Can You Have Too Many Bonds?

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When you’re transporting eggs, it is advisable to spread them between plenty of baskets in case one takes a tumble. But have you thought about carrying fewer eggs in the first place and leaving them where they are?

Research reported by aiCIO two months ago supported the idea that a concentrated equity portfolio performed better than a more-diversified one. We wondered if it would be the same with bonds. If so, were active managers really earning their fees for doing less work-or are they worth it for the returns?

24 Asset Management, a UK-based boutique active bond manager with approximately £2 billion ($3 billion USD) under management, supported the “concentration” theory.

“Due to the well-known liquidity constraints in fixed income, as funds grow in size they have a natural tendency to have more holdings. However, this places further pressure on the manager as they are less able to generate alpha from their stock selection,” says 24AM chief executive Mark Holman.

Big managers must give up some of the bottom-up value and have better top-down skills, Holman continued. If you have a £10 billion active bond portfolio, you can’t just invest where you like—you have to maintain a number of core holdings, making you slower to react to opportunities.

Is this small bond fund manager talking up his own book? Draw your own conclusions: 24AM’s Dynamic Bond Fund typically has between 50 and 75 different positions, and in the last two years approximately 300 basis points per annum of return has come from security selection.

It’s an interesting argument, particularly during a period where bond returns are at historical lows, and active managers who churn their portfolio in the search for alpha could see their fees eat away any returns they make for investors.

Asset-allocation decisions are at the heart of active bond investment, says Brigid Jackson, fixed-income product specialist at Legal & General Investment Management. But these decisions don’t have to come thick and fast.

“As an active manager, you don’t necessarily have to churn the portfolio, but for those with higher turnover strategies, you should look for cheaper, undervalued stocks.” she says. “You’re looking for something that’s 50% to 70% of par really-18 months ago there were a lot of subordinated bank bonds that we bought at around 60% or 70% of par that are now up to 80% of par.”

That sounds like “buy and hold” to us, which doesn’t rack up too many fees. But there is another way that active managers earn their keep, according to Nick Gartside, international CIO of global fixed income at JP Morgan Asset Management: making decisions about how to achieve the right balance of duration risk, default risk, and spread risk.

Hunting out quality is both an art and a science, according to active bond managers. Finding a company, examining and getting a feeling for it is the art; measuring it against what else is in a portfolio—and elsewhere in the market—is the science.

“Historically, fixed income has been managed relative to a benchmark, and it is still important to do this against a macro backdrop of tepid recovery, where there will be a big gap between the top- and bottom-performing bonds,” says Gartside. “But you also need to manage your benchmark.”

This “science bit” is not as easy as it sounds. The problem: Fixed income benchmarks are composed of debt in a world where there is too much of it. Because of this, bond benchmarks reward bad behaviour: If a company issues more debt, its weighting in the benchmark goes up, but its creditworthiness goes down. Investors can end up allocating more to a credit of declining quality if they are unaware of this seesaw effect.

Enter the active bond manager.

“Clients need to grab the benchmark and toss it away, liberating managers and allowing them to allocate to wherever there are opportunities, using an approach that is blind to sector and to geography,” says Gartside.

And make a smaller number of bond purchases to keep churn costs down and stay nimble? Gartside, whose unit manages more than $812 billion, thinks not.

“In a bond portfolio, you still want an element of diversity. This goes to the heart of what a bond is: namely, a debt instrument that pays you an annual interest payment and then the amount you invested when the bond matures. The risk profile is therefore asymmetric. Your upside is limited to getting your principal back, and your downside is that this can fall to zero if the issuer defaults. Therefore, we would advocate diversification in terms of numbers of bonds held in a portfolio.”

So the big guys want investors to think big, and the small ones urge you to think small. If any curious reader with a billion-dollar bond portfolio would like to try out both and let us know his or her thoughts, we’d be very interested to hear them. —CT