Bond investing beyond duration: sophisticated methods to improve the information ratio
In the third part of our series on fixed income investing techniques, we explore how to use every tool available to increase risk-adjusted returns.
Key takeaways
- One of the most valuable metrics in bond investing is the information ratio, an indication of efficiency in the use of risk.
- The information ratio is a function of a manager’s ability to take active positions that contribute positive performance, the diversification of those active positions, and the degree of freedom of implementing these active positions.
- Over the long term, a focus on the information ratio can help investors achieve consistently good risk-adjusted returns.
In the second instalment of this series, we discussed how duration and yield curve positioning often serve as the dominant drivers of return in fixed income. We wrote that a better approach is to spread risk more widely. Here, we offer a fuller explanation for this conviction, based on the information ratio of the portfolio – a measure of the risk taken to achieve over (or under) performance. In other words, the value added by the portfolio manager.
Why the information ratio matters
To understand the information ratio, it is necessary to grasp the importance of risk-adjusted returns. As discussed previously, many fixed income investors typically operate under constraints. Institutions such as insurers or central banks cannot afford to pursue the best bond returns at any cost. Rather, they want the best return per unit of risk.
The information ratio measures a manager’s ability to achieve consistently good risk-adjusted returns. To calculate it, we divide the portfolio’s excess return by the portfolio’s tracking error (a measure that reflects how closely the portfolio has matched its benchmark over time).
Let’s look at two examples. Portfolio A achieves an excess return of 1% with a tracking error of 4%. The information ratio would be 0.25.
Portfolio B achieves an excess return of 0.5% with a tracking error of 1%. The information ratio would be 0.5.
What is the information ratio telling us? That the manager of Portfolio B has been more successful in generating consistently good risk-adjusted returns. Portfolio A’s relative return may be higher, but because so much more risk was taken to achieve that return, its risk-adjusted return is lower than Portfolio B.
To understand why this is important, consider what would have happened to Portfolio A had that manager’s risky bets not paid off. Underperformance in the region of -4% versus a benchmark is a margin of error that institutional investors simply cannot tolerate for their bond portfolios. It is to avoid such scenarios that these investors pay attention to risk-adjusted returns.
As a general rule, an information ratio of around 0.5 is considered good while a ratio of 1.0 or more is exceptional.
An information ratio can be applied even to funds and mandates that do not have a specific benchmark (which may be described as “benchmark agnostic”, unconstrained or similar). In these cases, we can take a “risk-free rate”, such as the return on three-month US Treasuries, to stand as the benchmark. The information ratio still serves to reflect the consistency of excess returns in relation to risk.
Risk in fixed income – where duration comes in
It follows that a prudent investment approach will examine the sources of risk in fixed income. An obvious one is default risk – investors must guard against issuers failing to pay them what they are owed. Others include currency risk, liquidity risk and political risk.
However, among all these risk factors, there are two that have overwhelmingly the most influence on a typical portfolio’s returns: duration and yield curve positioning. Duration, as mentioned, expresses how a portfolio will respond to changes in interest rates.2 Yield curve positioning expresses how a portfolio will respond to changes in the yield curve’s shape.
We know about the importance of these twin elements thanks to an academic study published in 1991 that examined the returns of US Treasuries.3 The researchers looked at weekly returns of a portfolio of Treasuries between 1984 and 1988 to identify the components influencing excess returns. They reached the startling conclusion that an average of 97% of the total variance was explained by three factors of the yield curve: its level, slope and curvature. (While slope and curvature refer to shape, the level of the curve reflects the interest rate and is therefore linked to duration.)
It’s not that other risks had no effect. But according to the research, “specific risks that influence securities individually” tend to have a negligible effect on a diversified portfolio, while systematic risks relating to the yield curve have a general and more significant impact.
The fundamental law of active management
We have stated that it may be beneficial for certain investors to target a high information ratio rather than a maximal performance. But how? An influential answer was articulated in 1989 by Richard Grinold and later developed in partnership with Ronald Kahn. Their “fundamental law of active management” proposed that the information ratio depends on two things directly under portfolio managers’ control: a manager’s skill – what they called the “information coefficient” – and the “breadth” of the risk budget, meaning its diversification.1
It is worth noting that breadth does not refer to the number of bonds available but rather the total number of independent active positions.
So, how can we increase the diversification of active investment decisions? By analysing and investing across the widest range of risk factors possible.
These risk factors could include (among others):
- Sector. Finding the right balance between government bonds, corporate bonds, mortgage-backed securities and so on.
- Country. For strategies with a multinational reach, deciding which sovereign issuers to own and which to sell.
- Currency. Whether to buy bonds in hard currency or local currency, and when to use currency hedging.
- Quality. When does it make sense to hold investment grade credit and when to hold high yield bonds?
- Default. What is the probability the issuer will fail to repay what is owed? See our earlier article on this topic.
A more advanced approach
In the previous instalment of this series, we discussed how the role of bonds in most institutional investor portfolios is to provide steady, reliable returns. Given that the risk tolerance of these investors is limited, their risk budgets must be spent carefully.
Spreading risk across a wide range of risk factors can increase the number of investment decisions that are made, thus potentially boosting the information ratio. In the long term, that leads to the goal many bond investors seek – consistently good risk-adjusted returns.
