The Case for Core-Plus

Coverage of the 2012 Risk Management Conference.

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two road uncertain directionWe are currently in the midst of an environment of super low interest rates, where Central Bank easing continues through the use of both traditional (monetary policy) and non-traditional (QE and Operation Twist) methods. The central problem with low rates is a lack of sufficient compounding, especially when compared to many liabilities which are growing at an unrelenting pace. As such, the key risk currently facing fixed income investors is not that interest rates may rise quickly. In fact, higher rates is something they should hope for, particularly if they rise as a result of job creation, productivity and GDP growth (i.e. real wealth creation). Instead, the key risk is that low interest rates could persist for a long period of time. This could turn out to be the inconvenient truth. Given the uncertainty about the future of interest rates, core-plus deserves some consideration.

A core-plus approach uses multiple asset classes as a means of true diversification in order to replicate the risk of a core portfolio, or whatever liability you are mimicking, but with more total return opportunity. Core-plus offers investors a way to stretch for yield, targeting between three and four per cent, while keeping overall risk very near your traditional habitat. Core-plus has three key potential opportunities to add value for investors:

1)    Added yield from the use of “plus” sectors.

2)    Diversification, or negative correlations.

3)    Tactical allocation to move the portfolio where the puck is heading.

The core-plus menu includes a base of investment grade debt, including government securities, corporates, mortgages, and other securitized debt.  It then mixes in plus” sectors through high yield, leveraged loans, emerging markets debt, international debt, and then a blend of one-off illiquid yield investments such as private placements, structured product sectors such as non-Agency US mortgages and lower quality commercial real estate.

These additional “plus” sectors can be especially important for Canadian fixed income investors who want to gain access to markets outside of Canada with greater yield and return potential. While Canada has a mature and well-functioning bond market, it is relatively small on a global scale:  it represents less that 3% of the global bond market. A core-plus portfolio can offer access to a much broader opportunity set available away from home.

Increased opportunities for return and yield are not the only reason to invest outside of Canada, however. The diversification benefits of core-plus also involve greater overall stability as the different fixed income assets included in core plus respond differently to changes in interest rates, inflation and economic and credit conditions.

Finally, valuations in fixed income markets can change significantly over time, which can present opportunities to adjust portfolio allocations accordingly as market leadership changes across assets classes in fixed income.

In summary, given the current economic and interest rate backdrop, Canadian fixed income investors may be faced with a “low growth, low yield” environment for some time to come. However, opportunities exist outside of Canadian-only sectors that can provide investors with incremental yield, diversification and the potential for greater returns. A core-plus strategy can be used to achieve this. Given the significant differences in performance that can occur across fixed income sectors, a tactical approach can increase returns while keeping risk low as valuations change over time.

Jeff Moore, CFA, is fixed income portfolio manager, Pyramis Global Advisors

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