Monday, December 18, 2006

Value investing?

A commenter recently asked me what the best way to add alpha for a bond manager was. Its a very interesting question, and one worth exploring.

There are five basic strategies I see most bond managers employing to try to add alpha. Now, I'm speaking of bond managers who have a mostly taxable investment-grade mandate, and the flexibility to move in and out of various sectors and maturity ranges. They are:

1) Interest rate anticipation. This involves moving duration around to try to time interest rates. I know of very very VERY few managers who make a living doing this successfully. Most guys I know make small interest rate bets hoping to add a little value if they are right but not killing themselves if they are wrong. That's basically what I do as well.

2) Sector rotation. This is where one overweights one sector vs. another. In practice, this is a lot like interest rate anticipation, because certain sectors tend to perform better in different rate environments. Some managers use sector selection as a less risky way to make a bet on rates. For example, if you are bearish on rates, MBS are probably a good sector, while Treasuries are probably the worst sector. You can keep your duration neutral but overweight MBS and outperform if rates rise, but limit your under performance if rates fall.

I do some of this, but its hard to overweight Treasuries for very long, because the negative carry eats you alive. So if I'm bearish on corporates, I'm more likly to just own higher quality names. If I'm bearish on MBS, I'll own more 15-year paper or ARMs vs. 30-year paper.

3) Credit analysis. This is where most bond managers live and die. They overweight credit, try to pick the right names, and win the day on extra carry and spread tightening. People can be more or less aggressive with this, some putting big chunks in high-yield trying to buy into recovery situations. Others just try to find yieldy bonds and any tightening is gravy. Because the overweight corps strategy is so pervasive, any time corporate spreads generally widen out, most fund managers under perform.

I do less with corps than a lot of other managers. I like to pick steady names which have certain long-term, fundamental things going for them. I particularly like names where the company has a motivation to maintain their credit rating. Here is an old post about my credit philosophy.

4) MBS analysis. Something a lot of non-bond people may not realize is that mortgage bonds are the largest sector of the investment grade world. They make up about 35% of the Lehman Aggregate vs. only about 20% for corporates. Interestingly, a large number of investment managers try to index their MBS positions or else just buy in the TBA market. Why I hate TBA is another post for another time. Suffice to say that buying only TBA, in my opinion, is like admitting you can't analyze MBS and are trying to minimize the alpha you subtract in this sector. No one can look me in the eye and tell me that buying TBA is a way to add alpha. No way.

Anyway, I think MBS is the best sector for adding alpha, which I posted about here.

5) Quasi-arbitrage. This strategy has become the favorite of many gigantic mutual funds, in part by necessity. This is where a manager builds a portfolio which has the general credit and interest rate risk of a traditional bond portfolio, but its constructed with a series of derivatives and hedges in addition to traditional bonds. So when PIMCO wants to increase its duration, they may well enter into a futures contract or swaps contract as opposed to actually buying any bonds. And that makes sense, because PIMCO is too damn big to actually go around buying bonds. They are forced to act in the derivatives markets, at least in part, because their monsterous size is such a liability. Take a look at the sector weightings in their flagship Total Return Fund (scroll down a bit). 40% cash? Not really, that's cash or CP held as collateral against derivatives contracts.

Now, I'm not one of these ridiculous chicken little types railing against use of derivatives. Obviously Bill Gross has had plenty of success doing this. My question is why? Why do investors flock to this strategy when there are many more liquid and more transparent managers who are having just as much success? PIMCO and Western Asset Management and Blackrock and the like have become so big, who can say how liquid some of their contracts are? I mean, if you are the market, what happens when you want out of the market? Well, there is no market at that point, is there? The problem is not using derivatives per se, its a matter of being so large that you are the market.

Now, most people use more than one of these strategies. Particularly if they are doing the quasi-arb strategy, because you have to be using the derivatives to be making some kind of bet. But I'd say that every manager has a preferred means of adding alpha, and the good managers try to downplay the areas where they are less likely to add value. For example, I'm focused on MBS analysis first, sector weightings second, and credit analysis third. I spend time on interest rates, but I wait until I have a strong opinion before making a portfolio bet.


Anonymous said...

great post

as a follow-up , what leverage are Bond managers allowed , and does this vary amongst different type of funds : mutual funds , endowments , etc. ? also , can they write calls vs. debt ?

thanks is advance

Accrued Interest said...

That depends entirely on the mandate from the client or a fund's prospectus.

I'd guess that most situations do not allow overt leverage. If they allow derivatives, though, its quite possible to achieve de facto leverage without the client realizing it. By this I mean leverage is generally thought of as borrowing money to invest. But if you own a CDS for example, you don't have to post any cash, or at least very little. So if had a portfolio of cash bonds plus one CDS contract, then I'm really more than 100% invested aren't I?

This gives me an idea for a post on the concept of beta in the bond market that I might write today since its a slow week.