Index composition changes create opportunities for bond managers

Drastic changes to the composition of the US bond index, the Barclay’s Capital Aggregate Index, will create opportunities for active bond managers and provide rationale for institutional investors concerned about active management in the sector to adhere to their long-term asset allocation.

The financial crisis, and subsequent stimulus packages, have had an effect on the type of debt being issued as well as the relative price of Treasuries which will have important implications for the index constitution., according to a white paper released this week by performance analyst at Wurts & Associates, Curtis Yasutake.

The combination of a potential “Treasury bubble”, and the changing composition of US debt will provide opportunities for active managers to outperform relative to the benchmark, he says.

“Poor performance has had many institutional investors concerned about the quality of their fixed income managers. However, before cutting back on fixed income or replacing a manager, consider that better times may be on the horizon, Yasutake says. “The index is undergoing drastic change we believe will make it easier to beat in the near future.”

According to the research by Wurts, whose clients include pension and endowment funds, Treasuries are priced at bubble-like levels due to the recent flight to quality, in addition the US government will have to borrow trillions of dollars in the next few years to fund rescue packages.

“It is estimated the US budget deficit will be $1.9 trillion this year, and $1.4 trillion next year, or about 13 per cent of GDP, which will have to be funded by the issuance of record levels of Treasuries,” Yasutake says.

The bond index, which was formerly the Lehman Brothers Aggregate index, already contains a higher weighting to Treasuries relative to most active managers, and as more Treasuries are issued, Wurts says the weighting in the index may increase from 25 per cent today to around 40 per cent.

“Additional exposure in the Aggregate to this potentially poor performing fixed income sector indicates a likelihood of poor prospective performance for the index,” Yasutake says.

In addition, market conditions have had the opposite effect on corporate issuances, with 67 per cent less corporate bond issues in the second half of 2008 than the same time period the year before.

“Many companies have been forced to replace maturing long-term debt with short-term bridge loans or commercial paper to push their liabilities out until markets calm down. As the Aggregate only includes issues with over a year of maturity, that maturing corporate debt will simply fall out of the index until longer term debit is issued. Also, a higher than usual amount of downgrades due to tightening standards and deteriorating corporate balance sheets will lead to credit downgrades to below investment grade, which will in turn force more corporate debt out of the Aggregate.

Last year the average core fixed income manager underperformed the index by 1.4 per cent, while the average core plus manager underperformed by 8.1 per cent.

As of January this year the index, formerly the Lehman Brothers Aggregate index, contained about 9000 fixed income
issues and was valued at $11.4 trillion. The index is comprised primarily of very low risk government guaranteed debt, while active fixed income managers typically overweight their portfolios in credit.

“Our view is it will be easier for core and core plus fixed income managers to outperform the Aggregate going forward,” Yasutake says. “Take a deep breath, Greener pastures are ahead.”