Investing In Corporate Bonds: The Compelling Case For Active Management

by Ed Devlin, Michael Kim of PIMCO, 9/30/13
  • Passive investment returns in the Canadian corporate bond market have been unimpressive because of the way corporate bond indices are constructed and factors unique to the Canadian market.
  • Unconstrained by these limitations, active managers with global reach may provide superior returns.
  • The current environment presents an attractive opportunity for Canadian investors to implement a wide discretion, active approach to managing corporate bonds.
Passively investing in corporate bonds in Canada has been an unattractive proposition for many years: Historical risk-adjusted returns for corporate bonds have generally been only slightly higher than those for comparable government bonds. Structural reasons that involve how corporate bond indices are constructed, as well as factors unique to the Canadian corporate bond market, can generally explain why corporate bond returns have been less than impressive for passive investors.

Unconstrained by the structural limitations of corporate bond indices, active management may provide superior returns to passive management within corporate bond portfolios. Our belief is that active managers with global reach are best positioned to outperform the Canadian corporate bond indices. The recent widening in global corporate credit spreads has increased the attractiveness of a global investment style for Canadian investors.

Structural shortcomings of corporate bond indices

It is an increasingly recognised reality in investment circles that passive investing has been a sub-optimal strategy for credit investors. Over the last 15 years (from December 1997 through July 2013), for example, the Bank of America Merrill Lynch Global Corporate USD-Hedged Index has delivered annualised returns in excess of duration-matched government bond returns of approximately 0.48%, with a volatility of 3.8% per annum. To put this in perspective, the corporate index’s Sharpe ratio, a widely-used measure of risk-adjusted return that takes volatility into account, is just 0.13, indicating very modest value. The BofA Merrill Lynch U.S. dollar-denominated corporate index showed similar shortcomings, with an average annual excess return over government bonds of 0.53% and a Sharpe ratio of 0.10 across the same time period.

These results are disappointing and somewhat counter-intuitive. After all, given the cyclical nature of credit risk (credit generally performs well in good economic times and poorly in bad times, similar to equities), corporate bonds should reward investors for taking added risk over time. Why don’t they? Our research indicates that there are at least two major factors behind the less-than-impressive performance of corporate bond indices, both of which relate to the rules that lie behind the makeup of traditional indices.

First, there is the issue of “fallen angels.” To reflect different levels of credit risk, standard credit indices have strict rules regarding the credit ratings of the underlying constituent securities. In particular, investment grade indices stipulate that only bonds rated at or above BBB-/Baa3 can remain in the indices. This means that, should an issuer be downgraded below investment grade and into high yield, it would be forced out of the index at the end of the month of downgrade. Such “fallen angels,” however, often bounce back; losses initially experienced upon, or in the lead-up to, the credit rating downgrade are often at least partially recouped in the following months. For the passive investor, however, the initial losses are locked in as the bond falls out of the index and subsequent gains are not captured.

Second, many mainstream bond indices, including the widely followed suite of DEX indices in Canada, are restricted by maturity and include only bonds of at least one year in remaining term. As bonds slip below this maturity, they fall out of the index and must therefore be sold by holders of index-tracking portfolios. However, our empirical analysis of historical returns shows that shorter-dated credit has outperformed longer-dated credit. Such exclusions therefore force passive investors to relinquish potentially superior returns arising from this

sub-asset class of short-term bonds.

Figure 1 shows realised historical return-per-unit-risk measures (Sharpe ratios) for these categories, using widely tracked indices. While Canadian corporates (0.34) have outperformed their global counterparts, they still lag both fallen angels (0.43) and short-dated credit. Due to lack of data for longer-term corporates, we have used the one- to three-year sector of the standard index as a proxy (0.85). Since 2004, we find that the less-than-one-year sector shows the strongest performance, delivering a Sharpe ratio of 0.95. This historical evidence indicates that any investment strategy that precludes allocations to the more rewarding subsectors of credit, such as index-tracking, is prone to lower returns than one that allows participation in them.
Another weakness of typical bond indices is they tend to be market-capitalization weighted. This means that passive investors must make higher allocations to the most indebted companies. The Canadian corporate market is especially problematic in this regard. As of 31 July 2013, the largest 10 issuers in the DEX All Corporate Bond Index accounted for 44.4% of its total market value. The DEX Corporate Bond Long Index is similarly concentrated, with the top 10 issuers making up 46.7% of its total. By comparison, other global credit indices are considerably less top heavy, as shown in Figure 2.
In addition to this high concentration, the relatively healthy performance of the Canadian Corporate Bond Index has been largely due to a small collection of highly indebted companies (mainly financials, utilities and resource companies). This is clear in the historical performance figures, shown in Figure 3, for the large-cap sector of the Canadian corporate universe. (Here, we use the Bank of America Merrill Lynch Canada Corporate and Canada Corporate Large-Cap Indices.)

