Simplifying the Creation of Bespoke Bond Portfolios

This article was first published in the Fall 2017 issue of Family Office Elite Magazine.

Fixed income as an asset class has always been a core component of an ultra-high net worth individual’s portfolio. However, as an asset class historically lagging in innovation, are investors being adequately served, and are their investments truly tailored to their individual goals and requirements?

Adrian Gostick, Chief Revenue Officer of BondIT, shares his thoughts on the challenges facing investors, and how BondIT is bringing much-needed innovation to the world of bonds.

So what are the challenges facing investors in fixed income assets? Since the Great Financial Crisis of 2007-8, regulations limiting bank trading activities, and increasing costs of holding riskier bonds, resulted in dramatic drops in dealer inventory, reducing market liquidity and available

inventory.

To gain exposure to fixed income, in an environment of decreasing liquidity, many investors turned to bond ETFs. From 2008 to the beginning of 2017, assets held in bond ETFs grew 600% as investors were attracted by the perception of higher levels of liquidity, lower fees, and easy diversification. However, there is no free lunch, and such perceived benefits carry several negative consequences, which ultimately result in investors receiving sub-optimal returns versus a portfolio of individual bonds.

As an illustration, to provide sufficient liquidity to an ETF that is based on an inherently illiquid asset class, ETFs must invest into the more liquid spectrum of bonds. This liquidity comes at a cost, with more liquid bonds, in general, having lower yields, all other things being equal, than less liquid ones, thereby reducing the returns of an ETF versus a portfolio without such liquidity restrictions.

Looking at the tracking error of a bond ETF against its benchmark adds evidence this view. Despite the relatively low ETF fees versus those for an actively managed fund, once you add the tracking error, the overall cost of owning an ETF can be significantly higher. Many advisors, aware of the limitations of using bond ETFs, prefer the approach of providing a portfolio of individual bonds, tailored to their

client’s requirements. Providing a bespoke portfolio has many benefits, including optimising the returns for the level of risk taken, ensuring the holdings reflect their clients’ preferences, such as investing into “green” assets, or avoiding specific countries or issuers, and providing cash pay-outs for specific life events by aligning maturing bonds with those events.

Why don’t more advisors promote bespoke bond portfolios over ETFs?

Quite simply, the main challenge in providing bespoke portfolios to customers is that it is a mathematically challenging problem to create and maintain such portfolios. As businesses scale, e.g. with multi-family offices, the challenge becomes even greater.

Today the process to construct and manage bond portfolios is largely manual and Excel based. The universe of bond is much larger than equities, with issuers often having many bonds versus a single equity issue, and with each bond having different terms and conditions, levels of liquidity, and pricing. Making sense of such a large universe, and ensuring the bonds selected meet the customer’s constraints, is the first challenge.

Once a suitable universe of bonds has been selected there are additional challenges in selecting which of them, and in which quantities, should be combined into the portfolio. The difficulty is compounded by the need to look at non-linear constraints, such as a bond’s minimum denomination, or the increment in which it can be added to a portfolio, during the construction process, and the enormous amount of correlation data to be analysed in the universe selected.

Due to the mathematical challenge of creating a bespoke portfolio, that honours all the constraints set by the customer, and provides a target return with minimal amount of risk, it is normal to see the use of “model” portfolios, which although helping to avoid the lower returns of comparable bond ETFs, are not truly tailored to an individual customer’s requirements.

So how is BondIT helping?

Fixed income has always lagged other asset classes, such as equities or foreign exchange, regarding innovation. Whether it is electronic trading, algo-pricing, roboadvisory, or introduction of ETFs, bonds have always been last to the party! The same is true in portfolio construction, optimization, and investment idea generation, the space that BondIT is focused on.

BondIT was established in 2012 with a mission to leverage data science and machine learning techniques to simplify the process of constructing, optimizing and managing fixed income portfolios. By leveraging machine learning algorithms, a user can enter portfolio goals, such as target returns, portfolio rating, and duration, and detailed customer constraints, for example, types of bonds, level of exposure to specific issuers, and percentage ranges for specific currencies, sectors, and coupon types, and construct an optimised portfolio within a matter of seconds.

Once the portfolio is created the user can instantly see detailed characteristics of the portfolio, such as which sectors, rating buckets, or currencies are contributing to the risk, and portfolio level figures including the yield, duration, rating, and VaR. The agility to quickly create, and tweak; portfolios provides an advisor with the ability to have a more engaging and meaningful dialogue with his customer, helping ensure a truly bespoke portfolio is created.

Portfolio monitoring, with customisable alerts, for example on market level changes, rating changes, and upcoming cash-flows, combined with algorithmically generated switching and rebalancing ideas, helps ensure the portfolios remain optimised for the customer’s specific goals.

In conclusion

Fixed income has always been a challenging asset class for investors, with innovation lagging other asset classes. But rather than taking the simple approach of gaining exposure through bond ETFs, which in the long term will provide inferior compensation for the risk taken, and cannot be tailored to an individual’s specific requirements or life events, it’s worth taking the effort to construct a carefully tailored, bespoke portfolio of individual bonds.

BondIT’s unique technology can help family offices provide a truly bespoke service for their customers, by supporting the construction, monitoring and management of their fixed income portfolios.

Bio: Adrian Gostick is Chief Revenue Officer for BondIT, and has over 25 years’ experience working in financial markets trading and technology roles across Europe, Asia and the U.S.