Fixed-Income 130/30 Comes Out of Hiding

by: Christopher Holt

Short-extension strategies now have an extension of their own - into the world of fixed income investing. In a paper that sounds reminiscent of this one on fixed income 130/30 by Prudential and this webcast on fixed income portable alpha by Morgan Stanley (NYSE:MS) (AAA dossier sign-in required), Baring Asset Management reiterates that 130/30 isn’t just for the equity crowds anymore. After a dearth of news on fixed income 130/30 since the spring, we’re glad to see it back in the daylight again.

According to HedgeWeek, Toby Nangle, Barings’ director of fixed income management says:

Most of the debate around 130-30 strategies has, up to now, been focused on the equity side. However, the sources of excess returns and the potential benefits in 130-30 fixed-income investing are quite different from the equivalent equity only mandates.

Although the markets are different, the primary rationale behind fixed income 1X0/X0 is the same as it is for equities: to enable over-sized negative bets in smaller markets (what the report calls “inter-market spread positioning”). Other sources of fixed income alpha mentioned in the report include:

  • “Yield curve positioning”
  • “Currency positioning”
  • “Credit positioning”
  • “Duration management”

On the “quant vs. fundamental” debate Barings takes the quant side. According to Nangle:

‘Barings’ top-down fixed income investment process means that its active global fixed-income managers already spend much of their time analysing the relationship between markets and the main sources of excess return…Moving from long-only to a 130-30 approach for multi-currency global-fixed income is a natural extension of our top-down investment process…

While fixed income 130/30 may be a new message, Barings has apparently been shorting bonds for a number of years. But it appears that Barings really got the fixed income 130/30 bug last spring when it was awarded one of several fixed income 130/30 mandates by CalPERS. At that time, CalPERS said it expected the short extension managers to produce an additional 50 bps over a plain-vanilla 100/0 strategy.

No pressure, right? Wrong. According to Pensions & Investments, CalPERS’ international bond managers gave back all the alpha they had produced in the previous 9 years. (They had been pumping out a whopping 8 bps a year.)

It’s almost as if Wilshire, CalPERS consultant took pity on these managers in their March 2, 2007 letter to CalPERS’ CIO endorsing 130/30 for the fixed income yoemen (read full letter):

“…Unlike in equities, however, there exists little possibility for a great manager to vastly outperform the benchmark (i.e., 300bp or more) due to the inherent limitations of fixed income investing. The request by Staff to allow for the external managers to employ leverage will allow such managers to incrementally increase the alpha potential in their portfolios.”

(Translation: “Come on, throw ‘em a bone.”)

Notwithstanding the arguments in favour of this strategy, it took 6 months and a new CIO at Barings before the firm spun the CalPERS strategy into its own fund.

While CalPERS is solidly American, it sounds like they should start the dog-and-pony show in Europe. P&I reported last month that when updating their investment mandates, 95% of the clients of one consultancy were allowing fixed income managers to short bonds. In fact, a September 2007 FT story even proclaimed “pension funds clamouring for fixed income 130/30 info“.

At the end of the day, how different is fixed income 130/30 from equity 130/30? Not that much, apparently. Reports P&I:

Analysts are quick to point out the technical difference between 130/30 strategies in equity and fixed income. In equity 130/30 strategies, managers need a perfect balance between long and short positions to maintain a market exposure or beta of 1. In 130/30 or long-short fixed-income portfolios, managers are given discretion as to how far they can go short within certain limits set down by the trustees.

When a pension plan first allows its fixed-income manager to go short, it will typically set a limit of going short on up to 5% of the portfolio, said [consultancy] Hewitt’s Mr. Hartman. That level is often increased over time to around 20%, depending on the level of risk the plan is prepared to take.

Taking short positions in bond portfolios is quite a skill, said [consultancy] Cardano’s Mr. [Phil] Page. “Relatively few fixed-income managers are good at guessing when things can blow up. A blowup in a single bond in a fixed-income portfolio can be quite devastating.

But it takes a lot of skill to short the bond market and the question is, do you have the skills and the systems to do it,” he added.