This lack of diversification poses the risk of exaggerated losses from idiosyncratic, company-specific events. It also shows that active managers of corporate bond portfolios that are restricted to investing in credits within the index would be challenged to add value by allocating capital beyond the largest issuers in the index.

Regarding the diversity of companies in a portfolio, Figure 4 demonstrates that Canada offers a very limited selection, with a paucity of options for investors in the higher spread categories.

In other words, if most of the value in the Canadian corporate market is provided by the exposure to the largest issuers, why pay active fees for managers to invest in the more challenging sector of less-indebted Canadian issuers?

Canadian corporates: tighter spreads, lower liquidity

As shown in Figure 5, the Canadian corporate market has for several years looked expensive relative to comparable U.S. and global corporate credit. Measured by spread levels over duration-matched interest rate swaps, Canadian corporate index spreads, as measured by the Bank of America Merrill Lynch Canada Corporate Index, have remained well below their international counterparts, trading at 56 basis points (bps) below U.S. dollar corporate spreads, shown in the Bank of America Merrill Lynch US Corporate index as of 31 July 2013.

This spread difference is partly due to the slightly lower average credit rating of the BofA Merrill Lynch US Corporate Index; because of the lower credit quality, the US Corporate Index therefore would have a higher potential for defaults. To estimate the difference in expected return arising from this spread difference, we should therefore adjust this comparison for the expected losses from default for each index. Using long-term default probabilities and expected losses in the event of default, based on average corporate debt recovery rates from Moody’s Investors Service, we estimate that the U.S. dollar index has an annual expected default loss approximately 17 bps higher than that of its Canadian counterpart. This still leaves a gap of some 39 bps of spread carry return between the two indices.

If default losses experienced in a corporate portfolio are in line with those of the regional or global benchmark indices, this would imply that the opportunities for carry, or additional return, from spreads in the Canadian market are inferior to those elsewhere. All things being equal, therefore, allocations to credit outside of Canada could serve to increase investment returns.

Figure 6 further demonstrates that Canadian spreads in many sectors and rating categories are narrower than those in three major bond markets. In particular, in the lower-rated, higher-spread and potentially most rewarding sector (securities rated BBB), Canadian corporates put investors at a disadvantage in terms of picking up spread.

The two most common Canadian corporate bond indices, DEX Corporate and DEX Corporate Long, are relatively small and much less diversified than global credit indices. For example, Figure 7 shows that the Barclays Global Aggregate Corporate Index is over 20 times larger in terms of notional amount outstanding and has more than eight times the number of unique issuers, 10 times the number of bond issues and an average issue size more than twice that of the DEX Corporate Bond Index. When comparing the DEX Corporate Long Index against various global indices, the differences in size and scope are even more dramatic.

It has been our experience at PIMCO that Canada’s smaller corporate market translates into wider bid/offer spreads in the secondary market. Higher transaction costs make it more difficult for active managers to add value in the Canadian corporate market relative to larger corporate markets.

Recent outperformance of Canadian corporate bonds:Look to global opportunities

Between 1 May and 31 August this year, the BofA Merrill Lynch Canada Corporate Index tightened 5 bps, while the BofA ML Global Corporate Index widened 2 bps and the BofA ML U.S. Corporate Index widened 5 bps, as Figure 8 illustrates. We believe this environment presents an attractive opportunity for Canadian investors to implement a wide-discretion, active approach to managing corporate bonds.

