Over time, longer-duration fixed-income assets tend to generate higher, albeit more volatile, returns than shorter-duration fixed-income assets. But investing further out on the yield curve doesn’t always offer rewards commensurate with the risks, says Joseph Graham, investment strategist at institutional money management firm Lord Abbett. And that has some intriguing implications for stable value managers.
Speaking at the 2019 SVIA Fall Forum in Washington, D.C., Graham argued that investors in short-term credit are overpaid for the amount of risk embedded in those securities relative to what they earn on longer-term securities, as evidenced by short-term securities typically having much higher Sharpe ratios. The pattern holds, he said, across different categories of credit quality. While that may seem to run counter to modern portfolio theory, Graham said several factors help to explain it. To cite just one example, credit research is time intensive, and analysts and money managers may balk at devoting lots of time to researching securities that are going to mature in, say, nine months, rather than five years. That, he said, keeps the short-term sector inefficient. It also provides an opportunity for portfolio managers to search out returns without taking on term (interest-rate) risk.
This paradigm is particularly pertinent right now, Graham said, given that term premiums—the amount by which the yield-to-maturity of a long-term bond exceeds that of a short-term bond—have recently been extraordinarily low. He attributed this in part to price insensitivity on the part of the Federal Reserve and other central banks, who have been buying bonds to implement monetary policy, and pension plans who are buying them to match assets and liabilities in their portfolios.
While investors might worry about the principal risk inherent in credit, Graham presented evidence that the actual losses sustained as a result of defaults in short-term credit historically have been far less than the premium earned versus risk-free securities. “For short-term bonds, you’re really getting paid a lot for something that is not a default risk,” he observed. “Default risk is a tenth—even less. It’s 5% of what you’re being paid for.”
Even for an investor who might have been so unlucky as to invest in BBB debt on the eve of the financial crisis in 2006, Graham continued, the losses sustained in that sector during the crisis “never came close” to matching what that investor would have been paid in terms of the spread between BBB and higher-rated bonds.
To illustrate how these findings could be put to use in a stable value portfolio, Graham described a hypothetical portfolio that, beginning in 2008, held about 44% of its assets in short-term asset-backed securities, mortgage-backed securities and corporate mortgage-backed securities; 31% in short-term government, agency and sovereign securities; and 26% in short-term corporates. From January 2008 to about the fall of 2009, cumulative returns for that portfolio lagged those of the Bloomberg Barclays U.S. Government/Credit 1-5 Years index. Since then, however, the credit portfolio has outperformed. In addition, its theoretical crediting rate remained equal to or above the index’s crediting rate throughout the entire period.
“There is this anomaly where (short-term credit) keeps overpaying you,” Graham concluded. “It’s particularly useful now because there aren’t a lot of other great risk options to lean on.”