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Bonds As A Source Of Alpha
Retaining a focus on the fixed-income market, but looking to the excess return or alpha side of the equation, high-quality fixed-income strategies may be an excellent alpha source when paired with higher-risk market exposures (i.e., equities, commodities, etc.). The generally low correlation of high-quality fixed-income assets to higher-risk assets may result in risk-reducing diversification. Higher-quality, diversified fixed-income strategies may also impart important capital preservation and liquidity characteristics along with structural return advantages. Finally, compliments of the painful de-leveraging and extreme market dislocation, high-quality fixed-income yields outside of the Treasury sector are currently at extraordinary levels by most measures—relative to history, relative to LIBOR and relative to the apparent downside risk.
As was seen in 2008 and based on other periods of equity market decline, high-quality segments of the bond market have tended to perform relatively well. Looking across asset classes and across investment strategies during periods of financial market stress—for example, when the equity market is experiencing a material price decline—many investments exhibit a high correlation with equities. The exception is often high-quality segments of the bond market, which typically benefit from a flight to quality during such periods. The end result may be capital preservation, liquidity and the potential for excess returns when needed most. This may serve in sharp contrast to portable alpha strategies that often source alpha from riskier investment strategies that may exhibit a materially high correlation with equities during periods of equity market stress.
Importantly, unlike equities and other investments, from an investor’s standpoint, bonds have the structural benefit of eventually returning the capital invested (at par value) unless the issuer defaults. Therefore, yield tends to be a reasonable indicator of return over longer periods of time for high-quality fixed-income investments and portfolios. While the shape of the yield curve and yield spreads relative to money market instruments may vary over time, the end result is higher potential returns relative to money market rates across most market environments. In today’s market environment, of course, the levels of yield provided by even the highest-quality, non-Treasury fixed-income securities are compelling.
Portable Alpha Is Alive And Well
2008 represented a noteworthy test of portable alpha strategies, particularly for those employing lower-quality, less liquid and/or leveraged investment strategies in the alpha portfolio. The year also highlighted the importance of counterparty, investment and operational risk management of portable alpha programs.
Looking forward, what seems almost certain is that investors will demand transparency both in terms of the risk exposures in the alpha strategy and the collective portable alpha approach—and invest only in strategies where they have a good understanding of the combined risk exposure, the associated investment rationale and also the downside risk over their investment horizon. The end result may be that investors migrate out of some types of portable alpha strategies and into others.
The fundamental value of portable alpha is still very much alive and well—and approaches that meet key criteria as highlighted in Figure 5 are likely to provide powerful results to long-term investors prospectively, from both return enhancement and diversification perspectives. In particular, given the extraordinary level of yield premiums available from very-high-quality fixed-income assets currently, investment-grade fixed- income-based collateral alpha strategies may provide long-term investors with attractive returns in the coming years.
This article contains the current opinions of the authors but not necessarily those of Pimco.
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