As investors recalibrate their fixed income portfolios in the face of new duration, inflation and credit risks, Senior Portfolio Strategist Lara Reinhard outlines a framework that attempts to manage these risks by focusing on flexibility.

Key Takeaways

• In our view, duration and yield trade-offs in fixed income warrant a reassessment of where the anchor of a bond allocation should lie.
• With high inflation and rate hikes making the outlook for core bonds less attractive, we think a solution lies at the intersection of duration, yield and risk.
• While it remains an important part of a diversified portfolio, we believe fixed income in the current environment needs to be more flexible than the rigid passive fixed income anchors of the past.

For a long time, the Bloomberg U.S. Aggregate Bond Index served as a productive core allocation for a fixed income portfolio, providing a generous yield/duration trade-off. We’ve watched that benefit slip away, and today the index has taken on more duration for much less yield. This is, of course, not a new trend, but worries have grown louder given year-over-year inflation is sitting at 7.0%¹ and the market is expecting the Federal Reserve will raise interest rates at least three times in 2022.

High inflation and rate hikes do make the outlook for core bonds less attractive, but we think they still play an important role in portfolios. Where is the solution?

Traditional Fixed Income’s Dilemma
Bloomberg U.S. Aggregate Bond Index (1/1/1990 – 12/31/2021)

We think a solution lies at the intersection of duration, yield and risk.

Start with duration. Referring to the chart below, start with duration by shifting your focus to empirical duration. Theoretical duration, which is commonly found on a strategy’s fact sheet, often overstates real-life interest rate sensitivity. Empirical duration, on the other hand, estimates a bond’s reaction to Treasury yield changes by incorporating real-life market risks (e.g., credit spreads). Strategies with lower empirical duration have the ability to weather a period of rising rates better those with more duration sensitivity.

Next, factor in yield. Strategies with relatively lower (<3 years) empirical duration and higher (>3%) yield are positioned to perform better in high inflationary environments. This will lead you to the top left quadrant of the chart.

Finally, incorporate risk. High yield, emerging markets and bank loans are largely non-investment grade, benchmark-constrained categories (indicated in the chart by the red “Increase Income” dots), but the Multisector bond category (orange, “Diversify”) has the flexibility to invest in the full spectrum of sectors.

Seeking a More Flexible Anchor
Empirical Duration vs. Yield

The looser benchmark constraints of the Multisector space generally allow for more active duration and credit management on top of sector selection. One example of the risk-mitigating potential of this flexibility is the category’s duration management: the five-year correlation of the Multisector bond category duration to the 10-year Treasury yield is -0.48. Thus, as rates rise, the category has historically been able to lower its duration to combat negative returns.

Going forward, we believe this flexibility is paramount as investors continue to recalibrate their fixed income portfolios in the face of a new phase of duration, inflation and credit risks. Fixed income remains an important part of a diversified portfolio. However, in the current environment, we believe it needs to be more flexible than the rigid passive fixed income anchors of the past.

¹ YoY CPI for December 2021.