EFFICIENT PORTFOLIO MANAGEMENT INVOLVES ANALYZING AND BALANCING RISKS AND RETURNS. Therefore, any measurement process must account not only for returns but also the risks assumed to produce them. Yet when it comes to book yield performance, traditional measures of book yield focus almost entirely on returns, with little attention to risk—an imbalance that can incentivize investors to add an inordinate amount of risk to increase yields. Likewise, total return measurement omits a consideration of the volatility of those returns, potentially exposing investors to selling securities at lower prices. Information ratio should complement total return performance, as it takes into account the volatility of excess returns. Below, we discuss scorecard measures, which can complement total return and book yield measurements.
DIRECTLY MEASURING BOOK YIELD: THE BOOK YIELD ROLL REPORT
First, let’s discuss measuring book yield. A book yield roll report can quantify what book income was added to or subtracted from a portfolio. The book yield roll report we have developed for clients quantifies the book yield of our purchases and compares it with the book yield:
- of the weighted average benchmark yield on the date cash is available to invest
- leaving the portfolio because of sales
- leaving the portfolio because of sales, paydowns, calls, tenders and maturities
Our report shows the purchases made, including the relevant analytics. This allows us to compare the credit quality, interest rate risk, yields and spreads among purchases and other transactions. The same is done for sales and maturities (including paydowns). Purchases are compared vs. sales alone (typically, active decisions) and both sales and maturities (all cash generated from the portfolio). We also show deposits and withdrawals, since these are cashflows that affect the investor’s ability to manage book yield. For index yield, we match every cash flow to the benchmark’s yield on the date the cash flow came into the portfolio (when cash became available to invest). Cash flows can have different benchmark yields from one account to another. Cash flows can also have materially different yields at the beginning vs. the end of a time period. With our report, if an investor had a cash flow created at the beginning of the period but chose to sit on the cash and reinvest a few weeks later, the impact can be quantified. The purchase yield is measured against the yield available (benchmark yield) when the cash flow was created (EXHIBIT 1).
J.P. Morgan Asset Management report developed to help clients measure book income performance
EXHIBIT 1A: DIRECTLY MEASURING YIELD: BOOK YIELD ROLL AND TRANSACTION SUMMARY, Q1 2018
1B: BOOK YIELD ROLL REPORT
1C: TRANSACTION SUMMARY: JANUARY 1, 2018, TO MARCH 31, 2018
Source: J.P. Morgan Asset Management. For illustrative purposes only.
PROBLEMS WITH BOOK YIELD MEASUREMENT
If you want to maximize book income/yield, then just measure book income/yield. Although logical, there are limitations to this approach. Book income is an accounting value. As such, it lags economic measures of performance. Yield investors want stable, predictable cash flows that can withstand changes in interest rates, volatility, liquidity, credit spreads and credit performance. Book income measurement, in isolation, does not measure these risks. The following examples illustrate the specifics:
Example A: When the expected yield is not realized
An investor can obtain a higher purchase yield by investing in securities that have optionality. In essence, investors are writing options when they invest in securities that are callable, or which can be prepaid at someone else’s discretion. If interest rates drop, the investor may receive principal back faster and have to reinvest at lower yields. If interest rates rise, the investor may receive principal back more slowly and not have the same opportunity to reinvest at higher yields. The book yield of the initial investment may not reflect the opportunity cost of disadvantageous book yields on reinvested cash. The investor reports a higher book yield for that security than for one—which could have been purchased but wasn’t—with better convexity that might have ended up performing better over time.
As EXHIBIT 2 illustrates, if interest rates don’t change, both bonds earn their purchase yield. If interest rates drop 50bps, the callable bond gets called and the principal must be reinvested at the lower rates available in the market. Besides callable bonds, mortgage-backed securities and other prepaying bonds have varying amounts of optionality, which can lead to different achieved yields from their purchase yields.
Example B: When credit deterioration is not measured, total return attribution has an advantage
One of our portfolio managers likes to say that just because you heard a click, it doesn’t make it a good idea to play Russian roulette. Credit deterioration may be found in market prices well before impairment. This occurred with subprime mortgages: During 2007, a period of subprime contagion, subprime mortgages’ market prices started declining. Market prices continued weakening in 2008, yet, rating agencies were generally slow to downgrade these securities. Impairment by investors varied—some investors’ expected cash flows were closer to the rating agencies’ assumptions than others. Total return attribution would have started measuring the decline in value of subprime mortgages. Book yield measurements would not have signaled any risk prior to impairment.
