So far in our Investing in Global Bonds series, we have demonstrated that there are many potential advantages to adopting a global perspective when it comes to the fixed income opportunity set. However, establishing the case for an allocation at the investment policy level requires more than a favourable historical profile as a standalone asset class. Institutional investors manage multi-asset portfolios that are designed to support specific objectives, some of which are not wholly based on investment returns. Furthermore, making investment policy decisions by looking through a rear-view mirror can potentially result in the creation of portfolios that are ill-suited for the future environment. Therefore, the purpose of this article is to examine the potential role of a global fixed income opportunity set in institutional portfolios by considering a forward-looking, objective-oriented context.
Investing in global bonds part I, II, and III: Key takeaways
- Institutional investors tend to have a strong home country bias in their fixed income allocations, potentially resulting in unintended constraints, biases, and risks.
- A global perspective provides meaningful diversification opportunities by gaining exposure to different economic, fiscal, inflationary, and demographic environments.
- Different segments of the global fixed income landscape are characterized by varying degrees of interest rate and credit risk, resulting in different risk/return characteristics.
- Managing currency risk is a critical part of investing in, and realizing the potential benefits of, global bonds.
Background
Institutional investors typically have very specific objectives associated with the pool of assets under their care, for which they often act as fiduciaries. An endowment fund, for example, is typically interested in achieving a long-term return that will support its inflation-adjusted spending commitments, while preserving capital during short-term downside events – in other words, they are investing in an “asset-only” context. A pension fund, on the other hand, is typically most concerned with the performance of its assets in relation to its liabilities, which can result in a myriad of different objective-oriented trade-offs, from closing a funding gap to total liability defeasance – they are investing in an “asset-liability” context. Therefore, when it comes to making long-term strategic decisions, such as introducing a new asset class into the investment policy asset mix, it is critical to evaluate the risk/reward trade-off through the correct lens. It is also important to evaluate the decision at the total portfolio level, where the different asset mix exposures interact with each another to support these risk and reward objectives.
Strategic vs. operational decisions
As illustrated in Figure 1, setting investment policy is a decision that is strategic in nature. An example of such a decision would be determining the broad asset class exposures that are expected to best support the investor’s long-term objectives, such as the amount of fixed income, equity, and alternatives in the policy asset mix. This is in contrast to an operational decision, such as choosing between multiple implementation avenues that involve different considerations; for example, the amount of target added value over a policy benchmark. While these types of operational decisions will ultimately impact overall outcomes, they are a separate consideration from long-term policy decisions. We therefore do not consider implementation in analyzing the potential benefits of global fixed income at an institutional investment policy level in this article.
Figure 1: The fiduciary governance cycle
Source: PH&N Institutional
The challenge universally faced by institutional investors is that while the future capital markets environment is unknowable and fraught with risks, decisions must be made in real time despite the uncertainty. Forward-looking portfolio modelling can be a very powerful source of information to assist with this type of strategic decision making, but requires making assumptions about the future risk/return profile of different asset classes, which can be very different from what might have been observed over historical periods. These parameters are often referred to as forward-looking capital market assumptions (CMAs).
While a set of CMAs will inevitably be influenced by subjective views that can vary among investors, a consistent and robust methodology will tend to produce credible information that supports sound decision making and governance. Furthermore, while CMAs will change as markets evolve, views are revised, and new information is acquired, certain characteristics related to the fundamental nature of the asset classes remain relatively stable across time.
For example, Figure 2 illustrates PH&N Institutional’s quarterly forward-looking CMAs on Canadian universe bonds and global high yield bonds over the past five years. While infrequent periods of market extremes can have a material impact on a forecast at a specific date (e.g., onset of the pandemic in March 2020), the relative return differences exhibit a certain stability through time. High yield bonds are fundamentally characterized by higher spread risk, producing more volatility but also a return premium relative to investment grade bonds. Despite the changing level of the return premium based on refreshed information and views, forward-looking portfolio modelling will typically always reflect this fundamental characteristic of high yield.
Figure 2: PH&N Institutional capital market assumptions (2016-2021)
Source: PH&N Institutional. Please refer to the full PDF for information about our capital market assumptions. There is absolutely no guarantee that future performance will occur according to any ex-ante expectation.
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