Fixed Income: Great Beta, Better AlphaJeffrey Alt, CFAVice PresidentPrudential Fixed Income Management March 2008
Why Don’t More Investors Look to Fixed Incomeas a Significant Alpha Generator?
Low risk Stable Conservative Are Investors Conditioned ToThink Of Fixed Income As: … A Great “Workhorse” Beta Source?
Traditional Fixed Income Portfolios Offer Relatively Low Yields Yield (%) Credit Risk Corp MBS ABS Leh Agg Agencies Treasuries Maturity (years) Interest Rate Risk As of 12/31/07; Source: Lehman Brothers, CS First Boston. Past performance may not be indicative of future results. PAG-0282.
Adding Additional Sectors Can Generally Increase Yield Without Increasing Interest Rate Risk Yield (%) Caa High Yield B High Yield Ba High Yield Bank Loans Credit Risk Corp Emerging Market Debt MBS ABS Leh Agg Agencies Treasuries Maturity (years) Interest Rate Risk As of 12/31/07; Source: Lehman Brothers, CS First Boston. Past performance may not be indicative of future results. PAG-0282.
Additional Sectors Can Maximize Return Opportunities Broad Range of Sectors Provides Diversified Sources of Excess Return
What Else Can Your Fixed Income Manager Do To Enhance Returns? • Short-Selling • Absolute Return Strategies
Short-Selling Permits Managers to Fully Express Views • Long-only managers cannot fully express views on issuers expected to underperform • Underweighting alone can’t make a meaningful difference as a vast majority of issuers are too small • Short-selling increases opportunity for managers to fully express their views, both positive and negative Lehman US Corporate IndexIndividual Issuers Arrayed By Percentage Weighting In IndexAs of 12/31/07 Issuer’sMarket Value In Index Only 13 issuers are large enough to individually comprise at least 1.0% of Index The vast majority of issuers individually comprise 0.25% or less of the index Source: Lehman Brothers. PAG-0282.
The Long Buyer of Stocks May Have BetterOpportunities for Outsized Price Gains Positive Skew Creates More Upside Potential Small Cap Stock Prices • Upside is theoretically unlimited: • Opportunities for outsized gains from price appreciation (think Google), although probability is small • Results in long tail to the right • Downside is limited: • Lowest a stock’s price can go is to zero • Results in short (fat) tail on the left The Risk (“Tail-risk”) Is to Short-sellers of Small Cap Stocks
Short-sellers of Bonds May Have Better Opportunities for Outsized Price Gains Negative Skew Creates More Downside Potential Investment Grade Bond Prices • Upside is limited: • Theoretical maximum price • Sum of coupon flows + principal • Little chance of credit upgrades, typical trigger for price gains • Results in short tail to the right • Downside is greater than upside • Credit deterioration can cause price loss • Extreme levels would be bankruptcy/recovery levels • Results in long tail to the left The Risk (“Tail-risk”) Belongs to the Long-Holders of Investment Grade Bonds
Absolute Return Strategies Expand The Range of Opportunities • Gives managers additional flexibility to further increase alpha potential • Not tied to a market benchmark • Ability to short securities • Low correlation to traditional markets
Why Fixed Income in Sourcing Alpha? • Diversify your alpha sources • Not as popular for absolute return strategies • Popularly misunderstood • Asset class may lend itself to shorting (skew) • Can produce uncorrelated alpha which leads to higher information ratio for overall portfolios and Fixed Income: “Great Beta, Even Better Alpha”
Disclosures Prudential Investment Management (PIM) is the primary asset management business of Prudential Financial, Inc. (Prudential Financial). Prudential Fixed Income Management (PFIM) is PIM’s largest public fixed income asset management unit, and operates through Prudential Investment Management, Inc. (PIM, Inc.), a registered investment advisor. The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that Prudential Investment Management believes to be reliable. We do not guarantee their accuracy. This commentary, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and these views are subject to change. There is no guarantee that the views expressed will be realized.