Navigating the Fixed Income UniverseA Simplified Flight Plan Througha Complex System

Written by Susanna Gibbons, CFA Vice President, Senior Portfolio Manager

Navigating the Fixed Income Universe | 1RBC GAM Institute

The universe of fixed income opportunities appears to be expanding at an accelerating rate, with each opportunity bringing its own risks, rewards and idiosyncrasies. Institutional investors have more choices, but need to find a discipline for systematically evaluating them. Rather than being lost in space, investors can navigate their way with a straightforward flight plan. To take advantage of the opportunities available in the widening fixed income universe, institutional investors and their investment managers should distill the investment management decision into two separate components: a duration decision and a spread decision. These two types of risk factors introduce unique potential return streams, and investors need to carefully target their risk profiles in order to optimize their portfolios’ return potential. In this way, investors can bring a disciplined risk-managed approach to ensuring their fixed income allocation takes full advantage of what the fixed income universe has to offer.

Executive Summary

“It is far better to

grasp the universe

as it really is than to

persist in delusion,

however satisfying

and reassuring.”

~ Carl Sagan

RBC GAM Institute2 | Navigating the Fixed Income Universe

1Municipal securities are excluded from this discussion, with apologies to those focused on this unique discipline. Dealing with the cross-sector consequences of taxes is well beyond the scope of this endeavor.2This was the first year in which non-agency mortgages appeared in the Securities Industry and Financial Markets Association (SIFMA) database; they may not have been accessible as an investment opportunity until somewhat later.2Convertibles existed long before 1993, but this is when Barclays launched its convertible benchmark.

Sources: Barclays and RBC GAMAs of 12.31.13

Exhibit 2Agg Sectors Are Less Than 50% of Total Fixed Income Opportunity Set

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1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

Sources: Barclays, SIFMA and RBC GAMAs of 12.31.13

Exhibit 1Agg Sectors Have Fallen as % of Barclays USD Bond Universe

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110%

1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

Formation of the Universe

When the Lehman Aggregate Bond Index (“The Agg”) was formally introduced in 1976, it represented nearly all of the potential investments that a fixed income investor could access.1 Markets have evolved well beyond this simple time to encompass an increasingly broad range of securities. A touchstone for 40 years, the Agg (now the Barclays US Aggregate Bond Index), represents a diminishing component of the fixed income universe.

The original sectors in the Agg were corporates, mortgages, Treasuries and a smattering of other government-related securities. The mortgage market was in its infancy, as were the government sponsored enterprises (GSEs). Whether fueled by the Greenspan-era easy monetary policies is hard to say, but the universe of available fixed income securities began its dramatic expansion in the 1980s, and has continued unabated through the most recent financial crisis of 2008-2009. In addition to the Agg sectors, and roughly in order of appearance in a major index or database, the market now includes:

• Corporate high yield debt (1987)• Non-agency mortgages (1990)2

• Emerging market bonds (1993)• Non-U.S.-government related securities (1994)• Convertible bonds (2003)3

• High yield loans (2006)

If these sectors are included in the opportunity set, the Agg represents just about 75% of the fixed income universe, as indicated in Exhibit 1.

The market then evolved to introduce what might be considered either the quarks or the dark matter (depending on one’s view) of the fixed income universe: credit default swaps (CDS). The expansion of CDS trading paved the way for a whole range of new synthetic securities:

• Single name exposures• Indexes of CDS• Structured exposure to indexes of CDS• Customized baskets of CDS

If these securities are included (and granted, they are hard to count), the Agg shrinks further to a modest 40% of the full fixed income opportunity set, as indicated in Exhibit 2.

This estimate of the universe includes only U.S. dollar-denominated securities. The universe continues to expand once currency is introduced – but let’s stop here just for argument’s sake. Fixed income investing strategies, it seems, are limited only by our collective imagination. As the traditional benchmark for bond investors, the Agg does little to shed light on the risk and opportunity associated with this increasingly complex asset class.

