Unconstrained bond investing – an introduction

Unconstrained bond investing strategies can provide a solution for today’s investors and tomorrow’s liabilities. Here we outline what unconstrained investing strategies are, and why investors should consider them now.

Why unconstrained investing?

Returns, drawdown protection and governance

In the face of unwinding fiscal stimulus and continued high valuations, investors face a great challenge – protect current asset values whilst generating meaningful returns. To compound matters, the timeframe for meeting these objectives is shorter for many investors than ever before. For example, pension schemes are maturing and facing material benefit payments as a proportion of their assets. This all points towards the need for ensuring that assets are efficient and protected – both in terms of the risk exposures generally, as well as the risk of material drawdowns.

Unconstrained investing strategies can provide a solution. From an investment perspective, successful frameworks generate material return above the risk-free rate and have built-in drawdown protection. Meanwhile, thanks to their unconstrained and dynamic nature, these strategies can also work as an efficient governance solution.

Why unconstrained investing now?

Market backdrop

For the past 30 years investors have enjoyed outsized gains from both equities and bonds. However, since 2008, risks have mounted and today’s market backdrop is a challenging environment for any investor – let alone a pension scheme with ageing plans and imminent liabilities.

Equity markets are considered by some as having reached ‘fear territory’.1 With Schiller’s cyclically-adjusted price earnings ratio (CAPE) above 30 since July 2017, peaking at 33 in January 2018, we haven’t seen levels this high since 2000 - just before the Tech Crisis.2

Government Bonds
The bond market has also been priced highly for some time now, and is now showing signs of weakness. Take government bonds for instance – the 10-year gilt yield has risen sharply at the beginning of the years and is traded in a range of 1.4% to 1.55%, after trading in a range of 0.95% to 1.3% in 2017. Even with the recent increase in yields, if you consider that inflation is much higher, government bonds are delivering negative levels of real yield – implying that the economy is still on life support.3

High-yield corporate bond spreads are currently at around 3.5%. Given that the annualised default rate is roughly 2.9% over the long term, investors are not currently getting a large margin of excess spread over the default rate.

Investors are now seeking further de-risking options
However, in light of today’s current market backdrop, investors are asking themselves: ‘What can I do to further de-risk and protect myself in this environment?’ Unconstrained bond investing strategies have since become increasingly popular as they offer investors full-spectrum access to the bond market while diversifying against credit risk and drawdowns.

‘Typical’ unconstrained bond strategies

Return expectations

One of the most common expectations from investors is that the unconstrained bond investing approach is a ‘go-anywhere strategy’, i.e. risk will be increased when the outlook is attractive, and risk will be decreased when the outlook is unattractive. The lack of benchmark requirements means that typical strategies have a very open spectrum of investible assets.
This is of course an opportunity. But, in our view, the full benefit of unconstrained bond investing is that it can be much more tailored and customised versus traditional investing approaches. Truly flexible unconstrained bond strategies should seek to find assets which have high risk-adjusted returns and a high degree of certainty around delivering on these returns. Success isn’t just about selecting assets with the best returns, the key is delivering on that level of return.

Exposure to credit risk and interest rate risk markets

Many unconstrained bond market players have relatively high levels of interest rate risk or credit risk within their strategies. This is because they tend to rotate primarily through those particular risk-sensitive assets. Whilst credit risk and interest rate risk are the two most common concerns for pension investors, overreliance or focus on these two risks means that – at any one time, the strategy will be exposed to one or the other risk.

Who is unconstrained bond investing suitable for?

Unconstrained bond investing strategies are suitable for investors who are on the de-risking journey, or for those who have already made the move into multi-asset credit, but are concerned about further market volatility. It can diversify away left-tail risk without forgoing the need for material, consistent returns over time. In particular, unconstrained strategies can fit in smoothly along defined de-risking journeys for pension schemes as they move towards their end goal.

Decoupling is key

Overall, the separation from a benchmark provides unconstrained bond strategies the flexibility, if harnessed correctly, to add diversification and provide absolute returns with greater certainty. We have a slightly different view on the opportunity presented within unconstrained investing, versus the traditional approach. Decoupling from the benchmark is important, but we think that strategies should also decouple from those traditional credit and interest rate risk markets, and should seek out alternative diversification opportunities.

Next time, we put the spotlight on some of the more alternative and nuanced opportunities that come with unconstrained bond investing.

1 Source: https://www.ft.com/content/793fbb08-f5e5-11e7-8715-e94187b3017e
2 Source: http://www.multpl.com/shiller-pe/table?f=m
3 Source: Source: 2.3% at time of writing https://www.ons.gov.uk/economy/inflationandpriceindices