Towers Watson Asset Manager Review
PLEASE explain in simple terms how you construct a bond portfolio (whether on a free-standing basis or as part of a multi-asset balanced portfolio). What could the investment objectives of the bond portfolio be? How do you analyse and control risk in the bond portfolio?
boutique says as the company manages multi-asset class portfolios, it is concerned with the attractiveness of bonds relative to other asset classes such as equities, property and cash.
“This relative attractiveness is determined by our investment philosophy which incorporates the price and theme of assets. Price, most simply put, is the expected real return (the return in excess of inflation) as we are looking to grow the real wealth of our clients.
“We need to have high certainty that our clients are being sufficiently rewarded for the risk being assumed.
“Theme relates to the macroeconomic environment, which in the case of bonds looks at aspects such as the outlook for growth, the path for inflation and the size and extent of the interest rate cycle, to name a few.”
Tucker says when thinking about risk at a holistic level: “We need to consider how bonds integrate with the rest of the portfolio and ensure that we are exposing our clients to the appropriate level of interest rate risk”.
“For example, if we already have considerable interest rate exposure through our holdings in banks, retailers and property, then it may not be prudent to also hold a large amount of long-dated bonds, which are very sensitive to interest rate movements.
“Conversely, we may have a negative view on the rate sensitive shares, but see upside for bonds and can therefore afford to take risk and focus that portion of the portfolio into the most attractive area of the yield curve.
“When you move into corporate bonds, additional risks that you need to be aware of are liquidity and issuer risk. Issuer risk in particular can catch you by surprise.
“Consider the recent example of African Bank: you could have held the equity, the preference shares or the debt. And perhaps each of these was a small and acceptable risk in the context of the total portfolio, but not together.
“This illustrates why running an integrated portfolio is critical from a risk management perspective,” says Tucker. Adrian van Pallander, fixed income analyst at CORONATION FUND MANAGERS says: “Our philosophy is to take an active investment approach to fixed interest portfolio management, with investment decisions based on proprietary research across the full spectrum of potential return enhancers”.
“Fundamental economic re- search is the bedrock of this process, and it is from this starting point that we make decisions around duration management, asset allocation and yield curve positioning.
“Investment objectives are driven by our clients, and traditionally an active bond portfolio with the All Bond Index as a benchmark has been the standard bond mandate.
“These funds would typically have a target return above the All Bond Index, and risk within these funds is mainly controlled through relative duration ranges and limits to credit.
“More recently, flexible fixed income mandates with inflation or cash as a target have become more popular. These funds can typically invest in a wider array of fixed income type instruments such as inflation-linked bonds, floating rate notes or property.
“Apart from duration and credit, absolute downside is an important risk factor to manage,” says Van Pallander.
says client’s fixed interest portfolios are a combination of the views of the individual portfolio managers.
Each portfolio manager runs and takes full responsibility for their own portfolio that reflects their own views.
They rely on the broader team for input on credit and economic analysis, but make individual decisions on how to formulate their portfolios.
These portfolios are then combined by a separate team (the allocations team) so that client’s portfolios ultimately reflect the combination of the underlying portfolio managers’ views.
“The goal of the portfolio manager is to generate real returns clients within the context of risk.
“We do not track any benchmark in the fixed interest space as it is an odd concept to lend money based on where and how much borrowers want to borrow, rather than making your own mind up about where you want to invest your clients’ money.
“We do not trade bonds often as our strategy is to try and get the big moves right and this is based on fair value assumptions, which tend not to change very regularly.
“The portfolios consist of three main asset groups: money market assets, credit bonds and government bonds.
“We almost always hold the credit/corporate bonds to maturity as the market is illiquid and transaction costs high, while we use the money market and government bonds for liquidity and to alter the duration of the portfolios based on our view of fair value,” says Lapping. says the bond market has developed over recent years and now has a wide variety of instruments to consider when constructing a portfolio.
“Most funds target the ALBI (JSE all bond index), but it is important for a fund manager to target a real return in the long term.
“This, therefore, requires having a flexible and unconstrained mandate that can extract returns from a market that is rallying, but also having capital preservation awareness for when bond markets are not performing.
“The starting point of portfolio construction is to determine the correct interest rate risk (duration) for the stage of the interest rate cycle. This is decided largely through fundamental macroeconomic analysis.
“The second step is to choose the most appropriate instruments to reflect this position.
“The various options include government bonds, state owned enterprises (SOEs), corporate bonds, inflation-linked bonds (ILBs) and even some allocation to listed property.
“The corporate bonds and SOEs offer yield-enhancement opportunities, but can also be slightly less liquid and have more credit risk than government bonds.
“This is managed through bottom-up analysis and by diversifying the portfolio to ensure nonconcentrated holdings to individual names. ILBs essentially offer protection against inflation surprises,” says Kent.
He contends that a well-diversified portfolio is essential to control overall portfolio risk.
“Both duration and credit risk need to be managed from the topdown (macro-economic analysis largely) and bottom-up (individual credits need to be analysed at company level) in such a way that long-term performance is ahead of inflation,” says Kent. says just as an equity portfolio manager would define an investable universe of stocks from which to pick when constructing a portfolio, so too would a bond portfolio manager.
