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What is a Flexible Bond Fund?
05/08/2012 7:30 am EST
And should you invest in one? Jeff Ringdahl explains how his firm’s flexible bond fund goes long or short using three levers: Credit, currency, and yield curve. He says the fund can complement a traditional bond fund, or be used in its place.
Kate Stalter: We’re talking about fixed income today with Jeff Ringdahl, Chief Operating Officer at American Beacon.
Now, Jeff, as everybody listening to this is well aware, we’re in a low-interest-rate environment, and a lot of people have become hesitant about any kind of fixed-income investment. But I understand that Beacon has a fairly new fund that can address some of these concerns through flexible bond investing. Maybe you can tell us about that today.
Jeff Ringdahl: Yes, sure thing Kate, thank you. We have what we’ve called our Flexible Bond Fund (AFXAX).
It’s a fund that we launched in July 2011, and we had been working on that fund for the better part of almost two years before we brought that to market. We’ve had our eyes on flexible bond investing for that length of time as we have anticipated market environments that may be fairly challenging for your traditional bond investor.
Really, the premise behind that is: Not only are interest rates low, which reduces income and the yield on your staple bond index, which is the Barclays US Aggregate Bond Index, just north of 2%—I think it’s just under 2.1% at the end of April. So, you’ve got very little income, but you’re at historically low interest rates as well.
We’ve subscribed to this concept of fixed-income beta. A lot of folks pay attention to equity beta and how volatile your equity portfolio is, relative to the broad movements in the market, whether you are more or less volatile.
We think that it’s just as relevant to talk about fixed-income beta, because traditional bond funds are driven by large macro factors, the predominant factor being the movement in interest rates and, particularly last year, when rates in the ten-year Treasury went from the mid-to-high threes all the way down to about 1.75%.
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Maybe even over 100% of the return that was experienced in traditional bond funds was experienced through duration risk. That they were essentially long on duration and it was interest rates that drove that portfolio, not other decisions that could be made in a portfolio, or other investments that could be made in a portfolio.
That’s great in a steeply declining, fixed-income environment, but those don’t happen that often, and most folks wouldn’t bet that it would happen again here with rates being where they are. You know, today they are just under 2% now, so we are at historical lows on the ten-year Treasury rate.
Another thing to think about here is that there’s a double whammy effect with traditional bond investing, where you are very much tied to the direction of interest rates and which way they go. One, is not only are we at historical lows in real yields, they’re actually below zero, so after inflation you’re actually losing money.
But second is, there is an additional effect of low rates, which is that not only are they low, but your duration actually descends as yields come down, because you have less and less income that’s going to come to an investor in the years before maturity of a bond. And so actually, the same bond that is at 4% has a longer duration than the same bond at 2%.
Take the ten-year Treasury: the ten-year Treasury at a 4% yield is less risky, less sensitive to interest-rate changes than a ten-year Treasury at 2%. So, you got the double whammy of low income and a bond that’s going to behave a lot more like a zero-coupon bond, where it’s sensitivity to interest-rate changes is greater. So, it’s a double whammy of the risk that rates go up and that you are actually more sensitive to it.
So, we’ve been quite constructive on a product that introduces a lot of flexibility to bond investing, and one that actually is less sensitive and, hopefully, quite insensitive to interest rates in the broad US bond market. And there’s a number of ways we do that, Kate, with the product that we have.
One is that the product is unconstrained relative to geography, so when we talked about the sensitivity of the ten-year Treasury or even the Barclays Ag—the ten-year Treasury clearly is a US issuer only, but even the Barclays Ag has a very miniscule, almost a de minimis amount of non-US exposure, maybe it’s 5% of 7% of non-US exposure.
So you’re subject to one yield curve, the movements in one yield curve. It ought to be wise for investors to diversify across many yield curves across the world, because what we’ve experienced here is that, in any given year, you have such a wide disparity of return outcomes in different countries.
Even within developed countries, if you just take away the emerging-market countries—which can behave quite differently and currencies can move quite dramatically—but you look just at the developed world and at G7 or the G20 world, you have thousands of basis points of spread between the highest and the lowest performing country. So you have the ability to not only diversify, but also find additional return opportunities. So you ought to be diversified across geographies.
