Creating the right asset mix is sometimes an endless task, especially now in an environment where the investment outlook is best described as uncertain. This is also the case with pension mandates, where recent changes to accounting rules and a persistant gap between income generation and the returns necessary have made traditional asset mixes less effective. Current low rates of return and the prospect of lower than expected growth mean there are less obvious investment opportunities that might provide the long-term return characteristics required by pension funds.

Resolving this dilemma is a recurring theme among our clients when asked what issues they face with their current investment strategies. If it were a temporary phenomenon, then there would be little cause for concern, but these conditions have persisted since late 2000. As a result there has been a revision of the appropriate asset class mix, and increasing interest in exploring less traditional asset classes that can offer appropriate risk and return. As these alternative asset classes have developed, there is sufficient performance history for adequate allocation analysis and correlation, while efficient frontier models suggest that for similar risk, using domestic benchmarks, higher return can be achieved by increasing the long-term allocation to some of these asset classes.

Bonds have traditionally been included in investment portfolios to reduce risk and match liabilities. Through active management, however, bonds can also produce attractive returns. Active investment managers are exploiting their universes much harder; employing long/short techniques and allocating to European high yield bonds, emerging market debt and Asian fixed income to add value. A strategic allocation to one or all of these sectors can provide the opportunity for price appreciation as well as a high current income.

The high yield sector has a low correlation to other sectors of the fixed income market; consequently, an allocation to high yield can improve diversification. The duration, or sensitivity to interest rates, of high yield bonds tends to be relatively low, which can also help reduce risk. High yield bonds are typically issued with maturities of 10 years or less and are often callable after four or five years.

European high yield

The European high yield market really started in 1998, one year before the introduction of the euro. In its infancy the market suffered problems characterised by over concentration of risk in the developing telecom market, poor economic and corporate news flow, defaults, rating downgrades and ultimately income volatility and capital losses. Between November 2000 and 31 October 2002 the JP Morgan European High Yield Bond Index fell by 28.7 per cent on a total return basis.

The weakening credit fundamentals of many companies during the economic downturn meant that a number of bonds were downgraded by credit agencies, such as Moody’s and Standard & Poor’s. In particular, a large number of bonds were downgraded from investment grade (BBB or above) to junk status (BB and below) – the so-called fallen angels. During 2002 over ?31bn-worth of debt was downgraded into the high yield universe. This doubled the size of the market and introduced new industries to the sector.

At the same time, the market also experienced a substantial number of defaults. A default occurs when a company fails to make an interest or capital payment on one of the bonds it has in issue. Defaults occur each year but the level is much higher in periods of a weak economy as some companies may not be generating sufficient profit to make the interest payments due to their bondholders. Some 36.8 per cent of the high yield bonds outstanding at the beginning of 2002 defaulted in the European market over the year. Telecom and cable-related credits were the main casualties, but issuers from more traditional industries also suffered.

These problems served to cleanse the market of the more speculative issuers. It is now far more diversified in terms of industry mix with a massive reduction in its exposure to telecom related issues. The quality of companies within the arena has also improved, largely due to the number of credits that have been downgraded from investment grade to high yield. Furthermore, investor concerns about structural subordination (credit seniority) have led to new issues providing increased protection to high yield investors should the issuing company get into difficulties.

Given that Europe is about the same size as the US both in terms of the size of the economies as well as the populations, there is great potential for growth in European high yield. The size of the European market is just over one-tenth of the US market ($68bn versus $606bn), with 179 issues compared with 1911, according to November 2005 data from Bloomberg and Merrill Lynch.

Currently, the vast majority of debt finance for companies in Europe comes from the bank debt market. What has driven so many companies in the US to tap the high yield market is the increased flexibility issuing high yield bonds offer, both in terms of providing longer term financing and the ability to repay the loans early. Over time, European companies will increasingly use the European high yield market to borrow in the same way.

In addition to this, there is great potential for demand to increase from European investors. Pension funds and insurance companies in Europe are increasingly allocating a portion of their portfolios to the sector. Add to this the urgent need in Europe for individuals to save more for pensions: in the US it is much more common than in Europe for individuals to hold high yield mutual funds. These are key drivers for strong long term demand for this asset class both from companies looking to borrow and investors looking for a good source of income.

