Swiss bonds: out of the comfort zone

When it comes to asset allocation, many investors rely on passive and low-cost building blocks, justifying this with the cliche that active approaches do not fulfill their promise anyway and have exorbitant fees. 

What many investors overlook is the fact that the weighting of individual investment categories in a mixed portfolio has, by far, the most influence on overall performance.  This strategic asset allocation is also not any simpler than an active approach, and probably not any cheaper. Of course, passive approaches do have their place in some asset classes. In other cases, it may be worthwhile for investors and their advisors to step out of their comfort zone. 

The most important element in active investing is confidence. Active strategies often fail because investors lose patience and confidence during major performance setbacks and withdraw their money in a generally difficult market environment. With longer investment horizons, however, interesting findings emerge from both a strategic and an investment perspective.

The following analysis of long-term return data focuses on the CHF bond asset class and shows that the common comfort zone investment, the SBI AAA-BBB Index, is not necessarily the optimal choice. Nevertheless, many investors either passively track this asset class with the SBI AAA-BBB or take a ‘core-satellite’ approach. The majority of assets in the category are invested in the core strategy (usually passively in the SBI AAA-BBB Index). The rest go into one or more satellite strategies (usually focused on specific risk factors).

The following table shows the realised return and risk figures for various segments of the CHF capital market, as well as a comparison with the Swiss equity market (SMI Index). The return period begins with the launch of the new SBI index range at the end of 2006, spanning almost 17 years. It is characterised by various crises and the trend of falling interest rates, along with the exceptional investment year 2022.

Table 1. Swiss market realised risk/return figures (29 December 2006 – 31 October 2023)

Source: Bloomberg and LOIM. Past performance is not an indicator of future results.

It should be noted that although the SBI AAA-BBB fares well with a realised average annual return of 1.46%, that is still the worst performance in the group.  

It is hardly surprising that the Swiss Confederation Index benefited more from the drop in interest rates due to the significantly longer rate risks, and therefore performed marginally better than the SBI AAA-BBB Index. Some market participants might have expected even more return advantage from the Swiss Confederation given the plunge in rates over the last 17 years. This advantage is particularly evident when one focuses exclusively on the longer maturities. The Swiss Confederation Index with maturities of more than seven years, for example, achieved a cumulative return of 46.12% in the same period.

What particularly stands out – and may be surprising given the many crises over the return period – is the markedly better performance of the CHF corporate bond segment (SBI A-BBB Index and SBI BBB Index) versus the SBI AAA-BBB. Of course, one can assume that corporate bonds benefit from a higher credit risk premium on average in the long term, in contrast to high-quality borrowers. On the other hand, the SBI BBB Index, with an average interest duration of three years less than the SBI AAA-BBB Index, also benefited significantly less from falling interest rates.

If one also considers that the return and risk figures of the SBI BBB Index are much more influenced by price setbacks from rating downgrades than those of the SBI AAA-BBB Index, it is remarkable at first glance that the annualised volatility of corporate bonds is lower than that of the SBI AAA-BBB Index.  This fact can also essentially be explained by the interest rate risks.

In an investment grade bond portfolio, interest rate risks generally cause the majority of return fluctuations, especially if the proportion of A and BBB borrowers is relatively low. In the case of the SBI AAA-BBB Index, for example, more than 80% of the fluctuations are caused by interest rate risks, which is why it is fair to call this a more rate-sensitive benchmark index.

Only with average interest rate risks of less than five years and a clear focus on A and BBB corporate bonds does the ratio of interest rate and credit risks balance out somewhat. In the SBI A-BBB Index, they contribute roughly equally to the fluctuations. Since these two main risks generally correlate negatively in an investment grade bond portfolio, it stands to reason that the annualised volatility of the SBI A-BBB Index is lower than that of the SBI AAA-BBB Index, despite higher credit risks.

Predictably, the two Swiss Confederation indices have the highest volatilities because they are by far the most exposed to interest rate risks. The more interest rate risk you take on with the Swiss Confederation, the closer you are to investing in equities in terms of volatility. This is why long Swiss Confederates can make sense, especially from an asset liability standpoint.

When looking at the long-term return and risk figures, however, it is surprising that so little importance is still attached to CHF corporate bonds from a strategic and investment perspective. When an investment committee has a choice between two highly correlated investment categories for its asset allocation, and one of them promises a higher return with less risk, the choice quickly seems clear. Within the CHF bond investment category, this does not appear to be the case. Although the SBI AAA-BBB comfort investment promises less return with more risk in the long term compared with the SBI A-BBB, many investors and advisors still prefer the SBI AAA-BBB index as their core investment.

The same anomaly applies in the discussion about active versus passive investment solutions. Here is a simple example with the classic benchmark SBI AAA-BBB. In the knowledge that investment grade credit risks pay off in the long term, but have significantly lower interest rate risks on average, a model portfolio is constructed that invests 80% in the SBI BBB Index and 20% in Swiss Confederation bonds with a term of more than seven years. A look at the data shows that this 80/20 portfolio has still had an average interest rate risk of around 0.6 years less than the SBI AAA-BBB Index since the end of 2006 and has therefore not been able to benefit to the same extent from falling rates.

However, the simple 80/20 portfolio has outperformed the SBI AAA-BBB Index by a significant 17.28% cumulatively over the last 17 years with an ex-post tracking error of 1.50%. Of course, this is the gross performance and yes, the outperformance is based more on systematic risks than on uncorrelated alpha contributions. Critics who therefore posit that this is not proof that active investment approaches work (because it is less about actual alpha and more about systematic beta) are advised to define the simple 80/20 portfolio as the new strategic allocation instead of the SBI AAA-BBB Index.

 

Table 2. 80/20 portfolio vs index (29 December 2006 – 31 October 2023).

Source: Bloomberg and LOIM. Past performance is not an indicator of future results.

When it comes to allocation within the CHF bond investment category, there is very little to be said against a larger allocation to corporate bonds in the medium to long term. Compared with the SBI AAA-BBB comfort investment, the corporate bond segment features a much better diversification of the two main risk factors – interest rates and credit.

The current premiums for interest rate and credit risks also support the argument for why now is an ideal time to enter the market.