Optimizing Risk-Return Outcomes in Core Fixed Income

June 2020

Over the last several years, we’ve experienced a wide variety of interest rate and risk regimes. This has provided a unique opportunity to assess our overall process and validate strategy refinements we implemented in 2015-16. We updated our analysis of performance data for a subset of fixed income indices across maturity, sector, and quality segments over the past 23 years. Our goal was to ensure we continue to focus on building portfolios that consistently emphasize sectors with the most attractive risk-reward profiles.

We believe the role of fixed income in an investor’s portfolio is to provide risk mitigation, stable income, and a low correlation with risk assets, such as equities. Using a top-down, risk-focused approach, we seek to identify and invest in spread sectors (i.e., non-US Treasury sectors) that we believe will provided optimal risk-return characteristics.

Our objective is to generate a consistent risk-adjusted return profile to balance higher risk-seeking allocations in other areas of the portfolio. As such, we believe for a given level of expected return, a portfolio profile that is more certain and less volatile is superior to one with higher price volatility and less certainty. We offer our clients a repeatable process that is intended to deliver stable returns over time. We believe identifying and investing in spread sectors with favorable risk-reward attributes enables return consistency through economic cycles.

Generally, we define spread sector and security risk by the volatility of excess returns, calculated using duration-matched US Treasuries. In most cases, we assess a portfolio’s risk-return tradeoffs relative to an index that includes both risk-free and spread sectors. As part of our investment process, we frame relative value across a matrix of more than 50 market subsectors using historical excess returns and volatility. We focus on sectors that have historically demonstrated attractive return per unit of risk to create fixed-income portfolios comprising the following sectors:

Structured Products: The agency MBS and consumer ABS sectors are fundamental building blocks for our strategies, providing diversification and the risk-return characteristics we desire.
Corporate Credit: This segment provides a wide range of attractive risk-return opportunities across qualities and maturities.
US Treasury Securities: We use Treasuries as a strategic sector allocation to provide stability, manage targeted-duration and yield-curve exposures, and as a source of liquidity. Treasuries are considered “risk-free” in that they are absent credit risk (and therefore have no expected excess return and excess return volatility).

Key Insights

Structured products can provide an excellent source of diversification and return potential within a risk-focused investment framework. Our investing approach will continue to emphasize ABS and MBS securities, particularly in shorter-duration strategies.
Shorter-duration credit exhibits Modified Information Ratios (MIRs) comparable to that of structured products. As a result, we believe allocations to this segment can provide opportunities to enhance clients’ portfolio returns.
The longer-term average excess return and volatility characteristics of 5- to 7-year credit securities have been attractive relative to 7- to 10-year credits. We have emphasized these maturities in our credit security selection process, a position validated by a comparison of modified information ratios (MIRs) relative to longer-duration maturities.
Investing in longer-maturity credit securities can play a role in maximizing the excess return of the overall portfolio. We try to increase the emphasis in these sectors when we determine the risk-return opportunities are favorable.

SECTOR ANALYSIS

To assess our investment process against our objective to optimize risk-return outcomes, we analyzed 23 years of fixed income index performance data across maturity, sector, and quality. Our primary goal was to quantify how these characteristics correlate with returns. One key measure we relied on was MIR, calculated by dividing realized excess returns by the volatility of those excess returns. We find this metric helpful in comparing sectors with distinct investment risks and characteristics.

The following table shows the risk-return characteristics of the spread sectors we believe should form the foundations of a diversified fixed-income portfolio: corporate credit, agency MBS, and AAA-rated ABS.

Figure 1. Sector Analysis Chart

1 - As measured by the ICE BofA US Corporate Index.
2 - As measured by the market-weighted ICE BofA US FHLMC and FNMA 30-Year MBS Index and the ICE BofA US FNMA 15-Year MBS Index.
3 - As measured by the market-weighted ICE BofA AAA US Fixed Rate Credit Card ABS Index and ICE BofA US Fixed Rate Auto ABS Index.
Note: Calculated using annualized excess returns with monthly periodicity from January 1997 to December 2019. Return calculations compiled using geometric means. Annualized volatility was calculated by multiplying the monthly standard deviations by the square root of 12. Asset-backed securities sectors displayed are AAA-rated. Spreads are relative to Treasuries. Corporate and ABS spreads are expressed as option-adjusted spread. Mortgage-backed securities spread is represented by the current coupon. We exclude the time period between June 2008 and September 2009 from this analysis due to the exceptional volatility and correlations of excess returns exhibited at that time. During this time period, primary fixed income sectors experienced return periods that were multiple standard deviation events relative to the historical evidence of the past 40 years.Source: ICE BofA US Broad Market Index series, PNC Capital Advisors.

Sector Observations

Corporate credit generated the largest average excess return, but exhibited greater volatility and higher overall interest rate risk (as measured by effective duration).
Agency MBS had an average spread comparable to that of corporate credit with considerably lower return volatility and interest-rate risk.
Consumer ABS offered the lowest overall interest rate risk, as well as the lowest volatility of return.

