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How to use smart beta to reduce your bond market risk
by Robert St George on Oct 17, 2013 at 09:30
Bond indices have long been known as baskets of failure rather than success, promoting the most indebted. It is for that reason Towers Watson prefers to back smart beta products in the fixed income space, with 57% of its total allocation going into bond strategies.
‘Traditional fixed interest indices have a number of flaws in our opinion,’ said Phil Tindall, senior investment consultant at Towers Watson.
In the sovereign space, for example, he notes the concentration risk in a handful of debt-bloated economies: the US and Japan alone account for 54% of the Barclays Capital Global Treasury index.
A typical smart beta product might cap the weighting to any one country at a far lower level. An alternative for those with a different perception of risk could limit the total exposure to the eurozone, says Tindall.
A second smart beta approach could create indices based on the issuer’s economic fundamentals, encompassing anything from GDP size to any metric of fiscal sustainability, such as current account deficit or foreign reserves. ‘These methods do, however, have associated concentration issues that would also need to be managed,’ said Tindall.
Beyond government debt, he suggests using smart beta construction methodologies that screen out of indices the corporate bonds most at risk of a rating agency downgrade or default.
A particular area of concern here is emerging market debt, especially in Eastern Europe.
Russell Napier, an analyst at CLSA, has predicted that a trillion-pound wave of defaults will emanate from the region in the near term. For example, one third of each of what Turkey and Greece owe to external creditors – worth £74 billion and £110 billion respectively – matures over the next 12 months.
‘This plays to the asymmetric nature of bonds,’ Tindall said of smart beta techniques that would strip such exposure from indices. ‘Reducing downside is better than capturing upside.’
These methods are far closer to active management than a smart beta equity product that, say, minimises volatility or enacts a small cap value strategy.
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