Defined Contribution

Finding alpha in today’s fixed income market

May 24, 2017
By BlackRock

Is there anything normal about “normalization?” The Fed may be “normalizing” by inching rates toward historic norms and getting ready to start unwinding its balance sheet, but the fixed income market remains in uncharted territory. What’s more, global competition for U.S. bonds and aging demographics further complicate today’s fixed
income market. 


Fortunately, as Bob Miller, head of BlackRock’s U.S. Multi-Sector Fixed Income team, suggests, complexity may create the opportunity to generate alpha. Plan sponsors willing to introduce or increase active management within their core menu bond funds may be rewarded with stronger risk-adjusted returns than strategies that simply stick with the Bloomberg Barclays U.S. Aggregate Index (the Agg). 

The structure and size of the fixed income market would seem to increase the possibility of alpha through security selection. Can you give us a sense of
the complexity?

Miller: This will give you an idea: The top 10 companies in the S&P 500 represent nearly 20% of the market cap. Those same companies make up only 1.2% of the Agg and have 362 different fixed income securities. Those securities may be denominated in different currencies, with different maturities and different underlying covenants associated with where they sit in the capital structure. 

What’s more, there's a large number of participants - such as pension funds, bank portfolios, reserve managers, central banks, et cetera - that have objectives other than maximizing income or mark-to-market returns. They’re investing to meet longer-term liability obligations or may be simply rolling maturities to maintain their presence in capital markets or foreign exchange market efficiency. That creates opportunities for alpha because they're not all profit-maximizing enterprises.

Why would that complexity help make the case for active management?

Miller: Where there's more complexity, there's more opportunity. The opportunity set for security-selection alpha is even greater when you consider the broad universe and the subsectors within fixed income, such as non-agency mortgage-backed securities or commercial mortgage-backed securities, collateralized loan obligations, asset-backed securities and so on. The intricacy of those structured products is sufficiently high that you don't necessarily have to pick the direction of rates or credit spreads. You can generate alpha by relative value within a particular capital structure.

Let’s consider some of the current themes in the fixed income markets, starting with monetary policy.

Miller: Monetary policy has changed dramatically in the last 10 years. The Fed has departed from its historic management of the overnight interest rate and effectively targeted the entire yield curve and financial conditions generally. When they hit the zero bound on short-term interest rates, they pursued balance sheet expansion, i.e. the large-scale asset purchase programs to drive longer-term rates down.

They were clearly trying to influence the entire structure of rates to levels lower than they would've otherwise traded given the underlying supply/demand equation, underlying growth and inflation fundamentals. This has made monetary policy implications much broader than at any time in my career. It also brings a whole set of potential inefficiencies to the curve that introduces risk, as well as security-selection opportunities.

Have low yields globally increased the appetite for U.S. bonds?

Miller: Fixed income markets have become very global. I recognize everybody knows that, but it's a simple, robust, durable point. Markets are no longer necessarily dominated by their local investor base. 10 years ago, what investors in other countries were doing was often interesting but not necessarily germane to the valuation of the U.S. yield curve. Whereas today, it's quite easy for a Japanese institutional investor to decide 10-year Treasuries look more attractive than 10-year Japanese government bonds and execute that trade efficiently.

That means the average domestic U.S. investor is competing for good quality yield denominated in dollars. This has happened at a time when the U.S. population is growing increasingly older, with a large proportion of the current population entering retirement. Their demand for safe, reliable income is increasing at a time when global yields are very low. The aging process in and of itself would have likely led to lower yields than historically observed for the same underlying level of nominal GDP growth.

Are these themes – monetary policy, global competition and an aging population – short-term or long-term drivers?

Miller: The demographic effect is going to be with us for a very long time. We don’t think the flow of global capital is going to diminish anytime soon, either. The central bank influence may go away at some point in the future, but it's with us at least for our typical investment horizon, if not multiple years past our investment horizon.

Where should a plan sponsor start if they are looking to get beyond the Agg by introducing some degree of active management?

Miller: There’s no shortage of options, including a total return approach and an unconstrained strategy such as BlackRock’s Strategic Income Opportunity (SIO). Within a DC platform, total return may be a solid way to generate attractive returns where a component of that is designed to meet the income needs of retired participants.

At BlackRock, we put relatively narrow constraints on how our total return strategies can differ from the Agg. For example, duration is bound by plus-or-minus 40% of the model duration of the Agg. The Agg is currently approximately 5.5 years - so you're talking about plus or minus two years. Within the credit spaces and out-of-index exposures, we have pretty tight controls around that as well. For example, we can have 20% of the portfolio that's not investment-grade, including high-yield. Within the constraints, we have sufficient flexibility to pursue the good risk-adjusted return ideas that we can source across the platform, while still keeping the performance consistent with the Agg over different market cycles.

How does that look in practice? In other words, how do you apply your insights within those constraints?

Miller: Let’s take the duration example. We can match the duration of the index, but we don't need to own it in equal doses across the curve. They can have different curve positions in order to avoid the areas of the curve that we think are most susceptible to price decline. Active management can start with the basics of the opportunity set that's created in the index, and then give some thought to modifications in order to find return or manage risk in a way that the pure index exposure does not.

What does an SIO strategy potentially bring to a DC plan?

Miller: SIO seeks to remove benchmark constraints so that it has the broadest flexibility to adapt to changing markets in pursuit of attractive returns while controlling for risk. Our diverse and balanced approach has allowed for greater consistency of returns and protection against the impact of rising rates. SIO has the flexibility to pursue an outcome-oriented return stream that is less sensitive to the direction of interest rates.

Finally, what do you think your team brings to total return and other actively managed strategies that competitors do not?

Miller: We've got really good talent on our PM team, with a tremendous amount of high quality, successful experience across a number of different asset classes. Our process is very rigorous and very robust, and I would challenge anyone in the industry to demonstrate a more rigorous top-down and bottom-up process for sourcing and analyzing information.

In addition, I think BlackRock boasts the most well-resourced fundamental fixed income platform in the industry. And what I mean by that is, we have high quality talent in all of the fixed income teams across this platform - whether it's investment-grade credit teams in Europe and Asia, securitized product analysis and portfolio construction teams in New York or emerging markets and Munis teams - for a total of over 400 professionals across seven global centers.

I think that makes us very different than some of the more boutique firms, where you've got a handful of super-talented people, no doubt, but they're all doing the work on their own. Or they are very good in one aspect of the market, and enjoy strong returns when the market favors their specialty. By contrast, I think when you look at our performance attribution, we have a very wide and diverse set of alpha sources year-in and year-out.

Bob Miller
Managing Director, Head of U.S. Multi-Sector Fixed Income
Bob Miller, Managing Director, is head of the U.S. Multi-Sector Fixed Income team within BlackRock's Global Fixed Income group.