Global Global Mortgage-Backed High Emerging
Correlations Government Credit Securities Yield Market Debt Cash
Global Government 1.00 0.89 0.82 -0.03 0.43 -0.04
Global Credit 1.00 0.80 0.35 0.66 -0.11
Mortgage-Backed Securities 1.00 0.11 0.49 0.02
High yield 1.00 0.66 -0.08
Emerging Market Debt 1.00 -0.07
Cash 1.00
Exhibit 1 – History shows correlations vary among many fixed-income instruments
As of March 31, 2007
Correlations based on five years of monthly total returns of the following indices: High yield: Lehman Brothers US Corporate High yield Index
Global Government: JP Morgan Global Government Bond Hedged to USD Index Emerging Market Debt: JP Morgan EMBI Global Diversified Index
Global Credit: Lehman Brothers Global Aggregate Corporates Hedged to USD Index Cash: US 3-month LIBOR—constant maturity
Mortgage-Backed Securities: Lehman Brothers Mortgage Index Source: Goldman Sachs Asset Management (GSAM)
the chances of fully exploiting potential alpha opportunities. For example, • A relatively easy way to gain synthetic exposure to specific securities
being underweight Japanese government bonds at various stages over 2006 or asset classes through a large array of instruments, including swaps
was a profitable trade. A portfolio managed against a global benchmark (interest rate, credit default and total return), futures and forward
could have outperformed by selling some Japanese government bonds, or contracts, and
associated futures, in anticipation of an increase in market yields.
• A standardised legal framework, e.g. International Swap and Derivatives
However, unless the portfolio allocation to Japanese bonds had been
Association (ISDA) Master Agreements.
reduced to zero, the portfolio would still have declined in value as yields
The practical combination of these benefits results in a more efficient
rose. Without the ability to be net short, a zero exposure would have been
portfolio.
the best achievable result. In the case of a single-country benchmark (e.g.
For example, while insurance company portfolios will have limited
the Lehman Brothers US Aggregate Bond index), such a trade would not
deployment of derivatives in their portfolio, a more typical active fixed-
even have been possible, as there are no Japanese bonds in the benchmark
income portfolio today is likely to contain currency forwards, bond futures
to underweight. Incorporating the ability to be outright short allows a
and interest rate swaps. These instruments are used to express active interest
portfolio, with or without a benchmark weighting to Japanese bonds, the
rate and currency decisions, but derivatives allow the investor to do so in
potential to actually increase in value in absolute terms as yields increase.
a more precise way. The interest rate swap market enables the tailoring of
that view to any part of the yield curve.
Derivatives increase the flexibility to implement views Other over-the-counter derivatives—such as credit default swaps (CDS,
The use of derivatives in modern portfolio management is no longer
index and single name), total return swaps, credit-linked notes and mortgage
confined to hedging purposes. Today, derivatives form an integral part of
‘to be announced’ (TBA)—have also gained large popularity, providing
the active management process of fixed-income portfolios. They provide
increasing scope to express relative value views across the broad market
investors with greater choice and flexibility to implement a variety of
sectors. They also allow for additional flexibility in implementing active risk
different investment decisions, including both the replication of market
positions in bottom-up security selection strategies, such as corporate credit,
mortgage- and asset-backed securities, high-yield, and emerging market
risk and returns (beta) and the implementation of active investment views
debt. Exhibit 2 overleaf lists some practical examples of how derivatives can
(alpha). With derivatives, investors can exercise greater independence
enhance different investment strategies.
among investment views, greater risk management precision, and gain
access to otherwise inaccessible investment strategies.
From an investment perspective, derivatives provide a broad set of
Using derivatives as an overlay to seek alpha generation
benefits, including: The next stage of development in managing fixed-income portfolios
• High liquidity
centres on the idea of using derivatives to provide an ‘alpha overlay’ across
a portfolio. The practice—which derives from the concept of capital-
• Cost-effectiveness
efficient investing—is relatively simple: just as a single derivative contract
• Minimal portfolio disruption
can create a notional exposure in excess of the physical cash posted to
• Symmetry (the ability to more meaningfully express both overweight back the contract, so too can a portfolio of derivatives and cash bonds be
and underweight views) constructed, in varying combinations and employing considerably lower
• A large variety of maturities (maturities are available from one to 50
cash allocations than the intended notional portfolio exposure. Successful
years and beyond), which can be instrumental in the implementation of
capital-efficient investing depends on two key ingredients: access to a wide
investment policies that aim to hedge long-dated liability streams, such
range of derivatives instruments and a sound risk-budgeting and risk-
as liability-driven investing (LDI) strategies
management framework (more on this later).
Bermuda Re/insurance . November 2007 49
Page 1 |
Page 2 |
Page 3 |
Page 4 |
Page 5 |
Page 6 |
Page 7 |
Page 8 |
Page 9 |
Page 10 |
Page 11 |
Page 12 |
Page 13 |
Page 14 |
Page 15 |
Page 16 |
Page 17 |
Page 18 |
Page 19 |
Page 20 |
Page 21 |
Page 22 |
Page 23 |
Page 24 |
Page 25 |
Page 26 |
Page 27 |
Page 28 |
Page 29 |
Page 30 |
Page 31 |
Page 32 |
Page 33 |
Page 34 |
Page 35 |
Page 36 |
Page 37 |
Page 38 |
Page 39 |
Page 40 |
Page 41 |
Page 42 |
Page 43 |
Page 44 |
Page 45 |
Page 46 |
Page 47 |
Page 48 |
Page 49 |
Page 50 |
Page 51 |
Page 52 |
Page 53 |
Page 54 |
Page 55 |
Page 56 |
Page 57 |
Page 58 |
Page 59 |
Page 60