Like proprietors of some great tourist destination whose heyday has passed, Putnam Institutional Investments laments the lack of interest in fixed income investing in the age of portable alpha in their Winter 2007 institutional newsletter. But not content to sit back and watch tourists flock to some swanky new resort, Putnam warns:
In the rush to embrace exciting new ideas about the power of separating alpha from beta, institutional investors shouldn’t forget the importance of a traditional investment concept that has stood the test of time: diversification. In building a well-balanced portfolio of alpha generators, fixed income represents a compelling choice.
It’s not the most impassioned plea for the crowds to return, but it’s strangely compelling nonetheless. Rather than advocating a “back to basics” fixed income strategy, Putnam says that financial innovations such as credit default swaps have enabled a whole new world of alpha-centric fixed income strategies such as (but not confined to) portable alpha. And as we’ve pointed out before on this website, “fixed income” and “portable alpha” don’t often appear in the same sentence.
Putnam aims to dispel three “myths of fixed income investing”. The first is simply that there is no alpha in fixed income because markets are so efficient. They offer up the fact that Enron bond-holders where whistling in the wind while shareholders were packing it in.
Their second “myth” is that fixed income securities lack enough volatility to generate adequate alpha. While they point out several high-volatility ways to invest in fixed income (high yield etc.), they advocate “judicious” leverage to goose somewhat bland returns.
We find Putnam’s third myth most interesting. They argue that “Dramatic changes in the fixed income markets have created new opportunities that managers could only dream of ten years ago.”
What changes? Well the recent Economist article on credit default swaps illustrates one such development. Putnam points out several others:
The advent of liquid credit derivatives markets, in conjunction with liquid bond repo markets in some sectors, has broadened dramatically the opportunity set for relative value trades. Shorting bonds or buying credit protection may be used to exploit security selection opportunities, to implement market-directional views, or to achieve market-neutrality as part of a portable alpha strategy.
…Less than a decade ago, a trade such as (an inflation swap) would have been out of the question. Leveraging the position using cash or securities would have introduced far too much risk, while the derivatives that make it possible today either did not exist or were too expensive to even consider, as they would have introduced transaction costs that could have cancelled out nearly all of the benefits of leveraging in the first place.
Putnam is essentially suggesting that new finanacial technologies allow investors to separate the genes (factors) deep within fixed income securities and genetically engineer new securities.
Not content to let equity hedge funds get away with all the glory, Putnam pulls out this chart, showing how equity hedge fund returns have fallen over the past 12 years, while returns of fixed income hedge funds have remained steady (at more modest levels).
The report continues to hammer away at equity hedge funds with the following chart on “worse case scenarios”:
But at the end of the day, it’s quite apparent that no other asset class relies so heavily on derivatives and derivatives of derivatives like swaptions and the rarely executed “equity swap-arivative-come security” (okay, we made that one up).
To conclude, Putnam says fixed-income-ville is worth the short drive off the interstate:
As investors begin to separate alpha from the betas in their portfolios, they are realizing that alpha may be sourced from any market that has inefficiencies — and the appropriate instruments to cost-effectively take advantage of those inefficiencies — regardless of the market’s volatility. Knowledgeable investors are also recognizing that a leveraged portfolio of low-volatility securities may present less risk than an unleveraged portfolio of securities that exhibit higher return volatility. Likewise, investors are becoming more aware of the high correlation among many equity-based alpha strategies. With this new perspective, fixed income as an asset class should be garnering more attention from investors seeking to build well-diversified alpha-generating portfolios.
Now, if only they could fit that on a billboard.