Navigating the Fixed Income Universe | 3RBC GAM Institute

4”Fixed Income Active Strategies”, by Ronald N. Kahn, BARRA Newsletter (http://www.barra.com/newsletter/nl162/FIAcStratNL162.asp)

Sources: Bloomberg and RBC GAMAs of 3.31.14

Exhibit 3Periods When Interest Rates Rose Were Not Followed by the Continued Rises Forecasted by Pundits

Fixed Income Investment Strategies: A New Approach

When institutional investors have used a benchmark as the basis for an investment strategy, they have also used it to manage the principal/agency risk of delegating their investment decisions to investment managers. A benchmark is a way to define the opportunity set, evaluate investment performance and assess managers. The more complex the investment sectors, the more important the benchmark is. Within fixed income, institutional investors have used the Agg for decades as the gold standard for comparing managers. But the Agg was not introduced as an investment strategy. It was introduced to provide a benchmark which reflected the relevant fixed income universe.

The Agg as presently constituted probably does not represent the relevant universe for most institutional fixed income investors. It has a preponderance of risks which are unattractive for active investors (such as duration targets ill-suited to investor needs), with less exposure to risks (such as credit) that can add value over time. The one-size-fits-all approach to fixed income investing blurs the distinctions that should be made among the different risk elements in the investing universe, and narrows the universe in a way that may not suit investors’ needs.

In using the Agg as a basis, traditional core fixed income strategies combine what should be two separate risk decisions: duration and spread. The primary purpose of disaggregating the Agg is to disaggregate those two distinct risk decisions so that a more precise portfolio risk profile can be formulated to address each investor’s objectives.

The Need for Duration

It is likely that many of the institutional investors who are leaving Agg-oriented strategies intend to shorten the duration of their portfolios. While it may be unwise to challenge the prevailing sentiment that interest rates are likely to rise in the coming years, interest rate forecasting (whether for the short term or the long term) is one of the least reliable ways to deliver consistent alpha. For much of the modern era of fixed income investing, various investment managers, economists and market pundits have, when interest rates are rising, forecasted further increases, and at least so far, the dire warnings have been overtaken by subsequent market events. During each of the periods circled in Exhibit 3, a rise in interest rates led forecasters to call for an end to the bull market, but rates did not continue to rise as expected. In fact, the long-term trend of lower rates remains intact.

According to research provided by BARRA (now part of MSCI), active duration managers are not prevalent, as their strategies tend to produce very low information ratios:

While a top quartile manager in general has an information ratio of 0.5 before expenses, a top quartile active duration manager may have a significantly lower information ratio—perhaps on the order of 0.1. It is easy to generate significant amounts of active risk with interest rates bets, however, and so active duration managers can occasionally, just through luck, significantly outperform.4

Although this argument was made in the mid 1990s, it remains relevant today – investment managers have shown no data that indicates they have developed greater skill in consistently forecasting interest rate movements.

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ear T

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es (%

)

RBC GAM Institute4 | Navigating the Fixed Income Universe

4Fixed Income Active Strategies, by Ronald N. Kahn, BARRA Newsletter (http://www.barra.com/newsletter/nl162/FIAcStratNL162.asp)

Fixed Income Securities

Principal Stability/ Shorter Duration

Income Stability/Longer Duration

Investment Objectives

Exhibit 4Balancing Current Income Requirements with Tolerance for Principal Volatility

Exhibit 5Negative Correlations Are Most Powerful When Bonds Have Extended Maturities

Growth of $100

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Stocks 50/50 Stocks/Long‐Term Bonds 50/50 Stocks/Intermediate Bonds

Sources: Barclays and RBC GAMAs of 3.31.14Long-Term Bonds = Barclays U.S. Long Treasury IndexIntermediate Bonds = Barclays U.S. Intermediate Treasury Index

Instead of choosing a duration profile based on interest rate forecasts, institutional investors should select a duration profile that aligns with their overall portfolio objectives.

Given the contractual nature of bond coupon payments, fixed income instruments are uniquely suited to hedge a variety of risks, and most fixed income strategies take advantage of this. In this vein, there are two primary purposes for investing in fixed income:

1) To provide stability of principal2) To provide stability of income

To address the need for duration, investors need to balance current income requirements with tolerance for principal volatility, as shown in Exhibit 4. An insurance company may have a greater need for a steady stream of income, while a manufacturing company may have a need for stable principal to fund a capital expenditure program. Even in a flat yield curve environment, income stability will be sacrificed by moving to a shorter duration.

It is important to note that principal stability needs to be considered on the basis of net asset value, which takes into account the particular liability that the investor might be hedging. This framework can then be applied for investors with liability profiles ranging from less than one year to more than 20 years, across multiple asset classes. The optimal duration profile for any investor will minimize the risk-related impact of duration decisions while maximizing income generation potential.