Example C: When investors experience forced selling, book yield measurement is not ideal
Constraints imposed by investment guidelines and business needs can lead to forced selling. If a portfolio manager purchases bond A, which has a higher yield than a bond with less risk, and then a guideline or business issue requires bond A to be sold, was the decision to buy this riskier bond the correct one? Book yield measurement may not account for the early taxation of realized gains, going through the bid-ask spread two additional times or the cost of a forced sale while other investors are also being forced to sell.
Measuring purchase yield is not enough
EXHIBIT 2: BOOK YIELD BY YEAR, CALLABLE VS. BULLET; NO CHANGE IN RATES AND 50BPS DECLINE IN RATES
2A: NO CHANGE IN RATES
2B: RATES DECLINE 50BPS
Source: J.P. Morgan Asset Management Global Insurance Solutions. For illustrative purposes only.
Example D: When duration mismatches are not measured, book income measurement proves less useful
When the yield curve is positively sloped, book income for a bond can be improved over similar investments by investing in a security with a longer maturity date. Even if the longer-dated investments cause a mismatch with the liability or target duration, book income measurement rewards this decision.
PROBLEMS WITH TOTAL RETURN ATTRIBUTION
The purpose of attribution analysis is to determine how much each of the portfolio’s exposures to certain risk factors has contributed to the difference between its total return and that of the benchmark. The portfolio can differ from the benchmark with respect to certain issuers, certain maturities, sector distribution or yield curve positioning.
Total rate of return ignores many of the factors that can impact a company’s financial statements, including income, volatility and taxes. If an investment objective is to maximize yield, total return attribution by itself may not adequately measure how well an investor is achieving that goal. Here are some other concerns with total return measurement:
Yield investors do not want to sell higher-yielding assets and reinvest at lower yields. For one thing, selling higher-yielding assets can lead to taxable realized gains that reduce future book income. Although short-term portfolio reallocations can be beneficial for total return investors, they do not typically help yield investors.
Financial statements and capital management
Accounting rules reward accounting factors. Total return rewards economic factors. Total return measures how much market value a portfolio has today compared with how much market value the portfolio had in the past. Accounting methods (such as IFRS standards and U.S. statutory accounting for insurers) are based on a solvency orientation. This translates into more conservative liquidation accounting. To the extent that an investor’s goals are to improve financial statements and meet budget targets, the portfolio—and the portfolio’s measurement—should be based on more than only economic factors. Investors may also wish to maximize their capital efficiency. Total return attribution does not measure these factors.
Regulators and other constituents
Many constituents are impacted by the differences between financial statements and total rate of return measurements. Regulators are interested in the stability of financial results and encourage less risky investments. Equity analysts may determine that realized gains are not repeatable and not give them any credit in their models. Executives may have their compensation more aligned with financial statement ratios. Total return does not measure these factors. They can be measured more directly as part of a scorecard and, sometimes, less directly through book yield rolls.
USING A SCORECARD: PROBLEMS AND BENEFITS
A scorecard measures how the investor adheres to specific criteria. Put another way, it allows a focused investment goal to be measured. Our typical portfolio review quantifies upgrades, downgrades and any investment guideline issues; shows realized gains and losses on transactions, as well as the cash balance; and measures any duration gap between the portfolio and its target duration. If required, the scorecard also lets us report on Solvency II, S&P, RBC or BCAR1 capital charges for the investment portfolio.
PROBLEMS WITH A SCORECARD APPROACH
Scorecards are able to focus on factors that can get lost in total return attribution and book income measurements. Yet it is extremely hard for scorecards to measure a portfolio with an adequately holistic view over a market cycle. The importance of the items on the scorecard changes over time. The correct measure to focus on in an environment of credit spread widening may differ from what should come to the fore in a period of higher interest rate volatility. The importance of upgrades and downgrades in a risk-on market is different from when spreads are widening. The cash balance may be less important when rates are rising than when rates are anchored with a positively sloped yield curve. Unless you can predict the environment before it happens, scorecards will stress what they are designed to focus on.
Book yield roll, total return attribution and scorecards are all tools that should be used to measure the success of a yield investor. Picking a benchmark against which to compare the portfolio’s results is essential. Knowing the benefits and weaknesses of each methodology can help inform yield measurement. The measurement method we’ve developed brings transparency to the process so our clients can better evaluate our performance as a yield investor.