience in this market is crucial.
In summary, core-plus represents a new investment model that expands the role of fixed income management. The success of the strategy is dependent on the ability of the manager to tactically allocate some parts of the extended investment universe to a traditional fixed income portfolio.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management.)
