Fixed income returns from asset consultant’s perspective

Over the past few years, I have often been asked for my opinion on a fixed income or credit strategy offering double digit returns. Caveat emptor and do your own research is always my advice - but I thought it might be useful to share a mental model from my asset consulting days for assessing a range of credit/fixed income strategies.

My approach, before getting bogged down in the specifics of the manager/product, was always to:

1. try and figure out what their investment universe was. That is, what is the product actually investing in?

2. try and establish a listed/benchmark return for that investment universe.

Establishing a listed/benchmark return is useful for two reasons.

Firstly, you can use the attributes of this benchmark to assess what the yield to maturity (net of defaults) of the investment universe and use this to assess the manager’s return projections. For example, if a manager says they are going to mainly invest in Australian government bonds (10yr current yield to maturity 4.5%) and they say they are going to return 7-10% then you should be sceptical.

This is also useful for credit strategies. It is always interesting to check the alignment between the return targets of managers and the credit profile of their target investment universe. Take the US for example, current BBB spreads are approximately 1.5% and current high yield spreads (that is for issuers rated BB and below) are currently circa 3.2% (that is a total return of around 7.25%). Most asset consultants assume the long-term return from listed equities is risk free plus 4-6% (and a debt strategy offering higher than equity returns should be a potential red flag). For other countries and sectors, it is usually pretty easy to get some relevant benchmarks.

If a manager’s forecast returns are way out of line with these benchmarks - then the question is how are they earning this additional return? Usually, there are two options, either the manager’s strategy is based on making capital gains over and above the underlying asset yield - and you need to form a view of whether this is reliable and repeatable, or the there are other risks (eg subordination, illiquidity, leverage, derivates etc) that you need to form a view on whether you are comfortable accepting and whether the additional return is reasonable compensation. There are no free lunches.

Secondly, the benchmarks provide a useful guidepost for assessing past performance. Has the manager/product delivered historic returns that are consistent with the broader universe?

One key factor, for fixed income investors, with backward looking return outcomes is that base rates rose very substantially in 2022 and 2023. This means that any fixed income strategy which had meaningful fixed rate exposure - that is exposure to long-term interest rates - will have recorded capital losses (and relatively weak absolute performance in 2022 and 2023). For example, the five year return to the Bloomberg Ausbond Composite index to for the five years to end Feb was minus 0.6% per annum. If a manager says they take long-term base rate exposure and are reporting historic returns of 10%+ then there is probably something off.

My overarching comment for assessing all managers, don’t be a deer trapped in the headlights of returns. Look under the hood.  Figure out how they are generating their returns and whether you are comfortable that this is repeatable and are willing to accept the risks involved. Finally, no investment should be viewed in isolation, each manager/product should be assessed for its ability to deliver the role it is meant to play within the broader portfolio.