All investments, bonds and other debt instruments are subject to market risk, asso- ciated with interest rates and credit risk resulting from the issuer’s creditworthiness.
Theoretically, interest rates are the domain of the central bank’s monetary policy.
In practice, market factors can also have a significant impact on interest rates.
For instance, the expectation of moderate economic growth coupled with low inflation may characterize a movement of yields on ten-year bonds that is flat- tening the yield curve. The opposite expectations steepen the field curve. The market also impacts upon term premiums that compensate investors for the increased price risk of longer-term bonds.
Also impacting upon the shape of the yield curve are contradictory interests.
For example, while the low level of long-term yields has a certain stabilizing effect
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on the business environment of financial institutions, the profits these institutions make through maturity transformation are under pressure owing to a flatter yield curve. Critical framework conditions for the bond market also include:
● The dependability of monetary and economic policy, and
● Expectations that in the future intensive global competition will counteract potential price pressures.
Factors such as major capital inflows or a regulatory increase in demand for longer- term securities from insurance firms and pension funds put downward pressure on capital market yields, and contribute to significantly lower capital market interest rates, beyond the impact of the central bank’s monetary policy decisions.
According to economists, this action is associated with a decoupling of real long-term yields from both cyclical behaviour and from long-term growth expect- ations. At the same time, such decoupling includes the risk of an abrupt upward correction of long-term yields, a scenario fraught with risk for the financial system.
Against this background, what should a portfolio manager do to be ahead of the curve? The answer returns us to our discussion in sections 2 and 3 on the concept of limits to concentration. Classically, this takes the form of capital allo- cation between bonds, equities, other commodities and cash. This allocation is dynamic. Figure 8.1 shows the one-year net accumulation by insurers and pension
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Just note difference
1999 2001 2002 2003
Bonds with maturities less than 1 year
Quoted equities
2000 2004
Figure 8.1 Six-year trend in net purchases of bonds and equities by insurers and pension funds in euroland. (Statistics from the European Central Bank)
funds of bonds and equities in euroland in the 1999–2005 timeframe (statistics of the European Central Bank, Monthly Bulletin, April 2005).
Each of these investment classes must itself be analysed with respect to its indi- vidual merits as well as in terms of its fitness with other portfolio positions. Experts suggest that the three most widely accepted principles with debt instruments are:
● Creditworthiness
● Generation of stable returns, and
● Optimization of overall portfolio risk.
A senior banker participating in the research that led to this book commented that, based on these three bullets, his institution only considers the highest rated bonds, AAA and AA, when putting together a bond portfolio. Only in exceptional cases will it consider bonds with ratings as low as BBB, and it definitely excludes non-investment rated bonds.
The banker also added that all positions in the bond portfolio are actively managed. The long-term turnaround in bond yields puts them at significant risk in the case of rising yields – which are practically always followed by falling prices. With regard to managed portfolios, while the majority of bonds are in the reference currency of the client (the client may choose from five different cur- rencies), the bank may add some foreign currency bonds depending on the currency outlook of its specialists.
To arrive at a specific duration, the bank uses slice management. Duration slices are 1–3, 3–5, 5–7, 7–10 and above 10 years. By assessing the proper weights to these slices, the bank reaches a pre-specified duration of the bond portfolio and an average yield. However, the definition of duration and of currency mix is subject to the weekly meeting of the investment committee, which defines the framework of the investment strategy.
Specific strategy teams (bonds, equities, currencies and alternative instruments) implement the strategy established by the investment committee. They also define the tactical allocation and daily transactions of the portfolio. Duration-wise, pos- itions are kept quite close to the benchmark in almost every country in which these debt instruments originate.
Institutions that include non-investment grade bonds in their portfolio, and those of their clients, appreciate that higher interest rates than those obtained in investment grade bonds are available through junk bonds and so-called leveraged loans. The latter are speculative-grade loans secured by company assets.
Unlike the original junk bonds of the 1980s, leveraged loans have floating interest rates, a few percentage (basis) points above the London Interbank Offered
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Rate, or LIBOR (LIBOR is the cheapest rate banks charge one another for short- term money). But a few basis points don’t really compensate for a much lower credit rating.
Leveraged loans were once traded quietly among bank syndicates and a few institutional investors. More recently, however, these loans are attracting plenty of money from hedge funds, pension funds, mutual funds and others. According to Standard & Poor’s, investors funded a record $295 billion in leveraged loans in 2005, three times as much as in junk bonds.3