Knowledge. Shared Blog

July 2020

New Era, New Framework: Rethinking Fixed Income Allocations

In the face of low rates and market turmoil, investors may find themselves searching beyond core fixed income to meet financial goals. To that end, Global Head of Portfolio Construction and Strategy Adam Hetts suggests investors consider a new framework based on three objectives: Defend, Diversify and Increase Income.

Key Takeaways

  • Since the Global Financial Crisis, traditional lines in fixed income investing have been blurred by low rates, large price swings, high duration risks and a proliferation of new strategies.
  • Fixed income, as a result, has transformed from a traditionally straightforward asset class – one that seeks to provide downside protection and income – to one that investors may find disorienting.
  • To overcome this challenge, we believe investors should approach fixed income through a new framework: Defend, Diversify and Increase Income.

For traditional fixed income investors, much of the last 40 years has been a relatively enjoyable ride. The 1980s began with double-digit interest rates that over the following decades declined steadily, providing high total returns (as bond prices move opposite to yields) and a generally reliable buffer to market shocks.

With interest rates now plunging to near zero – coupled with extreme market turmoil resulting from the COVID-19 pandemic – many investors find themselves at a crossroads: High-quality government and corporate bonds traditionally make up “the core” of a fixed income allocation and serve as the low-risk, capital-preserving portion of an investment portfolio. But today, extremely low – or even negative – government bond rates mean investors must pay a considerable cost for this security. Meanwhile, a slew of “dynamic” fixed income strategies has entered the market, offering the potential for higher returns – but also carrying higher risks.

Arguably, fixed income investors faced this predicament even before the COVID-19 coronavirus emerged. In the years following the Global Financial Crisis (GFC), low interest rates, large price swings, high duration risks and the proliferation of dynamic strategies blurred traditional lines in fixed income, whether in the form of core products taking on more risk or investors venturing into high-octane bond categories. In this environment, fixed income seemingly transformed from a traditionally straightforward asset class – one that seeks to provide downside protection and income – to one that investors may be unsure how to navigate. Consequently, despite the deep losses experienced by some fixed income categories during the GFC, such as high yield, investors continued to pour money into these areas.

Fixed Income Crisis Performance: GFC and COVID-19

[caption id=”attachment_303013″ align=”alignnone” width=”1147″] Source: Morningstar. Past performance is no guarantee of future results.[/caption]

 

Here on the Portfolio Construction and Strategy team, we have seen this behavior manifest in the fixed income allocations of the thousands of financial professionals with whom we consult. Using our proprietary “Industry Portraits,” we’ve found that nearly 40% of the average financial professional’s portfolio had been diversified outside the core leading up to the recent crisis. As such, actual fixed income portfolio losses in our database during the February/March sell-off were as much as 20% or more. A decline of this magnitude is unacceptable for many investors and may raise the question if deep sell-offs in fixed income – previously thought of as once-in-a-lifetime occurrences – have become once-in-a-decade events.

New Era, New Framework

Such uncertainty, now compounded by the pandemic’s unknown trajectory and the unprecedented policy response of central banks, is making the fixed income landscape difficult to navigate. Investors, in turn, may be asking questions such as: “With rates at historical lows, should I be looking beyond Treasuries in core fixed income?” If rates start to rise, “Is high yield a better risk manager than Treasuries?”

We think there is too much focus on finding a single solution and believe the best approach is likely a multifaceted one. To that end, we think investors should organize their fixed income allocation through a framework of three objectives – Defend, Diversify and Increasing Income – and consider the risks and opportunities of each in the current environment.

  • Defend: This is the core portion of fixed income that seeks to provide capital preservation during a market downturn. With most sovereign bond rates globally below 1% or negative, traditional benchmarks with large passive weightings to sovereign debt are no longer a bond investor’s North Star. Investors may need to dig deeper into the defensive tool kit and consider new opportunities – and trade-offs – that exist within securitized products, investment-grade corporates, and both short and intermediate duration.
  • Diversify: Capital preservation combined with the potential for higher income is the goal. A number of dynamic strategies aim to do just that by either de-risking overly aggressive fixed income allocations or adding risk to portfolios that are overweight core holdings. However, we believe investors should focus on finding solutions that limit exposure to esoteric asset classes while avoiding strategies that are unnecessarily complex (and risky).
  • Increase Income: Here, the aim is to generate the highest income or return possible, investing in bonds with equity-like risk, such as high yield or emerging-markets debt. The March sell-off in financial markets was unprecedented in both speed and magnitude, potentially creating once-in-a-lifetime investment opportunities (barring another significant contraction as the pandemic continues). Wide yield spreads don’t guarantee positive prospective returns, but investors should pay attention to the opportunities presented. Sector- and security-selection expertise, combined with appropriate timing and a strong stomach, are the necessary ingredients to navigate a rebound in these markets.

The Majority Stays in the Core

The framework outlined above is intended to help organize the huge universe of fixed income options available today. We still believe the majority (50%-75%) of most fixed income portfolios should stay in the core. But we also believe investors should remember the three objectives above when considering their fixed income allocation. Our proprietary portfolio risk analytics support this framework and can help drive toward a solution that is tailored to each investor’s specific situation. For help, consider engaging our PCS team so that we can extend these tools to you, and for additional insights, download the full Portfolio Diagnostics Report, Shifting Gears: Moving to a Goals-Based Fixed Income Strategy.

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