How Risk Return Relative Value Approach Helps Create Higher Alpha for Global Credit Portfolios

Published on 31 Aug, 2016

Credit Portfolio Management Advisory

Security selection for a Fixed Income Investment portfolio is a critical task in the entire portfolio management process.

In contrast to the conventional top-down approach, the Risk Return Relative Value approach offers an alternate investment screening mechanism that helps generate higher returns for investors.

With global markets increasingly integrating and central banks’ role in managing monetary cycles changing, the Bond Investing dynamics have been transforming over a few years. The traditional dependence of bond yields on interest rates and macro-economic factors have now advanced meaningfully to include credit specific risks, demand supply dynamics, corporate cycles and default probabilities.

Security selection for a Fixed Income Investment portfolio is a critical task in the entire portfolio management process. Global asset managers employ various approaches to facilitate this. In fact, a most of the firms follow a top down approach to identify the economies and sectors they are overweight on, and then select appropriate credits from the universe.

However, we are now witnessing contrasting approaches to the Bond Investing styles.

Conventionally, a Fixed Income Portfolio Manager invests a portion of funds to fixed income instruments by selecting a bond issue or choosing a fixed income fund within the sectors and asset classes screened using top down approach. Such investments aren’t timed to generate incremental returns, and the Manager remains contented with the YTM offered by the investments during the time of investment.

In contrast, a Global Portfolio Manager initiates a relative value screening of the global bond universe, even before over-weighing the sectors and asset classes. The idea is to generate global credit opportunities, which offers the most compelling investment proposition – similar or higher returns at lower risk. The Portfolio Manager subsequently chooses which issues to invest in—by carefully considering the macro cycle and monetary policies. It is in this stage of the screening process that the Portfolio Manager decides on specific sectors to invest, duration of the investment, and the appropriate exit strategies.

While both the approaches consider relative value analysis at some stage of the investment screening process, the latter reflects an aggressive and active approach to screen attractive investment opportunities amidst currently volatile markets. We know this approach as Risk Return Relative Value approach.

While there are pros and cons of both the approaches, we believe the Risk Return Relative Value approach enables a detailed screening of the global credit universe, thereby offering attractive spread pick up opportunities to Global Fixed Income Portfolio Managers. Given the lower or negative yields in majority of developed markets, we believe this approach can assist Global Portfolio managers to effectively screen relevant investment opportunities in EM debt space.

Let’s try to explore in detail this second approach to draw an analogy, and figure how the better set of investment screening processes help generate higher alpha in global credit portfolios.

How Does the New Approach Work Better?

The Risk Return Relative Value approach seeks to find attractive opportunities in the global markets through drawing a meaningful comparison between risk and return profile of the bond universe. For example, a Portfolio Manager starts by screening BB+ to BB- rated corporate credits and plots a scatter chart by comparing modified duration to YTM of the investments to invest in high yield corporate debt. He selects the securities based on the risk reward dynamics. Given the large number of entries that he will generate, he filters the list down by eliminating sectors he does not want to invest in, or regions he thinks are too risky for the value proposition.

From the shortlisted securities, the Portfolio Manager takes valuation calls on the securities, duly supported by a Fixed Income Research team. He is interested in the spreads of the bonds versus the duration and risk ratings. The Research team helps draw specific conclusions on the fair value of spread vs. the risk and business cycle, and therefore draws an initial conclusion on the mispricing of securities.

This approach screens through the asset classes and securities with a global market view, and thus eliminates the chances of missing out on attractive mispricing opportunities in the global credit markets. The Research team thoroughly researches on the credits that look undervalued or overvalued upfront, and then shares relevant insights with the investment committee. The specific investments and entry and exit strategies are decided based on the Investment Policy Statement and the Portfolio mandate.

We believe the Risk Return Relative Value approach works well for global portfolio managers in conditions where the investment opportunities are skewed toward certain markets. For instance, a Portfolio Manager who does not want to invest in Russian markets due to sovereign specific risks might ignore the entire Russian credit universe in the traditional selection process. However, in the Risk Return Relative Value approach, he might select specific Russian credits, which are least likely to be prone to sovereign specific risks, and offer attractive spreads picked up over similarly rated developed market credits.

As a result, the Global Fixed Income portfolio becomes more dynamic and works with relatively more deep dived approach to security selection in Fixed Income Portfolio management process.

Ironically, the Relative Value approach hasn’t yet pervasively replaced the traditional approach. Top down approach still holds a place across the desks of many portfolio managers.

However, given the risk reward spectrum and market dynamics, several Portfolio Managers have started adopting the innovative approach to security selection in credit portfolios to generate higher returns for investors.

In our view, the Risk Return Relative Value approach not only enables the experts to screen relevant investment ideas globally, but also assists in devising an appropriate exit strategy based on the risk reward matrix results. This, evidently, results in a high market focused and dynamic credit portfolio management.


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