“We define our bond investment opportunity set by considering a wide range of fixed-income ideas, which are investable, liquid and have good price discovery.
“This universe is expanding on an on-going basis as markets develop and includes interest rate views, yield curve, credit and inflation-linked opportunities.
“We then conduct a rigorous research process on each of these opportunities, which culminates in risk-adjusted return forecast for each, after which the mandated portfolio risk budget is allocated optimally across these opportunities to ensure that we maximise the expected relative performance of the portfolio against the bond benchmark.”
Wood says there are several objectives that a bond portfolio could aim to achieve.
“The client will generally have an underlying liability profile of some sort (a bond index (ALBI)), cash flow profile or outperformance target above cash or inflation which needs to be matched and/or outperformed.
“This needs to be defined so that risk positions that will generate the active return can be taken around this.
“Risk relating to the benchmark-liability profile then needs to be managed by spreading portfolio risk across a broad range of opportunities. However, in an active bond portfolio, the manager is paid to take risk, so too much diversification is not a good thing.
“We therefore ensure that the available risk budget is allocated to our highest-conviction ideas without too much dependence on a single view dominating the portfolio,” says Wood.
says an ideal bond portfolio should provide the investor with income, as well as some growth.
Due to the risk inherent on the instruments, diversification should be the main aim when constructing a portfolio to prevent large losses if anything goes wrong.
“Diversification helps to control risk. A well-diversified bond portfolio would typically contain a mixture of government and credit bonds.
“As credit bonds carry a higher risk, it is imperative to have a detailed credit process to appropriately analyse companies.
“The higher the risk in terms of the companies, the more diversification you would need in terms of the fund.
“Through optimal diversification, the portfolio manager is able to reduce the overall volatility of the portfolio and this would apply to both a free standing portfolio and a balanced portfolio.
“When constructing a fund you need to find a balance between creating a quality portfolio and one that gives good returns over time,” says Mphaphuli.
says the risk parameters (return targets, liquidity, interest risk, and credit) of a fixed income portfolio will be governed by the client’s investment mandate, which in turn will be governed by the client’s risk tolerance.
For example a mandate may target a return of ALBI plus 1%, limit interest rate decisions of between ALBI plus or minus one year and limit the portfolio from having a weighted average credit quality of no less than single Arated.
“Following the example given above, there are broadly two types of investment decisions: interest rate and credit investment decisions.
“Interest rate decisions are implemented from both a top down (macro environment) and bottom up (valuation) perspective – is the macro environment bond friendly (low GDP growth, low inflation) or bond unfriendly (high GDP growth, high inflation), are the bond yields showing fair value, are all the bond negative or bond positive macro factors priced in, are the yields attractive on a real basis and which area of the yield curve is offering best value.
“A portfolio of credit (corporate bonds/debt) assets, on the other hand, is built from the bottom up (assuming an investment decision has been reached through a due diligence process) the portfolio will invest in the credit asset.
“The size of that investment (measured as a percentage of the portfolio) will depend on the issue size, the risk appetite as per the mandate and could further be limited by the investment philosophy of the asset manager around portfolio diversification,” says Liou.
says although bond portfolios are more conservative than equity portfolios, they still require diversification across a number of underlying bonds.
He says regardless of which entity issues the bond – government, parastatal or corporate – these instruments have two primary levels of risk, namely:
Credit risk, which refers to the risk that the issuer cannot return the capital, and
Interest rate risk, which refers to the risk that changing interest rates will impact on the capital value of the bond.
“Having a sense of the macroeconomic interest rate environment and the solvency or robustness of each issuer is key in controlling risk and returns in bond portfolios,” says Newell.
says allocating capital to any asset class is primarily a function of how attractively those assets are priced.
“Our investment process does not include any strategic or tactical allocation. Prospective bond investments need to provide a suitable risk adjusted return as opposed to looking at the asset class purely from an income or yield enhancement perspective.
“For higher quality corporate issuers we would usually require a real return of around 4%.
“We are not forced buyers of bonds. If the opportunity set is unattractively priced we would typically hold a higher percentage of our balanced funds in cash instead of allocating capital to the best relative value bonds.
“We define risk by the probability of permanently losing capital and mitigate by buying assets at a discount to our estimate of fair value.
“We mitigate credit risk by being more bottom-up in our process and spending more time trying to understand the creditworthiness of issuers than on broader macroeconomic factors,” says Neethling.
He reports that other important considerations which influence RECM’s thinking include the ranking of bonds in the capital structure, strength of legal covenants, sensitivity to interest rate movements (duration) and market liquidity.
says the company’s starting point would be to take a view of how much interest rate risk (or duration) is appropriate in the fund.
“This would be driven by a variety of factors, including macroeconomic fundamentals, the global environment and current valuations across the yield curve.
“The risk tolerance of the fund and requirement for income would be critical factors as well.
“We would then select individual instruments on a bottom-up basis (taking into account specific factors such as expected return, liquidity, supply and demand and credit considerations) such that the overall criteria are met.
“The investment objective of the bond allocation would be to maximise prospective returns with an appropriate allowance for risk and being mindful of diversification and exposure to a variety of market drivers,” says Floor.