IN PRINT ARCHIVE CIR Winter 2007
By Raman Srivastava, managing director, portfolio construction and quantitative research, Putnam Investments
While global bonds offer Canadian plan sponsors some diversification benefits from an interest-rate or duration perspective, an equal, if not greater, opportunity exists for skilled fixed income managers to exploit specific security mispricing of credit, prepayment, or liquidity risk. The key to unlocking value across the fixed income opportunity set lies in in-depth security expertise, diversification across potential alpha sources, robust risk management capabilities, expertise in the use of derivatives, and greater guideline flexibility on the part of plan sponsors.
Security selection is an important part of the picture. Most fixed income opportunities exist outside Canada and outside of government bonds. The global fixed income market has become much broader in terms of investable, liquid sectors, and deeper in terms of sub-sectors and individual securities. Issuance has migrated from government-backed securities to bonds issued by corporations or securitized by mortgage payments or other cash flows. Sector experts can identify myriad security selection opportunities across credit, securitized, and global macro areas.
At the same time, generating alpha from a single sector or across multiple sectors, a robust portfolio construction platform should not only identify risks, but also quantify its volatilities, correlations, and likely portfolio interactions. Expertise in the area of derivatives is also an important factor since the derivatives market has evolved into a highly liquid and useful tool for skilled investors. Derivatives can be used to isolate opportunities, reduce risk, and expand security selection. Managers also need a thorough understanding of counterparty risk and a willingness to work with plan sponsors to help them understand the potential benefits of implementing strategies using derivatives.
One example of an effective use of derivatives would be to use them in combination with a portfolio of foreign bonds to outperform a Canadian bond benchmark. In this example, a plan would buy mostly foreign bonds and use interest rate swaps and currency forwards to manage duration and currency mismatch. This would allow for greater opportunities to add alpha, as the plan would have access to 100% of the global bond market rather than the 2% represented by Canadian bonds. Over the past six years, the Canadian interest rate derivatives market has more than doubled in size from just under CDN$1 billion to nearly CDN$2.5 billion, illustrating the growing liquidity of these instruments.
With an ever-expanding
opportunity set and the introduction of new tools, skilled fixed
income managers are able to pursue substantial alpha opportunities
on behalf of plan sponsors. To unlock the true potential of fixed
income, plan sponsors are wise to re-evaluate their managers’
skill sets, looking for in-depth global sector expertise, an emphasis
on multiple alpha-generating strategies, and sophisticated risk
management. And with greater policy flexibility, skilled managers
are empowered to more fully express their conviction in securities
they believe offer the highest alpha-generating potential.
To view Raman Srivastava's presentation, click here.