Would You Buy Your Fixed Income Portfolio Today?

Brett Cornwell

Brett Cornwell, CFA

Client Portfolio Manager, Fixed Income

The investment landscape has changed dramatically—it’s time for plan sponsors to treat unconstrained fixed income as a strategic allocation.

Executive Summary

  • More than ten years of accommodative global central bank policy has ushered in a persistent low-rate environment that has made it challenging for plan sponsors to achieve their expected rates of return while balancing risks in their portfolios.
  • While traditional core and core plus fixed income has historically served as a portfolio anchor to balance risk-seeking allocations, the low yield and extended duration profile of the Bloomberg Barclays U.S. Aggregate Bond Index has made this allocation less efficient today.
  • To improve fixed-income allocations, we believe plan sponsors should complement traditional fixed income with a more flexible, unconstrained strategy to boost the yield and total return of the portfolio without extending duration or eroding the desired risk-hedging characteristics of fixed-income allocations.

More Risk, Less Yield: As the Agg Turns

Ready for a massive understatement? The investment landscape has changed dramatically in the last 30 years. Interest rates have been trending lower for more than three decades. Now, many investors are beginning to consider the possibility of negative rates in the United States.

As Figure 1 shows, this backdrop has forced fixed-income investors to take on more duration risk without a commensurate increase in yield. In 2004, the Bloomberg Barclays U.S. Aggregate Bond Index (the “Agg”) had a duration of 4.77 years. Today, not only does the Agg have a riskier duration profile, it yields significantly less than it did in 2004.

Figure 1. Now and Then: The Agg has more duration risk and less yield

Duration and Yield for the Agg: 2004 vs 2019

Figure 1. Now and Then: The Agg has more duration risk and less yield

Source: Bloomberg Barclays. As of 12/31/2019.

7.5% Just Isn’t What It Used to Be

Long-term investors expect change. Nonetheless, it remains staggering to take a step back and evaluate how this environment has affected investors’ portfolio allocations. As Figure 2 highlights, achieving the same level of return during the last three decades has required investors to significantly increase the complexity, risk and illiquidity of their overall portfolios.

Very simply, the world has changed—fixed-income allocations need to change, too.

In 1989, a 100% allocation to public fixed income netted investors a 7.5% return with a risk of only 3.1%. Achieving this same 7.5% return in 2019 required investors to ratchet up their risk to 18% and invest significantly more in equities and less liquid alternatives.

Today’s Tightrope Act

The current balancing act between the need to grow assets while being mindful of the risks ahead is difficult for all investors. This environment is especially challenging for plan sponsors. The tremendous run in public equities has helped many plan sponsors close the funding gap between plan assets and liabilities. Nonetheless, most plans remain underfunded, meaning they cannot afford to take risk off the table. Yet, at this stage in the cycle, without some level of diversification, plan sponsors are exposing their portfolios to the potential for sharp equity drawdowns like those that we witnessed in the fourth quarter of 2018.

Walking this tightrope requires plan sponsors to consider a new blueprint for fixed income, one that maximizes efficiency and diversifies against multiple risks.

Figure 2. Declining rates have forced investors to add risk and complexity
Figure 2. Declining rates have forced investors to add risk and complexity

Source: Callan Institute. As of June 30, 2019.

Don’t Make Macro Bets With Your Portfolio Anchor

More than ten years of extraordinary and unprecedented monetary policy action has reshaped the makeup of the Agg. Today, the flagship fixed-income index consists primarily of low-yielding Treasury and agency mortgage securities. Treasury securities are directly correlated to interest rates, while agency mortgage securities have virtually no exposure to mortgage credit risk due to the nature of their agency guarantee. As a result, the performance of the two primary components of the Agg—agency MBS and Treasurys—is largely driven by movements in interest rates.

In today’s environment, strategies that track the Agg are essentially tracking interest rates.