CORPORATE CREDIT

We focused our analysis of the corporate credit sector on investment-grade securities, defined as BBB-rated and above. The profile of the corporate credit index can be deconstructed into two primary factors that describe risk and return: default risk and spread duration risk. We define default risk across three quality buckets: AAA-AA, A, and BBB. These ratings represent the average rating assigned between the primary credit rating agencies. Similar to modified duration, which measures a bond’s price sensitivity to changes in yields, spread duration measures price sensitivity to changes in credit spread. We believe it is a good proxy for duration risk of excess return, as opposed to duration risk of total return (modified duration).The table below shows excess return, volatility, and MIRs over various credit quality and bond maturity segments.

Figure 2. Corporate Credit Chart

Note: As measured by the ICE BofA US Corporate Index. Calculated using annualized excess returns with monthly periodicity from January 1997 to December 2019. Return calculations compiled using geometric means. Excess return is calculated relative to duration-matched US Treasuries.
Source: ICE BofA US Broad Market Index series, PNC Capital Advisors.

Return

BBB-quality categories have had the highest average excess returns. Additionally, the A-quality segments have outperformed the AAA-AA tier in all maturity groups less than 10 years.
Longer-maturity segments have not necessarily driven larger average annual excess returns. In fact, across credit quality groupings, the 5- to 7-year maturity category has generated the highest excess returns.
The 10-plus-year maturity group had the lowest mean returns across the maturity landscape. Lower realized excess returns can be partially explained by demand from asset-liability managers and insurers with long-term liability targets. Demand from this investor base has compressed spreads in longer-dated securities and flattened credit curves. In addition, longer spread duration amplified the price impact from changes in risk premiums, which led to a greater proportion of time periods exhibiting negative excess returns than other maturity segments.

Figure 3 Volatility Return Chart

Volatility

Within all credit quality segments, longer maturities resulted in substantive increases in return volatility; larger spread durations at longer maturities amplified volatility.
Lower credit quality was also associated with increased return volatility across maturity categories. The table Spread Between Minimum and Maximum OAS illustrates the wide variation of risk premiums among these segments over the past 23 years, as measured by option-adjusted spread (OAS).

Figure 4. Modified Information Ratio Chart

Note: All data for the period January 1997 to December 2019. Annualized volatility calculated by multiplying the monthly standard deviations by the square root of 12. MIRs calculated by dividing Annualized Excess Return over the period by Annualized Volatility.
Source: ICE BofA US Broad Market Index series, PNC Capital Advisors.

Modified Information Ratio (MIR)

While shorter-maturity groupings have generated the most attractive risk-return profiles (the highest MIRs), the magnitude of average annual excess return in these segments is generally more modest.
Lower-quality and longer-maturity credit have the potential to provide opportunities to maximize excess return.

Corporate Credit Observations

Corporate credit has the potential to provide important sector allocation opportunities to produce alpha in client portfolios.
Given the more pronounced idiosyncratic risk, it is important to maintain both a well-diversified portfolio and a disciplined research process.
High-quality, low-risk premium portions of the market exhibit greater return consistency in the context of our historical analysis. As a result, we believe more persistent allocations to this segment provide the potential to enhance portfolio returns.
Selective investments in lower-quality and longer-maturity credit securities can play a role in maximizing excess return of an overall portfolio.

STRUCTURED PRODUCTS

Between 1997 and 2019, AAA-rated ABS and agency MBS sectors exhibited significantly less volatility of excess return than nearly all credit sectors, resulting in compelling MIRs. Additionally, there was a low correlation of excess return between structured products and the corporate credit sector over the 23-year period, due in part to the high-quality and shorter-duration profile of structured products relative to the overall credit index.

Figure 5. Structured Products Chart

1 - As measured by the ICE BofA US FHLMC and FNMA 30-Year MBS Index.
2 - As measured by the ICE BofA US 15-Year MBS Index.
3 - As measured by the market-weighted ICE BofA AAA US Fixed Rate Credit Card ABS index and ICE BofA AAA US Fixed Rate Auto ABS Index.
Note: Calculated using annualized excess returns with monthly periodicity from January 1997 to December 2019.
Source: ICE BofA US Broad Market Index series, PNC Capital Advisors.

We believe structured products provide an important source of diversification and can improve the risk-return characteristics of an overall portfolio. The diversification benefit provided by incorporating structured products in an asset-allocation strategy can be illustrated by comparing two portfolios, one consisting solely of government and credit sectors (Bloomberg Government Credit Index) and the other that includes structured products (Bloomberg Aggregate Index).

As shown in the following table, adding structured securities to a government-credit portfolio over the period 1997 to 2019 would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher MIR.

