Core strategies need to do more than just manage tracking error to a benchmark, typically the Bloomberg Aggregate Bond Index. Replicating a benchmark can come with some undesired tradeoffs. As of 30 September 2021, the Bloomberg Aggregate Bond Index posted bottom quartile returns in the core fixed income manager universe for the 1-, 3-, 5- and 10-year periods.i These returns highlight the shortcomings of an autopilot approach to core fixed income investing. Importantly, many active core strategies can and have generated attractive relative returns for investors over a market cycle.
A Deceptively Complex Puzzle
The investment universe for core strategies is vast and comprised of US Treasurys, agencies, agency mortgages, investment grade corporate bonds, CMBS and ABS. The economic and fundamental drivers of these investment grade sectors are markedly different. Therefore, making impactful, well-timed use of these sectors can be a challenge, even for the savviest investor. As illustrated in the table below, each sector of the universe uniquely contributes to a diversified portfolio. Within the Loomis Sayles Core Fixed Income strategy, we dynamically allocate among these sectors based on top-down views and populate them with our best bottom-up security ideas.
Macro sector teams, composed of portfolio managers, traders and macro analysts, furnish top-down macroeconomic insights, which are important inputs into our portfolio allocation. Market sector teams leverage the firm’s credit cycle framework, a model that analyzes changing credit conditions over time, to forecast sector returns, comprehensively assess risks and provide relative value recommendations. Using our sector team views as a baseline, we develop sector allocations across the core fixed income universe. To size these allocations, we primarily consider contribution to beta, a measure of risk and return potential.
Why Use Beta?
We believe beta is a more accurate way to measure our relative risk than simply relying on market value. Relative risk in beta terms may be different than market value weights because beta also incorporates duration, spread and historical volatility. In simplest terms, a beta greater than zero implies an overweight, while a beta of less than zero implies an underweight. Higher values also indicate greater relative risk exposure. For example, the two bonds in the table below are from the same industry, have identical portfolio market value weights and are represented in the benchmark. However, contribution to beta, both absolute and relative, differs materially due to unique duration and spread characteristics.
For us, contribution to beta is more than just a historical reflection of risk or volatility. It is a dynamic investment tool that we use to actively assess prospective relative risk at the security, sector and portfolio level. Our customized contribution-to-beta models guide us in determining optimal sector weights by considering valuations, spread levels and different market outcomes.
Our Active Approach to the Sector Allocation
We have dynamically shifted our beta exposures across sectors over time, as the charts below illustrate. Sector betas are actively managed and change as the relative attractiveness of each market evolves over time.
Our sector allocation process considers fundamental analysis and valuations relative to risk as well as the macroeconomic landscape. We leverage Loomis Sayles’ deep research capabilities and proprietary tools to help us frame our understanding of risk and shape our views on valuations. If valuations appear robust and we believe we can be compensated for taking risk, we typically dial up our portfolio risk. In many cases, we use corporate bonds to do this as they generally contribute more risk than other asset classes used in the strategy. If we believe valuations are unattractive or we view the opportunity set as narrow, we typically reduce portfolio risk and migrate toward higher-quality sectors like agency MBS and Treasurys. These higher-quality allocations can act as “dry powder” to capitalize on market opportunities or add to portfolio risk. We believe this valuation-driven approach to sector allocation is a key aspect of our active approach.
High-Conviction Security Selection
After determining sector allocation, we populate portfolios with our best ideas sourced from deep fundamental research. In partnership with Loomis Sayles’ credit and securitized research analysts, we identify what we think are attractive securities and determine appropriate position sizes based on issuer contribution to beta, relative valuation and liquidity. Importantly, fixed income markets have become less liquid but more transparent; an evolution that we believe validates our focus on strong credit research as a key driver of security selection.
As has been widely reported, Wall Street banks’ proprietary trading desk activity has declined due to new regulations while corporate issuance has continued at a robust clip. As a result, bond markets have become less liquid with higher levels of outstanding debt. For money managers like Loomis Sayles, this creates opportunities. We focus on leveraging our deep fundamental credit research to opportunistically identify and purchase fundamentally strong securities at better valuations, exploiting dislocations from lower liquidity.
At the same time, market information has increased with FINRA’s Trade Reporting and Compliance Engine (TRACE). We are now able to analyze market data to assess what bonds are trading, how often and at what levels. Quantitative insight into market dynamics provides valuable information that informs portfolio construction and implementation.
Furthermore, we have continued to refine the quantitative tools that support our fundamental research. For example, our corporate relative value (CRV) model analyzes an issuer’s curve to identify mispriced securities. When augmented by the depth of our credit research, we can initiate positions or swap into more favorably priced issues. Similarly, we track trends and nuances of prepayment patterns in securitized debt. We have built data warehouses to monitor prepayment speeds for different types of mortgage pools. Our securitized analysts also assess the fundamental asset and liability structures backing these bonds. We believe the depth and breadth of our credit and securitized research, combined with the recent evolution of fixed income markets, provides us a competitive advantage in security selection.
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OUR APPROACH TO AGENCY MBS Agency MBS is known for market depth and liquidity. Historically, the sector has also offered higher yields versus Treasurys without significantly increasing credit risk. We look for agency MBS sectors that have a prepayment risk premium but exhibit lower prepayment patterns. The commercial mortgage-backed segment, for example, typically has very stringent prepayment penalties that make it onerous and costly for the underlying loans to refinance. Agency CMBS often offers a higher yield than single-family MBS. Higher return for less risk may seem contradictory, but we find it prevalent in many sub-sectors of the MBS market. |
Benefits of an Integrated Approach
Some investors fear a core fixed income allocation will relegate them to interest rate risk, macroeconomic headwinds and lackluster returns. If investors sit statically in an asset allocation, this may be the case. Active core fixed income investing requires more than assembling a portfolio from disaggregated pieces of the Bloomberg Aggregate Bond Index. We believe it requires an integrated approach driven by top-down sector insights and deep fundamental security research. As evidenced by our strong long-term track record below, our dynamic investment process of tactical sector allocation and strong security selection has been successful when measured against the benchmark and the vast majority of our peers.
Historically, our investment process has resulted in consistent risk-adjusted excess returns over the Bloomberg Aggregate Bond Index. Looking at the past 10 years of trailing 12-month performance, the core strategy has consistently outperformed the benchmark or the median manager. As shown in the charts below, we have also lowered the strategy’s tracking error over time while still offering strong returns and information ratios.
Endnotes
ieVestment Alliance, based on 30 September 2021 data.
About Risk
Investing involves risk, including risk of loss. Portfolios that invest in bonds can lose their value as interest rates rise, and an investor can lose principal. Investments in mortgage securities are subject to prepayment risk, which may limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment.
Disclosure
Diversification does not ensure a profit or guarantee against a loss.
Indexes are unmanaged and do not incur fees. It is not possible to invest directly in an index.
Past performance is no guarantee of future results.
This paper is provided for informational purposes only and should not be construed as investment advice. Opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted, and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.
This document may contain references to third party copyrights and trademarks, each of which is the property of its respective owner. Such owner is not affiliated with Loomis, Sayles & Co, L.P. (“Loomis Sayles”) and does not sponsor, endorse or participate in the provision of any Loomis Sayles funds or other financial products.
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