You also ought to have flexibility in your duration, the risk in the portfolio, and flexible bond investing requires that. So the funds that we’ve developed have the possibility to be negative five years in duration, positive eight years in duration. It’s a very wide band of duration. We don’t anticipate that our sub-advisors would end up using that amount of flexibility, but it exists in the portfolio when the conviction is there among the sub-advisors to position their portfolio accordingly.
But what that says to you, the fact that the portfolio could theoretically be negative duration, means that it could actually profit from a rising interest-rate environment if positioned appropriately and timed appropriately. And a traditional bond fund simply lacks that constraint or lacks the flexibility.
A traditional bond fund is almost always tethered to the Barclays Ag and particularly, plus or minus a year, or plus or minus 25% of the duration of the Barclays Ag. So most traditional bond funds are going to have a duration between three and five years, simply because of their makeup, their benchmark-constraining guidelines in a fund, and we don’t have that.
In fact, we’re already positioned outside of that range of a normal, traditional bond fund. Our portfolio at the end of the quarter was approximately two years in duration, so it is insulated from rising interest rates, yet the rest of the flexibility that’s afforded in this portfolio allows it to outrun traditional bond investments because it’s finding other sources of return, things other than interest movements, yield curve moves that are creating return opportunities for a traditional bond fund.
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Another source or return here is flexibility across geography, flexibility by interest rate…so there is quite a bit of flexibility. The fund will always be investment grade, and the weighted-average quality will always be investment grade. But there is quite a bit of flexibility to put risk on or take risk off depending on market conditions.
And, if conditions are bearish, if our sub-advisors believe that conditions are bearish for credit, it actually goes short on credit. So we can go long and short, any one of three dynamics: Credit, currency, or yield curve or your interest rate risk.
Those are really the three primary levers, the three c’s as we like to refer to it—credit, currency, and curve. We can be long or short on any one of those and so our managers, and that flexibility allows the product to have an absolute return orientation vs. a benchmark relative return orientation.
And so, Kate, hopefully that helps, in terms of our view on traditional bond investing, why flexible bond investing can be quite helpful to a portfolio. The last thing that I’ll mention is the product.
The fund is designed to take the place of a traditional bond fund. While its return pattern will be different, over a long run, the level of return should approximate that of traditional bond investing, but the ride is going to be a whole lot different.
It will not correlate very highly at all with traditional bond investing, and we expect it and it’s proven out to be the case, if not even better than our expectations, that the volatility of the flexible bond fund that we’ve constructed is equal to or lower than that of traditional bond investing, again using the Barclays Ag as a proxy.
Over the long run, the volatility of the Barclays Ag is about 4% annualized per year, and that’s about what we would expect for the flexible bond fund, given the construction of that portfolio and the flexibility that the sub-advisors have in their overall risk-return appetite, per the guidelines that we’ve given to the sub-advisors.
So our goal here is to provide a superior alternative toward traditional bond funds, one that has greater flexibility. But unconstrained or flexible to us doesn’t necessarily mean more risk, as I’ve stated with the risk target for the product.
Kate Stalter: Jeff, given everything you’ve just said: Many of our listeners today are people who are perhaps, saving for retirement, near retirement or in retirement. How was this particular fund developed with an eye toward including it in an investor’s overall portfolio? Do you envision this as a core position, and how should they balance this with equities and, perhaps, other debt instruments that they’re holding?
Jeff Ringdahl: Yeah, that’s a great question, Kate. We would view this two ways, and I’m going to state them in order here, a primary and a secondary way that the fund could be used. Our feeling in the way that we’ve instructed our sales folks, and our sales folks work with their clients is: this product ought to replace a traditional bond fund, or complement a traditional bond fund.
But one way or the other, when folks invest in bonds, the decision is one of two things: They are investing in bonds for the income, which as we’ve stated, let’s set aside the fact that traditional bond investing is not providing a lot of income, so if you’re in bonds for income you’re probably struggling quite a bit and you’re looking at other alternatives for income, such as a dedicated high-yield product or maybe even a dividend paying equity.
So let’s set aside the income objective for bond investing. We think the other major objective and, probably, the primary objective for folks is that bonds are a risk allocation in their portfolio; they’re risk-budgeting their portfolio construction and bonds are that low-risk portion of the portfolio with the safety and principal preservation part of that portfolio where you want a little bit of return, but you’re very focused on protecting your portfolio, in particular with the equity market.
