Expectations of an economic rebound, government support programs, and low interest rates have all been cited as reasons for the corporate bond market’s strong performance. But when it comes to active fund managers, Fear Of Missing Out on the rally that kicked off in March should also be on the list. Institutional investors held record levels of cash in April, just as the rally was gaining momentum. As I discuss below, large cash balances are poison in a rising market. Over the past couple of months I think FOMO has led many mangers to shift their cash into bonds, driven by the existential need to avoid underperforming their portfolio benchmarks.
The index is not your friend
To recap, “active” investors buy and sell bonds with the aim of generating returns above those of the market, as represented by an index. They’re well compensated for this, but failure to produce “positive excess returns” can lead to an involuntary career change – hence the market adage that “the index isn’t your friend, it’s your enemy”.
“Passive” investors, by contrast, don’t aim to outperform their indices – they simply need to match their performance by holding portfolios that track the benchmarks. This is a simpler and lower cost approach and has been gaining in popularity as a result.
Place your bets
Active investors generate positive excess returns by “placing bets”, i.e., by constructing portfolios that include assets that perform better than the market and avoid those that perform worse.
There are many variations on this theme. For example, a portfolio manager can hold a greater share of long maturity assets than are in the index, or overweight (versus the benchmark) sectors or issuers. As with all wagers, the outcomes of such investment decisions are either wins (in the form of outperformance vs. the index) or losses (the opposite).
A classic way to benefit from an expected market decline is to hold a large amount of liquid cash-equivalent assets like Treasury bills. The value of such assets will remain steady while the prices of the bonds in the index (hopefully) fall, thus producing a better return on the investor’s portfolio than on the index. On the flip side, holding a lot of cash pretty much guarantees underperformance vs. the benchmark when the market rises.
In the next section I illustrate this dynamic by constructing investment grade and speculative grade portfolios with large cash balances and calculating their performances vs. their indices in both falling and rising markets.
Cash in king – until it’s not
I’ll use as an example an investor who manages two US corporate bond portfolios. One portfolio holds investment grade bonds and is benchmarked against an investment grade index and the other is invested in high yield bonds and is measured against a corresponding index. We’ll assume that in January 2020 the portfolios’ holdings matched those of the indices. A second assumption is that our investor has “perfect foresight” (to use a quant forecasting term), meaning that his bets always turn out to be the right ones.
Given this, at the end of January 2020 he “knows” that the Covid-19 pandemic will have a disastrous economic and human impact globally, and thus crater the bond markets. To position his portfolios for this he sells bonds equivalent to 15% of his holdings (taking them proportionately from each rating category), buys liquid cash-equivalent assets in the form of overnight Treasury bills, and sits back to await the catastrophe.
Figure 1: Investment grade returns for the index and portfolio (15% cash holdings)
Not much happens to the investment grade portfolio in February, when it posts a very modest 4 bp return above the index (Figure 1). Our investor does better in the more volatile high yield market, where his 15% cash position earns him a 47 hp excess return (Figure 2). (The portfolios’ returns include the earnings from their Treasury bill holdings.) His reward comes in March. Both the indices and the portfolios fall in value, but the latter, insulated by their large cash holdings, decline by considerably smaller amounts. The result is a 118 bp positive excess return for his investment grade portfolio and 183 bp in high yield.
However, our investor’s foresight unfortunately abandoned him in March, so he retained his large cash holdings even after the Fed announced its bond buying programs towards the end of the month, kicking off strong rallies in both sectors.
Figure 2: High yield returns for the index and portfolio (15% cash holdings)
The markets (and thus the indices) rose in value in April and May, but because our investor’s portfolios are not fully invested in bonds they are now underperforming – their excess returns are negative. If FOMO hadn’t already led him to convert his large cash balance to bonds, it probably has done so by now.
My contention, as stated at the outset, is that many asset managers in analogous positions have indeed “thrown in the towel” and bought securities, providing additional fuel to the market’s rally.
In a previous post I advanced arguments to reconcile asset managers’ expressed pessimism (in early May, only 10% thought that we would get a V-shaped recovery that would be consistent with a bullish investing position) with the markets’ continued recovery.
A simple explanation could be that since then many investors have become believers in the economy and/or the strength and durability of government support programs, and have bought risky assets as a result. But FOMO is not limited to college students worried that a better party is happening someplace else without them (in the pre-Covid era, of course). I think it’s a powerful motivator for fund managers as well, one that provides an underappreciated driver of the bond markets’ continued rise.