Emerging market debt

With little opportunity offered by low global interest rates there has been a renewed examination of the outperformance and merits of emerging debt over the last 10 years. While performance is impressive, it is still surprising to many with memories of the stark headlines regarding credit events in places such as Argentina, Russia or Turkey.

To examine an allocation rationale, it is instructive to note that performance of the emerging debt index over the last 11 years has outstripped most other asset classes including the S&P 500, government bonds and emerging equities. Given that, it would seem rather surprising that global investors would have little exposure to the asset class over that time, particularly as the correlation is so low with other asset classes over the same period. The traditional arguments of “extreme volatility” and “poor liquidity” have their merits, but there has been a noticeable change in the structure, liquidity and investor base in the market since the Russian crisis in 1997/8 that goes a long way to reducing the relevance of those arguments. The case for the asset class is compelling over the long term, yet the characteristics of the asset class have made many cautious.

But investing in a bond market other than your own domestic market can offer higher return opportunities without a drop in rating level. Regulatory and structural trends deliver these opportunities, for example, UK requirements to invest in gilts sustain the relatively expensive levels of some longer dated issues. Such restrictions or directions on domestic/international exposures are prevalent in most domestic bond markets.

Naturally there is currency risk although that risk can be managed on an unhedged or hedged basis. Allocating to emerging market debt can increase the pool of return opportunities without a significant drop in overall credit quality, especially as local currency markets develop and offer viable hedging mechanisms.

Emerging market debt has become an increasingly popular source of alpha generation as parts of the asset class have matured, and correlation between country returns has fallen. This is particularly the case as investors monitored performance during and after the Argentine default. There is still a natural mistrust of the asset class as investments are made in untraditional markets, and the lasting impression of certain countries may be front page headlines of social unrest and inadequate levels of transparency. However, in 1988 markets such as Italy, Portugal and Spain were seen as exotic. How times change. While understandable, this overshadows the significant credit improvement in most regions.

There has been a structural shift in the composition of the market and the types of investors, which has meant that a reasonable attempt can be made to allocate cash and get a representative exposure without paying too high entry and exit costs. As Brady bonds continue to be retired in favour of less expensive forms of debt, eurobonds have increased so that there are definable and liquid yield curves established for most emerging issuers. Most external issuance has been in dollars, and although issuance in euros has increased, experiences of EU retail investors with Argentine exposure have dented appetites for that kind of opportunity.

The most encouraging trend has been the ability of emerging countries to issue debt in their own currency. Naturally this has been made possible by a tightening of yields in the external market but it is a positive trend as external debt is expensive and has currency risk implications for the issuer. The characteristics of an investment grade credit are those countries that can finance themselves locally, through their own currency.

In the future, emerging countries will attempt to build yield curves domestically out to 10 and 20-year maturities and if local capital markets deepen, issuers will be less exposed to global events or loss of risk appetite, meaning de facto credit improvement.

These observations do not suggest that emerging market debt is the only solution; however, there are merits to the argument. We have noticed increasing demand for emerging debt exposure, albeit to varying degrees of risk appetite. Often it is worth thinking of the asset class as non-investment grade government debt (despite roughly 50 per cent of the standard bond index being investment grade in some form), as the stigma of emerging volatility lingers for those more used to traditional sources of risk/return.

Asian fixed income

Asian fixed income is increasingly recognised not only as a sub-set of the global bond market but as an asset class in its own right. In recent years, debt markets have matured, with governments issuing longer dated issues and thereby creating a reference yield curve that had hitherto been lacking in many markets.

Both dollar bond and local currency issuance has picked up, and this of course reflects the improving credit worthiness of sovereigns (and corporates) as well as falling global interest rates – which have reduced the costs of issuance.

The Asian fixed income market is supported by strong fundamentals. From a macro- viewpoint a stable global economic environment will continue to provide positive momentum for Asia’s export-led industries. In particular, the potential recovery in the fortunes of the Japanese economy can only assist the growth in intra-regional trade. While spending by both consumer and government is fuelling growth in domestic markets.

Since the Asian crisis, government finances have been stabilised: foreign exchange reserves are now substantial and most countries are running healthy current account surpluses. Only twice in the past five years has growth appeared to slow; once in the aftermath of the technology bubble, due to Asia’s huge outsourcing industry, and later, in 2003, in the wake of Sars.

For companies, however, improvement has followed some at first painful re-structuring and regulatory reform. This has led progressively to re-structured balance sheets, the selling off of non-core operations and a restructuring of debt.

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