Big Bond Bust

Abstract

The Editor's Corner is a regular feature of the Financial Analysts Journal. It reflects the views of Richard M. Ennis, CFA, and does not represent the official views of the FAJ or CFA Institute. Big Bond Bust With stocks, private equity, hedge funds, real estate, and commodities losing 20–40 percent of their value in 2008, it was a great year for bond portfolios to fulfill their promise as investors’ main source of downside protection. Investment-grade bonds did just that: The Barclays Capital Aggregate Bond Index returned 5.2 percent in 2008. A 25 percent portfolio allocation to assets earning a positive 5 percent return went a long way to blunt otherwise abysmal market returns. Alas, many investors did not enjoy that type of protection from their actively managed “core” and “core-plus” bond portfolios. Most core-plus portfolios actually lost money in 2008. A distressingly large number, including those of some prominent bond managers, suffered declines of up to 15 percent. Reflecting on the perplexing experience of 2008, a bewildered client asked, “When did our bond managers stop buying bonds?” Bond portfolio management began to morph more than 25 years ago. Even back then, managers realized that if their portfolios were limited to the credit-rating restrictions of an investment-grade bond index, consistently beating the index net of fees would be difficult to do. And so began a long cycle of “enhancing” bond portfolios’ return potential. It began innocuously enough with the inclusion of split-rated bonds, whereby one agency’s rating met the cutoff for investment grade but that of another did not. Downgraded bonds were selectively retained. And the odd belowinvestment-grade bond was added to the portfolio with the client’s approval. From there, bond managers began seeking authorization to place a percentage of assets—say, up to 10–15 percent of the portfolio—in bonds with ratings one or two notches below the investmentgrade limit. As time passed, this and other variance percentages grew to as much as 40 percent of the total as emerging market debt, non-governmentbacked mortgage-related securities, and other types of assets that fell outside the benchmark became fair game. The derivatives markets opened up new frontiers for creative risk taking. Now, some flagship bond funds encompass long and short exposures with notional values several times that of invested capital. Some funds sell protection via the credit default swap market. Some maintain thousands of complex positions. And some resemble leveraged fixed-income arbitrage hedge funds. When all is said and done, this is not your father’s bond portfolio. Through it all, however, by convention, coreplus strategies have generally been benchmarked against investment-grade bond indices. Most core-plus bond portfolios exceeded the return of the Barclays Capital Aggregate Bond Index with a fair degree of consistency in the years leading up to 2008. This performance reflected the collective payoff of numerous risks that had little to do with the coupon payments and yield-curve dynamics of the bonds that make up the index. But 2008 was a year of reckoning; as noted, after several years of steady, moderate gains, many of these funds experienced extreme losses. When the credit crunch finally hit, heavy reliance on credit securities was a big part of the problem. As is typically the case when credit markets are stressed, flight-toquality liquidations became an important dynamic that put downward pressure even on bonds of solvent issuers. Fixed-income arbitrage positions often have subtle, complex liquidity characteristics of their own. Thus, acute liquidity effects exacerbated the losses of many aggressive strategies. The high-octane bond strategy is reminiscent of what Andrew Lo describes in “Risk Management for Hedge Funds.”1 Lo illustrates the performance of a hypothetical hedge fund, Capital Decimation Partners, that produces steady profits for many years by selling deep out-of-the-money put options, only to have its day of reckoning. Referring to the strategy’s asymmetric payoff pattern, Lo notes, “This is a very specific type of risk signature that is not well summarized by static measures such as standard deviation” (p. 23). And so it is with coreplus bond management.