Tow­ers Wat­son As­set Man­ager Re­view

The Star Early Edition - - LABOUR FOCUS - Gra­ham Tucker, port­fo­lio man­ager at OLD MU­TUAL IN­VEST­MENT GROUP’s MACROSO­LU­TIONS An­drew Lap­ping, port­fo­lio man­ager at AL­LAN GRAY Peter Kent, port­fo­lio man­ager at IN­VESTEC AS­SET MAN­AGE­MENT Con­rad Wood, head of fixed-in­come strate­gies at MO­MEN­TUM AS­SET MANA

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.

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