For investors whose primary purpose for owning fixed income is to hedge risky assets, longer duration exposures will be the most effective. Negative correlations between fixed income and equities are most powerful when bonds have extended maturities. In Exhibit 5, a portfolio with a 50% allocation to equities (represented by the S&P 500 Index) and a 50% allocation to long duration Treasuries generates the highest total return over time, with a significantly lower standard deviation of returns, compared to an all equity portfolio and a portfolio that is half equities and half intermediate duration bonds.

By reducing the risk associated with duration, investors can free up a significant risk budget for allocation to spread strategies, which can be expected to carry both higher absolute returns and greater alpha opportunity. The decision-making process regarding spread has three steps:

1) Choose to buy spread2) Choose which spread to buy3) Choose how much spread to buy

RBC GAM Institute Navigating the Fixed Income Universe | 5

5OAS is a way to measure and compare the spreads of securities with different cash flow optionality.

Source: eVestment AllianceAs of 12.31.13

Exhibit 6Information Ratios (%) of Top Quartile of Managers

Strategy 3 Years 5 Years 10 Years

U.S. Government 0.20 0.66 0.22

Core Fixed Income 1.18 1.28 0.54

Core Plus 1.10 1.40 0.55

Corporate 1.07 1.32 0.67

U.S. Mortgage 1.41 1.62 0.55

High Yield 0.42 -0.20 0.14

Exhibit 7The More Volatility Investors Are Willing to Tolerate, the More Sectors They Should Allow

Sources: Barclays and RBC GAMAs of 2.28.14

0

0.5

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3.5

U.S. Securitized Corporates Emerging MarketSovereign (USD)

High Yield HighQuality

Emerging MarketCorporate

High Yield

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ndar

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of O

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Sector Inclusion

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The Need for Spread

Investors usually benefit from taking risk in credit, mortgages and other “spread sectors,” so named because they trade at a yield spread above Treasuries of comparable duration. The opportunity to add alpha from investing in the spread sectors is significantly greater than focusing on duration management strategies. Compared to the 0.1 information ratio noted in the BARRA research and the 0.2-0.7 information ratios for U.S. Government-only mandates, top managers in the spread sectors have provided significantly higher information ratios, as shown in Exhibit 6.

On a standalone basis, high yield strategies have relatively low information ratios that suggest less alpha opportunity. However, the beta opportunity is significant. For an investor with higher tolerance for volatility, an optimized fixed income allocation should allow this sector. The more tolerance an investor has for volatility, the more sectors the investor should allow in the fixed income allocation. Sector flexibility allows a fixed income manager to search for the best opportunities available in the current market environment.

Spread Decision: BetaOnce the decision to purchase spread product has been made, the next step pertains to beta, i.e., which types of spread product deliver a return and volatility stream that is consistent with investor objectives and risk tolerance? In the simplified schema presented in Exhibit 7, spread sectors have been plotted purely on the basis of risk as measured by option-adjusted spread (OAS) volatility.5 Investors can select the sectors which achieve those objectives.

An investor could opt for a more conservative risk profile by confining the opportunity set to the sectors on the left or add incrementally greater risk by allowing sectors on the right. By allowing additional spread sectors, an investor gives the investment manager more opportunities to add value to a portfolio either through relative value strategies or bottom-up security selection.

The more volatility investors are willing to tolerate, the more they can expand the investment universe for their fixed income allocation. It is important to think about this in terms of increased risk tolerance driving higher return potential, rather than the other way around. Sectors do not always present return opportunities commensurate with their risks, and an investment manager has a critical role in evaluating the expected return potential for a given level of risk.

Optimal Portfolio ConstructionIn an ideal world, an investment benchmark functions as a proxy for both sector exposures and risk tolerance. In practice, however, given the evolving complexity of fixed income markets, the standard benchmarks do not always serve those functions. Unfortunately, the world of customized benchmarks is cumbersome and difficult to manage. By breaking the investment decision down to two targeted decisions on duration and spread, investors can reverse engineer the appropriate benchmark.

6 | Navigating the Fixed Income Universe RBC GAM Institute

The chart below establishes beta targets, i.e., benchmarks or categories of benchmarks, that should be met (over an investment cycle) in order to achieve an institutional investor’s desired risk level. In addition, each strategy will also have an alpha target; the alpha target generally increases along with sector flexibility.