To the extent that that’s the objective of an investor by investing in bonds—again, back to the comment just a moment ago—this portfolio was designed to have the same volatility of a traditional bond fund, that being approximately 4% per year.
If you look at the current market environment, with rates at historical lows, with very little income being produced by a traditional bond portfolio and the strength of a traditional bond portfolio really hampering and really constraining your return opportunity. If your yield on your Barclays Ag is just north of 2%, and if you subscribe to the view that rates are not going down—it’s a “when” and not an “if” proposition as to when they go up—then the best that you do is the income coming off your portfolio. Let’s call it 2%, because as rates go up, that’s actually going to start to deteriorate the principal value.
You can actually lose money investing in bonds, and that’s not a proposition that most folks are used to. We’ve been in a 30-year bull market for Treasuries, with essentially, rates coming down almost without a hiccup for 30 years. There have been slight ticks up here and there, but they’ve been very short-lived.
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And to a point I made earlier, Kate, the ticks up in rates that we’ve experienced, while short-term, have been while rates are higher, so again your sensitivity to changes and interest rates were much less in the past.
Our sensitivity is as great now as it’s ever been, and rates are as low as they’ve ever been. So that’s how we view that portfolio, Kate, for folks. It’s a risk-budgeting decision for folks to invest in the bond asset class. We just think that we have a superior way, a superior option to provide to folks who want to shield themselves from some of the risks of traditional bond investing.
Kate Stalter: Let me just ask you one last question briefly. I was just curious about the sub-advisor model, and just how you determine the allocations within the funds, using the sub-advisors.
Jeff Ringdahl: That’s a great question too, Kate, and I probably should have mentioned earlier, so this is a great opportunity to mention the approach.
There are several unconstrained bond funds out there. That’s generally the word that’s used to describe these; we prefer the word “flexible.” We think it better articulates the strategy of the product.
But we have a multi-manager approach to it, and we don’t think that there’s a multi-manager approach the way that we do it with three generalists. Each of our managers has flexibility in credit, currency, and curve—long and short. We don’t have a portfolio of specialists, we are a portfolio of three generalists, each with a wide open mandate to invest as I’ve just described.
We like the idea of discretion with diversification, and so there’s broad discretion in the portfolio as I’ve just described, but there is diversification. When you provide this much discretion to a single manager, when you talk about that wide range, that wide band on duration, the ability to go long and short across the different macro factors, you can introduce some risk into the portfolio, not withstanding your risk target of a bond like volatility.
So we think it’s prudent, particularly when you have this much flexibility to diversity that risk, that single manager risk, with three managers. So we have three managers in the fund, and they are equally weighted.
Our view on this is that we wanted three of the very best managers that run flexible-bond portfolios, and that we didn’t want to make a bet on any one manager more than another if we had equal conviction that all three were excellent stewards and representatives of the fund. We’ve entrusted each of them with a third of the portfolio.
And as the approach to selecting the managers is—well, it’s going to sound simplistic, it’s fairly complicated in execution, but we really were looking for three simple things here. This is a fairly new investing category. In fact, Morningstar just created a new category for these funds last October. Before that, Morningstar didn’t even have a category for it, so that’s some sense for just how new this investing style is.
But we didn’t want a Johnny-come-lately. We saw the attractiveness of flows going into the unconstrained bond funds; we wanted folks who, from an investment standpoint, believed in it, made their decisions years ago when they have actually been investing in portfolios, so we wanted managers that had experience.
So, while the fund is not even a year old at this point, the managers have run these portfolios for four, and as much as eight, years in underlying separate account strategies, before they ever managed the fund.
The second thing we want is, if we wanted something that was different than a traditional bond portfolio, we wanted each manager individually to have very low correlation relative to traditional bond indexes, like the Barclays Ag. And that indeed was the case, and that was one of our primary selection criteria.
And the third thing is, if we wanted the benefit of this diversification that I’ve talked about, we wanted them to have low correlation to one another, and that also is the case. Each has complementary investment styles and thus has resulted in a very nice, overall combined portfolio risk and return profile, with a very, very smooth chart.
If you were to chart this fund, you would see a very nice upward steady upward trajectory because of the different approach that each manager has to the market, the flexibility that each has. They have different views on the market, and they have different instruments, and that’s created some great diversification across the portfolio.
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