Benchmark Risk and Portfolio Immunization Considerations
During a Global Pandemic
December 2020
Yield to Worst
Quality
Duration
Conclusion
Chart 1
Bloomberg Barclays U.S. Credit Index - Yield to Worst
Chart 2
Quality Analysis of Bloomberg Barclays U.S. Credit Index
Chart 3
Bloomberg Barclays U.S. Credit Index – Modified Adjusted Duration
Yield to Worst
Chart 1
Bloomberg Barclays U.S. Credit Index - Yield to Worst
Quality
Chart 2
Quality Analysis of Bloomberg Barclays U.S. Credit Index
Duration
Chart 3
Bloomberg Barclays U.S. Credit Index – Modified Adjusted Duration
Conclusion
Indices
Important Disclosures
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- Corporate credit generated the largest average excess return, but exhibited greater volatility and higher overall interest rate risk (as measured by effective duration).
- Agency MBS had an average spread comparable to that of corporate credit with considerably lower return volatility and interest-rate risk.
- Consumer ABS offered the lowest overall interest rate risk, as well as the lowest volatility of return.
Next we examine each of these sectors in more detail.
CORPORATE CREDIT
We focused our analysis of the corporate credit sector on investment-grade securities, defined as BBB-rated and above. The profile of the corporate credit index can be deconstructed into two primary factors that describe risk and return: default risk and spread duration risk. We define default risk across three quality buckets: AAA-AA, A, and BBB. These ratings represent the average rating assigned between the primary credit rating agencies. Similar to modified duration, which measures a bond’s price sensitivity to changes in yields, spread duration measures price sensitivity to changes in credit spread. We believe it is a good proxy for duration risk of excessreturn, as opposed to duration risk of totalreturn (modified duration).
The table below shows excess return, volatility, and MIRs over various credit quality and bond maturity segments.
Return
- BBB-quality categories have had the highest average excess returns. Additionally, the A-quality segments have outperformed the AAA-AA tier in all maturity groups less than 10 years.
- Longer-maturity segments have not necessarily driven larger average annual excess returns. In fact, across credit quality groupings, the 5- to 7-year maturity category has generated the highest excess returns.
- The 10-plus-year maturity group had the lowest mean returns across the maturity landscape. Lower realized excess returns can be partially explained by demand from asset-liability managers and insurers with long-term liability targets. Demand from this investor base has compressed spreads in longer-dated securities and flattened credit curves. In addition, longer spread duration amplified the price impact from changes in risk premiums, which led to a greater proportion of time periods exhibiting negative excess returns than other maturity segments.
CORPORATE CREDIT Continued
Volatility
- Within all credit quality segments, longer maturities resulted in substantive increases in return volatility; larger spread durations at longer maturities amplified volatility.
- Lower credit quality was also associated with increased return volatility across maturity categories. The table Spread Between Minimum and Maximum OASillustrates the wide variation of risk premiums among these segments over the past 22 years, as measured by option-adjusted spread (OAS).
Modified Information Ratio (MIR)
- While shorter-maturity groupings have generated the most attractive risk-return profiles (the highest MIRs), the magnitude of average annual excess return in these segments is generally limited.
- Lower-quality and longer-maturity credit have the potential to provide opportunities to maximize excess return.
- Corporate credit has the potential to provide important sector allocation opportunities to produce alpha in client portfolios.
- Given the more pronounced idiosyncratic risk, it is important to maintain both a well-diversified portfolio and a disciplined research process, as demonstrated by our fundamental, team-based approach.
- High-quality, low-risk premium portions of the market exhibit greater consistency in the context of our historical analysis. As a result, we believe that more persistent allocations to this segment provide the potential to enhance portfolio returns.
- Selective and opportunistic investing in lower-quality and longer-maturity credit securities can play a role in maximizing excess return of the overall portfolio.
STRUCTURED PRODUCTS
Between 1997 and 2019, AAA-rated ABS and agency MBS sectors exhibited significantly less volatility of excess return than nearly all credit sectors, resulting in compelling MIRs. Additionally, there was a low correlation of excess return between structured products and the corporate credit sector over the 22-year period, due in part to the high-quality and shorter-duration profile of structured products relative to the overall credit index.
We believe structured products provide an important source of diversification and can improve the risk-return characteristics of an overall portfolio. The diversification benefit provided by incorporating structured products in an asset-allocation strategy can be illustrated by comparing two portfolios, one consisting solely of government and credit sectors (Bloomberg Barclays Government Credit Index) and the other that includes structured products (Bloomberg Barclays Aggregate Index).
As shown in the following table, adding structured securities to a government-credit portfolio over the period 1997 to 2019 would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher MIR.
When constructing a portfolio, there are additional aspects of the MBS and ABS sectors to consider.
MBS
- Interest-rate volatility has the largest impact on relative performance of MBS. The inherent prepayment-convexity risk of these securities affects the timing of cash flows from monthly amortization of principal and interest.
- The MBS and corporate credit sectors are driven by different economic and market dynamics: interest-rate volatility (MBS) versus business fundamentals and corporate default cycles (corporate credit).
STRUCTURED PRODUCTS Continued
ABS
- While the ABS market has very little exposure to prepayment volatility, and relative performance is not interest-rate driven, the sector has shown a low correlation with credit overall due to limited exposure to the corporate business cycle.
- Additionally, ABS securities benefit from structural enhancements that boost credit quality. These include cash reserves, overcollateralization and/or subordination, which can mitigate the loss potential for investors at the top of the capital structure.
- Structured securities can play an important role in optimizing the risk-return profile of a fixed-income portfolio.
- The enhanced income and relatively low volatility historically offered by AAA-rated consumer receivables make the sector an important component in the construction of a risk-focused portfolio.
- We believe the credit card and prime auto segments of the ABS market are high-quality, liquid asset classes with an attractive risk-return profile.
OUR COMMITMENT TO OUR CLIENTS
We believe opportunistic sector allocation, coupled with an investment process focused on risk management and identifying relative value opportunities should result in consistent risk-adjusted returns over a full market cycle.
Over the last several years, we’ve experienced a wide variety of interest rate and risk regimes. We’ve adhered to the tenets of our risk-based philosophy throughout and used these opportunities to evaluate the findings of our historical analysis in practice.