Spread Decision: AlphaFinally, an investor needs to have an alpha target. Within the construct of a duration decision driven by an investor’s overall portfolio objectives and a sector decision driven by an investor’s risk tolerance, how much incremental return does the investor expect or require? The duration and sector decisions define the beta selection, or benchmark. The incremental return required is the alpha target, which can be defined through the use of ex-ante tracking error (TE).6 An investment manager can use TE to assess types of risk (such as interest rate risk or credit risk) in a portfolio and based on the expected interactions of those risks, forecast the extent to which portfolio returns will vary from the benchmark’s returns. Every portfolio will have an embedded level of value at risk (VaR) defined by the duration and sector decisions already made. The amount of incremental risk that an investor is willing to take can be defined by the amount of portfolio TE expected over an investment cycle. Higher TE implies a higher level of portfolio risk; higher risk implies greater potential for incremental return.7

6Ex-post tracking error is a useful tool for evaluating portfolio performance relative to a benchmark, while ex-ante tracking error is a risk management tool.7Traditionally, institutional investors have used investment policies or guidelines stipulating allowable sectors, minimum credit quality and other parameters in an effort to control risk and oversee their investment managers. A viable substitute for these kinds of parameters can be a robust risk-budgeting process made possible through the use of TE estimates. This process will help investors manage risk and benefit from increased flexibility in terms of sectors and credit ratings. Investors may select managers based on their demonstrated skills in particular sectors.

The Next Generation

In many ways investors have already gone boldly into the new world of fixed income investing. The adventurous spirit is laudable, but runs the risk of placing investors at the creative whim of actors outside their control. These masters of the universe are largely responsible for the expansion of the fixed income opportunity set in the first place. At this point, investors should step back, take control of the process and start constructing their own flight plans. The steps proposed here – the simple distillation of the decision-making framework into the two discrete components of duration and spread – start to determine what that plan will look like. Instead of reflexively selecting the traditional benchmark for managing fixed income exposures, investors can more accurately target a portfolio which incorporates the risks they want to take, avoids the risks they don’t want, and provides managers with clear guidance on where in the universe they actually want to go.

About the Author

Susanna Gibbons, CFAVice President, Senior Portfolio Manager

Susanna Gibbons leads the credit research team in our fixed income group. She researches the banking sector of the corporate market and is a portfolio manager for several of our core fixed income solutions. Susanna joined RBC GAM-US in 2007 from Jeffrey Slocum & Associates, where she was director of fixed income research. Before that, she held several senior positions, including director of fixed income research and senior portfolio manager, at The St. Paul Companies (now The Travelers Companies). Susanna’s experience also includes research analyst roles at several other U.S. insurance and investment firms, including MetLife and J.P. Morgan Investment Management. She earned a BA from Bryn Mawr College and an MBA from the New York University Stern School of Business. Susanna is a CFA charterholder.

SpreadShort

(0-2 yrs)Intermediate

(2-4 yrs)Long

(4-7 yrs)Very Long (7+ yrs)

Low Volatility Sectors: Securitized, Investment-Grade Corporate Credit, Investment-Grade Sovereign

LIBORBarclays

Intermediate Gov’t/Credit

Barclays Aggregate U.S. Gov’t

Medium Volatility Sectors: Above Sectors, Plus Certain Structured Product, Emerging Market Sovereign

LIBOR +100 Swaps +100Barclays

Investment Grade Corporate Index

Swaps +100

High Volatility Sectors: All Above, Plus Emerging Market Corporate, High Yield, Synthetic Credit

LIBOR +300 Swaps +300 Swaps +300 Swaps +300

Exhibit 8Intersection of Spread and Duration is Beta Target

RBC Global Asset ManagementMinneapolis | Boston | Chicago

800.553.2143 | www.rbcgam.us

Navigating the Fixed Income Universe | 7RBC GAM Institute

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. The views expressed herein reflect RBC Global Asset Management (U.S.) Inc. as of 5.31.14. Views are subject to change at any time based on market or other conditions.

RBC Global Asset Management (U.S.) Inc. (“RBC Global Asset Management - US” or “RBC GAM-US”) is a federally registered investment adviser founded in 1983. RBC Global Asset Management (RBC GAM) is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management Inc., RBC Global Asset Management (UK) Limited, RBC Alternative Asset Management Inc., BlueBay Asset Management LLP and BlueBay Asset Management USA LLC, which are separate, but affiliated corporate entities. ®/™ Trademark(s) of Royal Bank of Canada. Used under license. © 2014 RBC Global Asset Management (U.S.) Inc.