While fixed income has long had the reputation of being the conservative and stable supporting partner in the traditional balanced portfolio, unbundling fixed income into its sub-components presents opportunities for enhanced risk-adjusted returns, said Aaron Young, vice-president and client portfolio manager at CIBC Asset Management.
When investors buy the FTSE universe bond index or even a corporate bond index, interest rates dominate both the return and volatility profile, he said during Benefits Canada’s 2023 Defined Contribution Investment Forum in late September. As an example, he referred to Bloomberg Canada’s corporate bond index, which saw a total return of 6.97 per cent over the past 10 years, with 68.3 per cent of the return coming from interest rate risk and 31.7 per cent from credit spread risk.
“We think that’s where there are interesting opportunities to start breaking down this total bond package and . . . get a bit more precise with how we do our fixed income allocations.”
Young suggested credit be considered its own asset class, distinct from both traditional fixed income and equities and deserving of its own exposure, given its ability to generate excess returns above the risk-free alternative and its unique risk exposure that can’t be diversified away. “This really goes against the narrative that it’s equity versus fixed income. I would argue that if you break down your classic balanced portfolios, you really have interest rate risk, equity risk and you have an interesting pocket in the middle, which is credit risk.”
While he noted interest rate exposure has its place in the portfolio, it’s “highly unpredictable and driven by players who are a bit more non-economic,” such as pension plans looking to hedge their liabilities at any price and central banks exerting influence over interest rates and yield curve pricing.
Meanwhile, the equity markets are a “highly efficient asset class [where] it’s really hard to add value,” said Young, pointing to 10 years of data from eVestment that found the median passive manager in the U.S. large cap equity universe consistently outperformed the median active manager across every time horizon.
Corporate bonds and investment-grade credit — especially in Canada, the U.S. and Europe — is still an inefficient market, he noted. Credit managers can take advantage of market participants — such as central banks buying bonds during the coronavirus pandemic and liability-driven investors looking to hedge their long exposures — and benefit from the old-school, opaque fixed income market structure. Credit also sits within all elements of the portfolio — from high-yield emerging market debt to mortgages, infrastructure debt and distressed and venture debt.
CIBC has been working with its plan sponsor clients to remote interest rate risk and determine what return profile they’re producing if credit risk is isolated. Giving the example of a five-year Enbridge Inc. bond, Young broke the bond down into its two components: the five-year Government of Canada bond and the credit spread Enbridge would get paid because of its credit risk short to the bond.
While credit spread risk on its own is a lower return profile, he noted plan sponsors can gain access to it with a prudent amount of leverage. “Even [with] our most sophisticated clients that we talk to, leverage is the four-letter word that no one wants to hear about, especially when it’s outside of just duration management. [But] we would argue, in this case, applying leverage to that pure credit exposure is actually lower risk than what you get when you go with a passive [exchange-traded fund] for the Canada corporate bond index.”
Comparing that index to owning pure spread exposure at 1.5-times leverage, Young found the latter had significantly lower volatility than traditional bond holdings over most of the past 25 years.
Pure credit exposure essentially creates a hybrid asset class, with equity-level returns but volatility similar to Canadian corporate bonds, he noted. For example, when CIBC experimented with adding pure credit exposure at a five per cent interest rate to a median conservative income portfolio, a moderate growth portfolio and an aggressive growth portfolio, it demonstrated “distinct and complementary exposure.”
In the conservative income portfolio, pure credit risk resulted in a higher return and lower. volatility; at moderate growth, volatility was reduced and the return was flat; and in the aggressive growth portfolio, the volatility was lower but returns took a minor hit.
Read more coverage of the 2023 DC Investment Forum.