Figure 6. Bloomberg Indices Chart

Note: Calculated using annualized excess returns with monthly periodicity from January 1997 to December 2019.
Source: Bloomberg Indices, PNC Capital Advisors.

When constructing a portfolio, there are additional aspects of the MBS and ABS sectors to consider.

MBS

Interest-rate volatility has the largest impact on relative performance of MBS. The inherent prepayment-convexity risk of these securities affects the timing of cash flows from monthly amortization of principal and interest.
The MBS and corporate credit sectors are driven by different economic and market dynamics: interest-rate volatility (MBS) versus business fundamentals and corporate default cycles (corporate credit)

ABS

While the ABS market has very little exposure to prepayment volatility, and relative performance is not interest-rate driven, the sector has shown a low correlation with credit overall due to limited exposure to the corporate business cycle.
Additionally, ABS securities benefit from structural enhancements that boost credit quality. These include cash reserves, overcollateralization and/or subordination, which can mitigate the loss potential for investors at the top of the capital structure.

Structured Products Observations

Structured securities can play an important role in optimizing the risk-return profile of a fixed-income portfolio.
The enhanced income and relatively low volatility historically offered by AAA-rated consumer receivables make the sector an important component in the construction of a risk-focused portfolio.
We believe the credit card and prime auto segments of the ABS market are high-quality, liquid asset classes with an attractive risk-return profile.

OUR COMMITMENT TO OUR CLIENTS

We believe opportunistic sector allocation, coupled with an investment process focused on risk management and identifying relative value opportunities should result in consistent risk-adjusted returns over a full market cycle.

Over the last several years, we’ve experienced a wide variety of interest rate and risk regimes. We’ve adhered to the tenets of our risk-based philosophy throughout and used these opportunities to evaluate the findings of our historical analysis in practice.

Important Disclosures

Presentation of Performance of Market Indices

Various market indices may be referred to in these materials. Please see following for a brief description of these indices and comparisons. Indices are unmanaged and not available for direct investment. The performance of an index does not reflect expenses associated with the active management of an actual portfolio.

ICE BofA US Mortgage Backed Securities Index tracks the performance of US dollar denominated fixed rate residential mortgage pass-through securities publicly issued by US agencies in the US domestic market. 30-year, 20-year and 15-year fixed rate mortgage pools are included in the Index provided they have at least one year remaining term to final maturity and a minimum amount outstanding of at least $5 billion per generic coupon and $250 million per production year within each generic coupon. Hybrid, interest-only, balloon, mobile home, graduated payment and quarter coupon fixed rate mortgages are excluded from the index, as are all collateralized mortgage obligations.

ICE BofA Conventional 30-Year Mortgage backed Securities Index is a subset of ICE BofA US Mortgage Backed Securities Index including all 30-year securities issued by Fannie Mae and Freddie Mac except for interest-only fixed rate mortgage pools and hybrids.

ICE BofA US 15-Year Mortgage Backed Securities Index is a subset of ICE BofA US Mortgage Backed Securities Index including all 15-year securities except for interest-only fixed rate mortgage pools and hybrids.

ICE BofA AAA US Credit Card Asset Backed Securities Index is a subset of ICE BofA US Fixed Rate Asset Backed Securities Index including all asset backed securities collateralized by credit card loans and rated AAA.

ICE BofA AAA US Fixed Rate Automobile Asset Backed Securities Index is a subset of ICE BofA US Fixed Rate Asset Backed Securities Index including all securities collateralized by auto loan receivables and rated AAA.

Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

Bloomberg US Government Credit Bond Index is a broad-based flagship benchmark that measures the non-securitized component of the US Aggregate Index. The index includes investment grade, US dollar-denominated, fixed-rate treasuries, government-related and corporate securities.

ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.

ICE Data Indices, LLC (“ICE Data”), is used with permission. ICE Data, its affiliates and their respective third party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ICE Data, its affiliates nor their respective third party suppliers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. ICE Data, its affiliates and their respective third party suppliers do not sponsor, endorse, or recommend PNC Bank, NA, or any of its products or services.

“Bloomberg®” and the Bloomberg indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by PNC Capital Advisors LLC. (PCA). Bloomberg is not affiliated with PCA, and Bloomberg does not approve, endorse, review, or recommend this material. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the information herein. This publication is for informational purposes only. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Unless otherwise noted, all data showing results from January 1997 to December 2019. We exclude the time period between June 2008 and September 2009 from this analysis due to the exceptional volatility and correlations of excess returns exhibited at that time. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice or a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be profitable. Past performance is no guarantee of future results.

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PNC Capital Advisors, LLC is a wholly-owned subsidiary of PNC Bank N.A. and an indirect subsidiary of The PNC Financial Services Group, Inc. serving institutional clients. PNC Capital Advisors’ strategies and the investment risks and advisory fees associated with each strategy can be found within Part 2A of the firm’s Form ADV, which is available at https://pnccapitaladvisors.com.

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