To date, many investors have addressed this issue by allocating to core plus fixed income. And for good reason. Core plus strategies help investors expand the investible universe to include a broader array of risk sectors stretching beyond the benchmark, including securitized credit, high yield, emerging market debt, senior loans and CLOs. Nonetheless, these off-benchmark allocations are generally limited, which results in strategies that remain tethered to the Agg. Duration remains the key risk factor. This means investors in core plus strategies are still assuming an undue level of interest-rate risk in the fixed-income anchor of their portfolio at a period of time where the risk premium for interest-rate risk is low.

Figure 3. Would you buy your current fixed-income portfolio?

Bloomberg Barclays Aggregate Bond Index

Figure 3. Would you buy your current fixed-income portfolio?

Source: Bloomberg Barclays. As of 12/31/2019.

Investors in core plus strategies are still assuming an undue level of interest-rate risk in the fixed-income anchor of their portfolio at a period of time where the risk premium for interest-rate risk is low.

Answering this question should reinforce the primary role of fixed income in a broader portfolio. Fixed-income allocations are not about immunizing your portfolio against one specific type of risk. Fixed-income allocations should protect portfolios from risk on multiple fronts. In this regard, adding flexibility can significantly enhance the risk profile of a fixed-income portfolio.

Unconstrained Can Complement Core Allocations

Given the downward trend of interest rates, traditional Agg-tracking core fixed-income strategies have generally helped investors diversify and protect their broader portfolios. However, there have been bumps in the road when traditional fixed income actually exposed plans to more downside volatility than equities. Figure 4 shows returns for the S&P 500 and the Agg during the “Taper Tantrum,” a short-term period where rates spiked significantly and caused the Agg to plummet.

Figure 4. When duration risk goes wrong

Taper Tantrum 5/22/13 – 9/5/2013

Figure 4. When duration risk goes wrong

Source: Standard & Poors, Bloomberg Barclays and Voya Investment Management. 5/22/13 – 9/5/2013.

To manage volatility in fixed-income portfolios driven by interest rates, we believe plan sponsors should complement Agg-based strategies with a more flexible unconstrained strategy that can add diversification through exposure to an array of credit sectors. However, given the wide range of approaches applied by unconstrained managers, manager selection is critical in this space.

Manager Selection is Always Important—in the Unconstrained Space it Matters Even More

While manager selection in all categories is important, we believe it is even more crucial within unconstrained fixed income. Given the significant amount of discretion that unconstrained managers have around portfolio construction, the range of investment approaches taken among unconstrained managers is quite wide.

We believe duration positioning should be used more as a risk-management tool and less as a source of alpha.

A manager’s approach to duration management is one of the most important items for investors to review when considering an unconstrained fixed-income allocation. Strategies around duration vary significantly in the unconstrained space. We believe duration positioning should be used more as a risk-management tool and less as a source of alpha. Our research has shown that modest amounts of duration reduce portfolio risk due to the negative correlation between interest rates and credit spreads (Figure 5). This relationship has allowed us to drive alpha from exposure to spread sectors while maintaining a risk profile consistent with the Agg.

Figure 5. The negative correlation between credit and duration risk offers a potential diversification benefit

Rolling 3M Correlation of UST 5-Yr and Corporate Spreads

Figure 5. The negative correlation between credit and duration risk offers a potential diversification benefit

Source: Correlation represented by 30-calendar day rolling period for the daily change in the Bloomberg Barclays 5-Year Bellwether Treasury Index yield and the daily change of the Bloomberg Barclays US Corporate Index OAS. As of 6/30/19.

Conclusion

Against a backdrop of increasing equity market volatility and extremely low interest rates, unconstrained strategies are an effective way to add attractive diversification through credit and spread duration risk. As more sponsors of underfunded plans look to lock in equity gains and reduce funded status volatility, we believe unconstrained strategies will start to play a larger role in fixed-income portfolios. In our view, unconstrained managers who remain focused on the long term, primarily using their flexibility to manage volatility, are the ones most likely to help plan sponsors improve risk-adjusted returns and create a smoother path towards the ultimate goal of improving a plan’s funded status.

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Past performance does not guarantee future results.

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions, and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest-rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.