Building a Diversified Fixed Income Portfolio: An Analysis of the Availability and Correlation of Excess Returns

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by Mark Huamani and Karl Mergenthaler, CFA, CPA
JPMorgan Investment Analytics and Consulting

It is a challenging environment for institutional investors in fixed income securities. The fixed income universe includes a large and complex range of products. Moreover, traditional U.S. Treasury and corporate debt securities may not offer attractive opportunities for excess returns. Based on our client interactions, many portfolio managers and plan sponsors are looking for ways to invest new funds without taking on excessive risks.

Consider the dilemma faced by managers of reserve portfolios at Central Banks. At the Central Banks around the globe, reserve accumulation is reaching record highs. According to the latest official foreign reserve figures, global foreign reserves doubled in 2006 and exceeded $5.4 trillion as of March 2007.¹ Yet, the available investment opportunities pose certain risks because yields on most fixed income securities are low and credit spreads are narrow.

In order to diversify, Central Banks are increasing exposure to new fixed income asset classes that may offer higher yields. Based on our interactions with clients, more than half of Central Bank reserve managers are moving into high grade spread products. Also, approximately two-thirds of Central Banks are using external managers to initiate the move into new asset classes.² Finally, investment managers at Central Banks are searching for sophisticated tools to manage this process.

We believe many institutional investors, from corporate cash departments to defined benefit pension plans, face a similar dilemma: namely, what fixed income asset classes offer the potential for excess returns and diversification benefits?

In this article, we provide a brief framework for building a diversified fixed income portfolio. First, we discuss the size and complexity of the overall fixed income market. Next, we analyze the long-term performance of the active fixed income managers within the JPMorgan Manager Universe. Also, we analyze the correlation of excess returns among the major categories of fixed income assets. Finally, we provide a brief overview of the tools available to monitor exposures and manage risks.

A Large and Complex Asset Class
Broadly speaking, fixed income markets are larger and more complex than equity markets. In the table below, we provide a summary of yields and recent returns for the major categories of fixed income assets.

Fixed Income Market Breakdown (click to enlarge)

Source: Lehman Brothers, EcoWin, Factset, JPMorgan Investment Analytics & Consulting.

As shown, emerging debt and high yield debt performed exceptionally well in 2006. Also, credit spreads are narrow - the incremental yield on high yield versus corporate credit, as well as emerging versus developed markets, is small relative to historical levels. At this juncture, many institutional investment managers are wondering where to find the most attractive risk-adjusted returns going forward.

Long-Term Perspective on Excess Returns
In order to understand the relative performance of the various categories within the fixed income asset class, JPMorgan Investment Analytics & Consulting analyzed 20 years of return and performance data for fixed income managers. At this time, the JPMorgan Manager Universe includes approximately 6,000 fixed income managers, including both domestic and international firms. In general, our analysis suggests that active managers in the high yield and MBS categories have been able to generate excess returns over time. Also, our analysis suggests the addition of one or more new categories may contribute diversification benefits to an existing fixed income portfolio.

Within our universe of fixed income managers, we analyzed the impact of three factors - market, term, and quality - on the overall performance of active managers. We found that the market factor explains approximately 80 - 90% of the average active manager's returns over time. This suggests that active managers generally follow the performance of the fixed income market overall, although they may take modest positions with respect to term and quality.

Next, we analyzed the average quarterly alpha for active managers within the major fixed income categories. In each case, we compared the results of active managers versus an appropriate benchmark. Our findings are illustrated in the chart below.

Average Quarterly Alpha

Source: JPMorgan Investment Analytics & Consulting.

As shown above, active managers of high yield securities have demonstrated the greatest ability to add excess returns above their benchmark.

Moreover, we analyzed the correlations of excess returns among the major fixed income categories over the 20-year period from 1986-2006. It is important to note that this time period includes both bullish and bearish markets, as well as several periods of "crisis" such as the World Trade Center attacks and the Far East Currency Crisis. In the table below, we show the correlation of excess returns among the major fixed income categories, and U.S. equities.

Correlation - Excess Returns

Source: JPMorgan Investment Analytics & Consulting.

As shown above, the correlation of excess returns among the major fixed income categories is relatively low. For example, the correlation of excess returns generated by core fixed income managers in relation to high yield managers is -0.15. Stated simply, this suggests that active managers of high yield securities may add value at times when active core fixed income managers are not able to generate excess returns. As such, a diversified portfolio that includes several categories of fixed income securities should have a relatively stable return profile.

Compliance and Risk Management
Within each fixed income category, we believe it is prudent to establish clear guidelines and monitor compliance on an on-going basis. In our view, fiduciaries should establish guidelines relative to security, market, credit, and interest rate risks. For example, a plan sponsor may determine that external managers will invest no more than 5% of assets in Collateralized Debt Obligations (CDO's), or that the Effective Duration of the portfolio must be within 0.25 years of the benchmark. It is a fairly rudimentary process to monitor compliance with these guidelines over time.

Also, we believe it is prudent to use modern statistical analysis to quantify and monitor risks within an overall portfolio. For example, Value at Risk (VaR) quantifies a predicted maximum loss (or worst-case loss) in absolute terms or relative terms for a specified period within a given confidence interval. Also, managers can use scenario analysis to determine the potential downside risks if there are extreme movements in macro-economic or other market factors. In this way, managers can ensure that downside risks are within acceptable limits.

Conclusions
Fixed Income securities offer a wide range of investment opportunities. Despite their recent volatility, emerging debt, mortgage backed securities, and high yield securities have generated attractive returns over time. Our analysis suggests that excess returns among active managers in the various fixed income categories are not highly correlated with one another. In our opinion, a diversified portfolio that includes several of the major categories of fixed income assets should be able to generate attractive and predictable returns over time.

In our view, institutional investors that oversee external managers should thoroughly analyze the long-term return history of each of the major categories of fixed income assets. Moreover, managers may be able to use active external managers to gain knowledge and expertise in asset classes that are new to their overall portfolios. As such, we believe it is worth the effort to analyze active managers and consider adding new categories to an existing fixed income portfolio.

¹ Total official foreign exchange reserves as of March 2007 including gold at book value and excluding foreign currency assets held at government investment agencies.
² Based on research produced by the JPMorgan Investment Bank in June 2007.