The ABC of alpha and beta returns
Too much money chasing too much risk for too little ultimate return? Or a reasonable response to an unprecedented situation? Olivia Albrecht, Michael Story and John Valtwies take us back to basics with global bonds.
Extraordinary central bank support has driven prices higher for safe-haven and risky assets alike, despite challenging economic fundamentals.
This leaves investors in a quandary: Should they respond to today’s unusual combination of elevated, macro-driven risk and thin compensation by stretching for additional yield and continuing to capitalise on central banks’ reflationary policy for asset prices?
Or should investors focus on capital preservation after remarkable gains, acknowledging that central banks cannot drive a wedge between fundamentals and asset valuations forever? This is the challenge investors face in the New Normal (see Figure 1).
The answer of course lies in striking the right balance between the aims to capitalise on the current environment and to preserve investment gains, which, in turn, requires setting realistic return expectations.
And to do this properly, we should differentiate between alpha, or above-market returns, and beta, or market returns.
Alpha, beta and volatility
Looking first at beta, we expect a lackluster environment over the cyclical horizon. The total carry on the Barclays Global Aggregate Bond Index Australian dollar hedged (5.21 per cent as of 1 July 2013) may, in fact, be the best indicator of a capital gain on the benchmark.
There is little room left for yields to decline, and yet a global rising-rate environment seems very unlikely, given below-trend global growth, elevated unemployment, biting fiscal austerity and unusual policy uncertainty, particularly in Europe.
Therefore, we expect lower returns over a longer time horizon and an eventual rise in interest rates.
Clearly, beta shouldn’t tell the whole story. With today’s low yields, alpha is going to have to play a greater role in overall portfolio returns for investors in seeking their return targets – for some, simply beating inflation.
So what is a realistic alpha expectation going forward? Some have argued that the current low yield/tight spread environment translates into a less alpha-rich landscape. We disagree.
We believe successful active management requires new information and asset re-pricing, and for better or worse, market-driving news and major re-pricing seem to have become a prominent market feature since the financial crisis.
Financial markets have become particularly sensitive to unpredictable political outcomes, and unorthodox central banking is focused increasingly on manipulating the markets as a means of indirectly influencing economic outcomes.
We expect both of these conditions to persist and to create bouts of market volatility in coming years – in fact, even more so than in recent years as political relationships are redefined and central banks are forced to devise more creative ways of stabilising the systems.
We therefore believe the current environment affords a healthy opportunity set for alpha generation. Under normal market conditions, PIMCO’s core, global bond strategies are designed to generate consistent alpha, and we are focused on this target in what we believe to be an alpha-rich environment.
Generating alpha
In efforts to generate alpha in global bond portfolios, we look at several strategies.
Credit risk
We look to scale exposure to credit risk, most notably between corporate credit risk and sovereign credit risk.
In the summer of 2012, for example, we reversed a multi-year underweight to the European periphery, at the same time reducing exposure to core European corporate bonds to create space in the risk budget.
Mindful of hedging against tail risks, or extreme events, we have held only modest allocations to emerging markets despite our long-term bullish outlook.
However, we have the scope to increase this allocation significantly and would consider doing so should left-tail risk, such as a steep market decline, abate.
Issue selection
This bottom-up component of active management is more attractive than it has been in years.
We find that home bias and investor segmentation have created unprecedented relative value opportunities across global markets and across the capital structure in the corporate bond market.
Even within countries, liquidity transmission remains highly fragmented – especially in Europe, where bank deleveraging continues – which has created opportunities in government and government-related issues.
Sector rotation
Should we anticipate the end of the Federal Reserve’s quantitative easing program, we could consider deploying a large underweight to agency mortgage-backed securities, a reversal of our overweight position for most of the past five years.
Currency hedging: yield pick-up
We typically limit currency strategies’ contribution to alpha in our global bond strategies due to their disproportionate level of volatility, preferring to hedge most currency exposure.
However it is worth remembering investing in foreign-denominated bonds and hedging to AUD results in a pickup in yield roughly equivalent to the difference in cash rates between the two countries (see Figure 2). This yield pick-up for global portfolios hedged into Australian dollars is an additional benefit to investing in global bonds.
Alpha and rising interest rates
What happens to these alpha opportunities if interest rates rise?
Our view is that a rising-rate environment over the next year or so is not very realistic given the macroeconomic environment – we anticipate an extended period of low rates anchored by global central banks.
However, should rates rise sooner than we expect, we would not anticipate concurrent rate rises across global markets.
Regional business cycles remain distinctly unsynchronised, with each of the major economies struggling through its own unique set of economic, political and financial challenges.
As a result, we believe the advantage of global diversification in core bond allocations is stronger than ever.
Nevertheless, in rising rate environments, global bond portfolio managers can draw on a number of specific alpha strategies to offset the possibility of capital losses from rising rates. For example, if interest rates were to rise in the current market:
Non-agency mortgage-backed securities are currently priced to compensate investors for further home price depreciation and loan foreclosures.
A rising rate environment driven by a burst of inflation would likely put upward pressure on home prices and benefit non-agency mortgages.
Local currency emerging market instruments could possibly be used to diversify duration, or interest-rate, risk; and, in contrast to developed market currencies, many emerging market currencies appreciate in response to inflation.
Currencies of commodity exporters could likely perform especially well against the commodity-importing currencies, such as the euro, US dollar, sterling or yen, should any of these economies be threatened with inflation and rising commodity prices.
Global bond strategies typically have the capability of reducing duration below the benchmark. PIMCO’s Global Bond Strategy has the flexibility to reduce duration well below its index.
More importantly, our strategy has no constraints on duration at the country level. If, for example, inflation was rising in the US but not yet a threat in Europe, our global strategy could potentially be to void US duration, shifting instead to, say, German duration.
As the market digests the probability of rising rates and central bank reactions, different parts of the yield curve would typically react differently.
Thus, yield curve strategies – focused on finding the part of the yield curve that has priced in the largest increase in policy rates – could potentially play a significant role.
And of course, selling nominal government bonds in favour of inflation-linked bonds can help prepare portfolios for rising inflation.
Investment conclusions
To come full circle, what are reasonable return expectations coming into the fifth year of the New Normal, a landscape defined by an exceptionally challenging combination of tempered global growth, hyperactive central bank intervention in financial markets and elevated systemic risk?
Our base case is that beta returns will be muted and alpha returns will play a much larger role in portfolio performance than they have historically.
In our view, the key to achieving alpha in this environment is the flexibility to pursue many different sources of added return potential as events unfold.
Olivia Albrecht and Michael Story are product managers and John Valtwies is a portfolio specialist at PIMCO.
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