ARTICLES OF INTEREST

Bond Premiums: Guide to Yield-Enhancing Strategies

by Jafer Naqvi, CFA, Vice-President, Fixed Income & Multi-Asset, Greystone Managed Investments

Investors are increasingly seeking solutions for enhancing bond yields in today’s low interest rate environment. New solutions, encompassed within a broad range of naming conventions such as unconstrained bonds, absolute return, core plus, global credit, private debt, are but a few of the new-age strategies. At their heart, these strategies are a blend of four, long-standing bond risk premiums that have always existed as fundamental pillars.
 
  1. Duration Premiums: examples include global bonds, extending term
  2. Credit Premiums: examples include domestic corporate bonds, high yield, global credit, emerging market debt
  3. Convexity Premiums: examples include selling options
  4. Private Debt Premiums: examples include enhanced returns from investments not traded in capital markets
While leverage has the potential to enhance returns for any investment, prudence suggests a strategy must stand up on its fundamental merits before applying leverage.

Most sources of fixed income yield are bucketed as one of the four fundamental premiums. For investors, the key is to understand how the premiums are packaged into new bond solutions. This is all the more important as the shorter term track record of strategies may hide the true risks that arise from different bond premiums.

Using Credit to Understand Relative Value and Risk

At various stages of the economic cycle, the fundamental premiums can witness relative attractiveness or overpricing of their value. Credit relative value can be evaluated by analyzing the premium (or spread) that is provided above government bonds. The higher the premium the more return provided per unit of risk. Looking at the cross-section of global credit sectors shown in Figure 1, credit premiums appear expensive relative to history. Investors may have a market outlook that justifies a high allocation despite current valuations relative to historical, but it is important to evaluate credit against other premiums available.

 
Figure 1:



Equally important is the risk side of the equation when analyzing the attractiveness of bond premiums. In Figure 2, we can see that the higher yield associated with global credit sectors has historically increased the equity-like risk of a fixed income portfolio. As a result, diversifying credit risk within the bond portfolio does not necessarily equate to diversifying risk on a total portfolio level, when including equities.

Figure 2:



Cross Section of Bond Premiums

A similar analysis of relative value and risk for the other bond premiums can provide investors with a snapshot of what today’s fundamental bond premiums provide from a risk and return perspective, shown in Figure 3 below. The correlation to equities provides an analysis of each premium’s return stream and its connection to stock market returns. Relative value assessment reveals if the measure is above or below its average since inception of the measure.

Figure 3:
 
 Yield Factor  Source  Premium
 (%)
 Correlation To
 Equities
 Relative
 Value to
 History
 Absolute Yield  10-yr Canada  1.0  Uncertain  -
 Long Duration  Long vs. 10-yr Canada  0.5  Uncertain  +
 Global Duration  G7 Long Hedged vs. Canada
 
 0.4  Uncertain  +
 Corporate Bonds  10-yr Canada Corporate vs.
 10-yr Canada
 1.3  High  +
 Foreign Credit  Foreign IGC less Canadian IGC  0.0  High  -
 High Yield  High Yield less Canadian IGC  4.0  Very High  -
 Emerging Markets  EM less Canadian IGC  3.0  Very High  -
 Convexity  US Agency MBS vs. US Agency Yield  0.4  High  -
 Private  Custom Real Estate Debt Portfolio  0.5 to 2.0  Low  +

We have seen bond premiums collapse across the board relative to history. Of note however, is that certain private market premiums appear to remain attractive relative to history, while also exhibiting a lower correlation to equity markets.  There are, however, additional considerations when investing in private debt markets.

Beware of Blended Private Premiums

Private markets can provide return enhancing and risk mitigating benefits, but also provide a potential transparency challenge. Private debt is a broad label that can cover a myriad of strategies. Strategies labelled as private debt can provide liquidity premiums but can also blend other bond premiums, resulting in a wide range of risk-adjusted return expectations.

In Figure 4 below, we examine how the fundamental fixed income premiums can potentially roll up into different strategies labelled as private debt. Higher-yielding private debt strategies do not necessarily equate to a higher private premium. Often investors may be gaining yield from moving down the credit spectrum or through extending duration. While this may provide enhanced yields, investors should understand if accessing credit or duration risk is desirable and cost effective through their private debt allocation. When leverage is applied to a private debt strategy, investors should also understand if the additional risk is desired from a total portfolio perspective.

Figure 4:



Conclusion

By understanding the relative value and risk across fundamental bond premiums, investors will better position yield-enhancing strategies within multi-asset portfolios. While it may be desirable to enhance yields through credit risk, understanding the connection to other risky assets can help investors better position themselves in the event of future market sell-offs. One of the benefits of disaggregating risk factors is the ability to combine duration, credit and private premiums at appropriate levels, minimizing unintended exposures.

   

 
    Jafer Naqvi, CFA
    Vice-President, Fixed Income & Multi-Asset
    Greystone Managed Investments





 
Jafer Naqvi is Greystone’s Vice-President for Fixed Income and Multi-Asset solutions. Jafer joined Greystone in its Toronto office in 2012. His internal responsibilities include serving as a member of the Fixed Income team, Asset Strategy, Client Strategy and the Marketing Leadership Team in which he acts as the primary liaison between Marketing and the investment teams. Externally, he has marketing, client service and research responsibilities, working with clients and the investment/consulting community to ensure they are well informed regarding Greystone’s fixed income and multi-asset capabilities.
 
Jafer has over 10 years of industry experience working in fixed income, multi-asset consulting and investment solutions development. Prior to joining Greystone, Jafer was Vice-President, Product Specialist, with Pacific Investment Management Company (PIMCO) where he was responsible for Canadian product management. Prior to that, he was an Investment Analyst and later a Manager Research Consultant with Hewitt Associates (now Aon Hewitt).
 
Jafer holds a Bachelor of Business Administration Degree (Honours) from Wilfrid Laurier University and is a CFA charterholder.