Juiced up portfolios adopt leverage and shorting, panelists at P&I roundtable say

SACRAMENTO, Calif. — Traditional bond managers are meeting hedge fund fixed-income managers halfway, adding tools such as leverage and shorting to their portfolios, according to panelists at Pensions & Investments’ roundtable on the changing world of fixed income.

But the panelists were undecided on whether the evolution is a cyclical one — which can change course once volatility is reintroduced into the markets — or a secular one, reflecting a fundamental shift in the way institutional investors allow their managers to operate.

With low volatility, tight credit spreads and a low interest-rate environment, institutional investors are looking for ways to boost their fixed-income portfolios.

“You need to make more return, you need to push out further. … The question before us is: Is this a cyclical phenomenon or is it a secular change in the markets?” said Andrew Phillips, a managing director at BlackRock (BLK ) Inc. (BLK ), New York.

The roundtable was held June 12 at the Sacramento, Calif. headquarters of the $247.9 billion California Public Employees’ Retirement System. Besides Mr. Phillips, other participants were: Eric Busay, fixed-income portfolio manager at CalPERS; Gregory DeForrest, senior vice president at consulting firm Callan Associates Inc.. San Francisco; Albert Gutierrez, chief investment officer at SCM Advisors LLC. San Francisco; Paul McCulley, managing director at Pacific Investment Management Co. Newport Beach, Calif.; and Olaf Rogge, founder and co-CIO of Rogge Global Partners PLC. London.

Secular change

Traditional bond managers recently added shorting or leveraging techniques used by hedge funds, participants said. The one consultant in the room, Mr. DeForrest, said using these techniques is, to “a certain extent” a secular change brought on by investors loosening their guidelines.

The move toward liberalizing fixed-income investment guidelines began more than two decades ago, with the shift to core-plus from core strategies, Mr. McCulley said. That, combined with more managers — traditional and hedge fund — entering the marketplace and making the markets more efficient, is making excess return harder to find, he said.

But there are cyclical elements at work as well. Fixed-income managers have been operating in a fairly placid environment where investors have not had to deal with a major global or regional market downturn in some time.

“I have to believe that when that happens, that is … just going to change the nature of risk from where we are currently, which is low volatility,” said Mr. Phillips.

Despite the muted market environment, opportunities exist for managers to bring in alpha. Mr. Rogge tagged the domestic-fixed income markets as “a loser’s game” and sees opportunity in taking advantage of the spreads between global bond markets.

His firm looked at thesix largest bond markets from 1985 to 2007 and found a spread of 25% between the best and worst performers each year. “Now that is the opportunity set,” said Mr. Rogge.

CalPERS officials also saw an opportunity to boost returns in the international fixed-income markets. In March, pension officials allowed the external managers of the fund’s $6.9 billion international fixed-income portfolio to go up to 130% long and 30% short on a tactical basis in order to eke alpha from the lackluster portfolio. Among the fund’s managers are Rogge and BlackRock. The fund also allows the managers to invest up to 10% of their portfolio in international high-yield debt.

“What we are looking for is for managers to be able to take a look at risk in a sober view and be able to look at the best risk-adjusted returns they can get over as wide an opportunity set as possible,” said Mr. Busay.

Mr. Busay said CalPERS has added a moderate amount of leverage to its international bond portfolio. What’s more, the shorting tools can be used to reduce risk, he noted. Unlike shorting stocks, where managers take on substantial downside risk, shorting bonds actually can reduce risk because bonds go to par value at maturity. In addition, bond managers can take a short position to lower duration, thus reducing risk in the portfolio.

A modest step

Mr. Gutierrez agreed that CalPERS had taken a modest step. “I really look at the ability to, say, have leverage up to 130/30 … as basically (giving) the manager (the ability) to tweak on the edges what they can or can’t do.”

Not every institutional investor is keen on giving managers more latitude. Mr. DeForrest said some Callan clients have strict guidelines for their international fixed-income managers. “They only want their managers to eke out 15 to 20 basis points and that’s fine for them,” he said. “They just have structural limitations to the amount of latitude they can give their managers. So it’s not for everyone.”

Panelists said the fixed-income markets are in flux. New players, such as China, are accumulating tremendous wealth that will eventually have to be invested in more diverse markets, and they might play by different rules.

“They haven’t started (diversifying) because it is run by politicians or by employees of government and are scared of making the first step of going outside (to the global markets),” said Mr. Rogge. “Eventually it will happen, and what will happen to the world? What will happen to the currency markets?”

Besides new sources of sovereign wealth, a return to volatility in the markets or changing risk tolerances could drastically change the investment environment. The question among the roundtable participants was: “How?” No clear answers were provided.

“It is important that none of us … whether on the money management side or on the other side, are beguiled into believing that where we are right now is the new normal world,” said Mr. McCulley. “I don’t know what the new normal world is going to look like, but this ain’t it.”