What's in Your Fixed Income Allocation - Core vs. Core Plus Bonds
Investors allocate to fixed income to accomplish a variety of objectives. Those objectives include diversifying risk from return-seeking asset classes, matching liabilities, generating income, and providing liquidity. It is important to understand how the allocation within your fixed income portfolio may perform through different market environments.
This paper looks at some of the similarities and differences between Core and Core Plus Fixed Income managers and discusses some of the reasons why Core Plus mandates might be favoured for investors who can tolerate higher tracking error and less liquidity than a traditional Core mandate.
Core vs Core Plus
The base of a fixed income allocation is often the core bond manager. Unfortunately, the term “core bonds” is often used to describe everything from pure investment-grade managers that stick closely to the FTSE Canada Bond Indices to more aggressive managers who have discretion to enhance returns through active management strategies, such as interest rate anticipation, credit, liquidity, etc.
A first step to understanding these mandates is to understand their benchmark. The FTSE Canada Universe Bond Index (Universe Index) is intended to be a broad measure of the performance of the Canadian dollar-denominated, investment-grade, fixed-rate bond market. There is a lot to unpack in those words – what do they mean? In general, the Universe Index includes four broad sectors – Canadian federal government bonds (35% of the Universe Index), provincial government bonds (35%), municipal bonds (2%) and corporate bonds (28%). While that may seem comprehensive, in fact, a large share of the Canadian fixed income market is not in the Universe Index. The Universe Index excludes any issue that is floating rate, inflation protected, non-investment grade or unrated, residential or commercial mortgage-backed securities, other monthly pay or pre-payable, convertible, or securities that have less than a year to maturity. Additionally, included bonds are subject to issuance size limits that vary by the type of bond. The issuance size limits most dramatically impact the securitized credit market, which has more small issues than the government and corporate sectors.
Often lumped in with “core” mandates, is what has come to be known as “core plus” mandates. Core and core plus managers have important similarities and differences. An important similarity is their benchmark. The majority of managers in each category benchmark themselves to the Universe Index. An important difference is how these managers invest relative to the Universe Index. Their investment approach may differ significantly across sector rotation, security selection, and/or duration management, as well as how aggressive their alpha and tracking error targets are. The typical gross benchmark excess return target for core managers is 50 basis points (bps) with tracking error of 100 bps. For core plus, the excess return and tracking error targets are typically 75-125 bps and 100-200 bps, respectively.
Portfolio Tilts and Out-of-Benchmark Exposures
The types of trades managers use can vary dramatically both across and within core and core plus mandates. In general, core and core plus managers approach the non-benchmark sectors differently. An erroneous assumption is that when mangers go outside the Universe Index, they are adding risk to the portfolio. A truer risk assessment is evaluating the specific securities being purchased and excluded.
For example, adding Real Returns Bonds increases tracking error as they are non-benchmark securities, though they are lower risk than equivalent duration nominal government bonds due to their eliminating the risk of unexpected inflation. While highly rated non-benchmark credit may add spread and volatility risk over government bonds, the allocation has the ability to reduce risk if it replaces lower rated credit.
With a higher tracking error allowance, core plus managers will typically be more aggressive in search of alpha. A partial list of non-benchmark securities for core plus mandates can include global credit, high yield bonds, senior loans, global rates and currencies, private debt, emerging markets debt, and mortgages. Core plus managers are often also more aggressive within the benchmark and can be more opportunistic in making duration and yield curve trades.
In addition to the differences between core and core plus, within each of those categories managers can run very different portfolios. Certain managers may focus on a specific sub-set of the bond market based on their expertise – corporate credit for example. Others may concentrate on duration or yield curve management.
In the following two charts we illustrate the dispersion of the core and core plus investment manager universes on a risk/return basis. There can be meaningfully different levels of risk among managers.
Historical Risk and Return and Call to Action
While return and tracking error targets tell investors a lot about how managers approach risk and return, they are, of course, just targets. How do the targets match up to actual performance numbers? As noted in Table 1, over the last ten years to December 31, 2019, the Universe Index returned 4.31%. According to eVestment, the median core bond manager returned 4.61% gross of fees while the median core plus manager returned 5.04% on the same basis. For core plus managers, historical performance largely aligns with the lower end of the excess return expectations for the category, while traditional core mandates have tracked below their target excess return expectations. In recent years, as bond yields have continued to drift lower, and credit spreads narrowed for corporate and provincial bonds, core managers have had a more difficult time in finding sources of alpha. While the same environment was present for core plus managers, the broader tool box they are able to access has allowed them to continue to find compelling investment ideas and track closer to value-add targets.
Due to the more aggressive nature of core plus managers, we would expect them to underperform the Universe Index and core strategies when equities decline strongly. A good example of this is the fourth quarter of 2018, which saw a sell-off in riskier assets. During this period, the median core plus manager trailed the median core manager, and both trailed the Universe Index. However, in the first quarter of 2019, which saw a meaningful rally in risk markets, those performance numbers were reversed, with core plus leading the pack. The same performance pattern occurred during the financial crisis. Volatility, in general, is higher for core plus managers, although on a longer-term basis (10-years), both groups have exhibited index-like volatility (see Table 2). The exposure to riskier assets is the primary reason for this performance pattern.
For investors, where to allocate on the core/core plus spectrum requires thoughtful consideration. We believe that fixed income is an attractive segment for active management with a wider set of opportunities, as active managers can profit from illiquidity premiums and profit from taking the other side of market movements driven by investors motivated by factors other than fundamental value (e.g. hedging liabilities and regulatory requirements). As a result, we tend to favor core plus mandates for investors who can tolerate the tracking error and liquidity.
With financial markets seeing a sharp rise in volatility through the first quarter of 2020, major headlines have focused on equity market sell-offs, however, fixed income markets have not gone unpunished, despite positive overall returns. Credit spreads across most segments widened substantially, rating downgrades occurred, and investor demand within the illiquid fixed income segment faded. While we believe these conditions are representative of real risk being priced into markets, we also believe this environment presents opportunities for managers with greater discretion to add value.
If investors haven’t recently reviewed their fixed income strategy, now would be a great time to do so.
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