Jeremy Rosten contributed research and analysis to this article.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk.Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity.

The Barclays U.S. Short-Term Corporate Bond Index is designed to measure the performance of the short term U.S. corporate bond market. The Index includes publicly issued U.S. dollar denominated corporate issues that have a remaining maturity of greater than or equal to 1 month and less than 1 years, are rated investment grade (must be Baa3/BBB- or higher using the middle rating of Moody's Investor Service, Inc., Standard & Poor's, and Fitch Rating), and have $250 million or more of outstanding face value. The BofA Merrill Lynch 1-3 Year Canada Corporate Index is a subset of The BofA Merrill Lynch Canada Corporate Index including all securities with a remaining term to final maturity less than 3 years. The BofA Merrill Lynch Canada Corporate Index tracks the performance of CAD denominated investment grade corporate, securitized and collateralized debt publicly issued in the Canadian domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch). In addition, qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of CAD 100 million. Warrant-bearing and defaulted securities are excluded from the Index. The BofA Merrill Lynch Global Fallen Angel High Yield Index is a subset of The BofA Merrill Lynch Global High Yield Index including securities that were rated investment grade at the point of issuance. The BofA Merrill Lynch Global High Yield BB-B Rated 2% Constrained Index tracks the performance of below investment grade bonds of below investment grade bonds of corporate issuers domiciled in countries having an investment grade foreign currency long term debt rating (based on a composite of Moody's, S&P, and Fitch). The index includes bonds denominated in U.S. dollars, Canadian dollars, sterling, euro (or euro legacy currency), but excludes all multicurrency denominated bonds. Bonds must be rated below investment grade but at least B3 based on a composite of Moody's, S&P, and Fitch. The BofA Merrill Lynch Sterling Non-Gilt Index tracks the performance of GBP denominated investment grade non-sovereign debt publicly issued in the eurobond or UK domestic market, including quasi-government, corporate, securitized and collateralized securities. Defaulted securities are excluded from the Index. The BofA Merrill Lynch Sterling Corporate Index tracks the performance of GBP denominated investment grade corporate debt publicly issued in the eurobond or UK domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch). In addition, qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of GBP 100 million. Defaulted securities are excluded from the Index. The BofA Merrill Lynch Global Corporate Index tracks the performance of investment grade corporate debt publicly issued in the major domestic and eurobond markets. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch). In addition, qualifying securities must have at least one year remaining term to final maturity and a fixed coupon schedule. Taxable and tax-exempt US municipal, warrant-bearing, DRD-eligible and defaulted securities are excluded from the Index. The Barclays Euro Corporate Bond Index contains fixed-rate, investment-grade Euro-denominated bonds from industrial, utility and financial issuers only. Inclusion is based on the currency of the issue and not the domicile of the issuer. The Barclays U.S. Corporate Index covers USD-denominated, investment-grade, fixed-rate, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements. Securities in the index roll up to the U.S. Credit and U.S. Aggregate indices. The U.S. Corporate Index was launched on January 1, 1973. The Barclays Euro-Aggregate Index in an unmanaged index that tracks fixed-rate, investment-grade Euro-denominated securities. Inclusion is based on the currency of the issue, and not the domicile of the issuer. The principal sectors in the index are Treasury, Corporate, Government-Related and Securitized. Securities in the index are part of the Pan-European Aggregate and the Global Aggregate Indices. The Euro-Aggregate Index was launched on July 1, 1998. Barclays Global Aggregate (USD Unhedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. Barclays U.S. Credit Index is an unmanaged index comprised of publicly issued U.S. corporate and specified non-U.S. debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The DEX Corporate Long Bond Index is a subset of the DEX Universe Bond Index and contains investment grade (BBB and above) semi annul pay fixed rate Domestic corporate bonds with 10 years plus to maturity and at least 10 institutional buyers at issue. The DEX Universe Corporate Bond Index is a subset of the DEX Universe Bond Index and contains investment grade (BBB and above) semi annul pay fixed rate Domestic corporate bonds with more than 1 year to maturity and at least 10 institutional buyers at issue. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2013, PIMCO.

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