Times are changing in the Canadian fixed income market. To drastically oversimplify, the proportion of Government bonds in the market is decreasing and the proportion of corporate bonds is rising. The changing structure of the market is causing gradual but significant changes to the structure of portfolios and the management process around them. We need to ensure that our philosophy, strategy, and management processes are in step with, if not ahead of, the environment. The key element is the increasing role of credit in the final outcome--the ability to meet or exceed portfolio objectives.

The change in the TSE 300 in 1999 is a rapid example of what may happen in the bond market over the next five to 10 years. With the sharp change to the index in what many argue is an unsuitable direction, there is renewed debate on the nature of a benchmark. It is still not clear what the outcome will be. In the fixed income market this change is occurring more slowly, which gives us the opportunity to be ahead of the change, rather than behind.

Benchmarks
A benchmark encapsulates the risk/return trade-off required for a particular investment. There will usually be a range of suitable benchmarks that satisfy the risk/return trade-off desired. In the United States there are thousands of different benchmarks one could adopt for a fixed income portfolio. The number is fewer in Canada, but growing.

Many of these benchmarks have one common factor: a structure that generally follows the structure of the overall market. There are reasonable, but far from overwhelming, arguments that such a structure would be most suitable for a neutral position for a portfolio.1 Some of the questions that make us doubt the wisdom of always using this market structure as our neutral position are these:

* Why let the markets dictate your investment style? If proportionately more corporate bonds appear, then is it appropriate to invest in more corporates with no active decision?

* If governments and corporations start to issue bonds with longer maturities2, the benchmark will follow and so will the portfolio. Is the consequent duration suitable to match liabilities?

Risk/return trade-off
What are some of the changes that may flow from an increase in the proportion of corporate bonds with their associated credit risk?

There will most probably be an increase in return for a market-based benchmark. If the weighting of A-rated bonds increases by 20% at the expense of governments, then the rise in return will be about 20 basis points (bps) per annum. For this not to occur, rates would have to shift downward by the same magnitude.

The impact on volatility isn't as clear. An increase in overall volatility of returns may occur due to the greater weight that the volatility of the spread will have on the volatility of the whole market. However, this potential increase has an offset; for corporate and government bonds of the same maturity, the corporate bond will have lower duration than government bonds because of its higher coupon and higher yield with which to discount future cash flows. The trade-off between spread volatility and duration shift will determine the consequent change in the volatility of the market.

Related to the volatility is the correlation of the asset classes within a diversified portfolio. A plausible effect would be closer correlation between equity and bond asset classes. When companies go bad in a recession, both their bonds and their equities decline in price.

Most significantly, there are multiple portfolio management implications of an increase in credit risk for these broad benchmarks.

Implications
In a diversified portfolio there will be an increasing exposure to corporates overall, from both equities and bonds. More thought will need to be given to the exposure to any single company or group of companies when bonds and equities are combined.

The increase in credit risk is of greater importance because more of the behaviour of the bond portfolio will be determined by the behaviour of relatively heterogeneous individual assets--the main source of heterogeneity is credit risk. Previously the bond portfolio was dominated by the homogeneous government bonds, which primarily differ just by duration.

The portfolio management group has to be equipped to handle new or more demanding research. For active mandates, there has to be the ability to fulfil a larger forward-looking credit research, selection process, and portfolio construction process than previously if value is to be added to the returns. As passive mandates do not fully replicate the benchmark, they too are subject to increasing credit risk in the form of negative tracking error arising from the specific selections made.

Endnotes
1. Fischer Black and Bob Litterman give a good summary of the argument in "Global Portfolio Optimization" in Financial Analysts Journal--September-October 1992.

2. There is always the chicken and egg argument here; perhaps the issuers are responding to price signals that say investors want more product in these areas.

Frank Ashe, Ph.D., is senior advisor, market risk management at Elliott & Page in Toronto.