Dr Michael Hasenstab looks at unconstrained fixed income strategies that focus on generating absolute return and investment allocations that are outside core indices.
The 2016 calendar year ended with signs of a possible, gradual return to a reflationary and rising-rates environment. Yet, with continued uncertainty as to the likelihood of such a development, and its possible timing and breadth, investors may find themselves still challenged to squeeze the most out of their fixed income portfolios against a backdrop of historically low interest rates.
Traditionally, many investors have employed a strategic asset mix that is based on, or at least resembles, a common core index, such as the Bloomberg Barclays Global Aggregate Index. However, the current rate environment demonstrates how investors taking this approach may be left especially vulnerable to interest-rate risk, when low interest rates combine with the long-duration characteristics of several common core indices.
The limitations of an index-based fixed income strategy suggest that investors could benefit from exposure to an “unconstrained” fixed income strategy, one that focuses on generating absolute returns and can shift allocation to investments that are generally outside the realm of core indices.
Risks and limitations
The Bloomberg Barclays Global Aggregate Index is used as a benchmark for many fixed income strategies, and the perception is that it is a representation of the broad global fixed income market and general investor sentiment.
Our analysis of the aggregate index highlights several notable risk components that investors should be aware of. These generally fall into four categories:
- Risk from longer duration
- Overexposure to heavy debtors
- Sector allocation drift
- Correlation risk
The aggregate index’s longer duration
Duration is vital to understanding the nature of the aggregate index; in fact, for an index-based portfolio, duration is the primary driver of performance. Credit risk – the other main driver of returns in fixed income investing – is largely absent from aggregate indices due to their heavy emphasis on lower-yielding, interest-rate-sensitive developed-government issues and agency securities.
In general, for a fixed income security or portfolio, the longer the duration, the more sensitive it is to fluctuations in interest rates.
When rates go up, generally the value of these securities goes down more if they have longer-duration characteristics. With economic and geopolitical developments at the end of 2016 and so far in 2017 signalling a possible return of inflation, investors should be looking closely at how rising rates will impact their fixed income holdings in the future.
The chart below shows that the index’s overall yield has also noticeably declined in recent years as longer-dated bonds have been issued at lower coupon rates. As a result, investors may be taking on greater interest-rate risk and lower yields at the same time.
Overexposure to heavy debtors
Under certain macroeconomic conditions, an index can become increasingly concentrated in a few large entities, and investors may find themselves with much less diversification than they might have previously assumed.
Historically cheap financing levels have prompted many investment-grade companies to lock in longer-term debt at record-low interest rates, and the aggregate index, like many core fixed income indices, is issuance weighted.
As large entities issue more debt, their positions within the benchmark increase. This has another effect as well: increasing the index’s duration and leaving portfolios vulnerable to interest-rate movements.
Sector allocation drift
The perception of the aggregate index is that it is a strongly diversified mix of government and investment-grade corporate issues. However, the composition of the index is actually heavily weighted towards Treasury securities, with an approximate allocation of 50 per cent or more.
Furthermore, recent years have seen the index’s Treasury allocation approach historically high levels at the expense of other assets.
This shift could present problems for investors who may find themselves far less diversified than they might have assumed, leaving their portfolios vulnerable to capital loss or erosion should only a few fixed income asset classes experience a downturn.
High correlations amongst index constituents
Due to a combination of the aggregate index’s composition practices and recent market and economic trends, its correlation to US Treasuries and other developed-market indices has been fairly high. In the table below, we compare the five-year correlations between the index and US Treasuries, other developed-market indices and some non-index asset classes.
The high levels of correlation to US Treasuries and other developed market debt signify two potential problems. Firstly, as Treasuries and other developed market bonds tend to have low credit risk, this again reinforces the premise that it is duration that is the main driver of performance, which again suggests that the aggregate index, and portfolios that mirror it, carry significant interest-rate risk. Secondly, the high correlations also underscore the lack of true diversification in the index.
Using unconstrained strategies to enhance yield, manage risk
Unconstrained strategies can invest in securities similar to those contained in the aggregate index, but will often invest selectively in assets such as emerging markets, leveraged bank loans or high yield in order to enhance the yield and manage the risk of a fixed income portfolio.
The chart below illustrates the greater yield opportunities offered by the asset classes represented in unconstrained fixed income strategies.
Many investors will be familiar with the argument that assets like emerging markets and high-yield credit offer better potential returns, but will also consider these assets to be risky, especially compared with a portfolio that mirrors the aggregate index.
An analysis of actual data from these various asset classes tells a different story, and challenges the perception that introducing unconstrained strategies into a fixed income allocation also introduces undue risk.
In reality, a fixed income strategy focused on generating absolute returns will have an asset mix that changes according to the investment manager’s analysis of where the best opportunities are.
With global fixed income markets consisting of tens of thousands of securities at a given time, not to mention alternative strategies as well, the inherent complexities of investing in this sphere necessitate finding true active managers with expertise and experience.
Fixed income positioning for current, future economic conditions
The uncertain rate environment of early 2017 has put at risk fixed income programmes with asset allocations that adhere too closely to core indices, making them vulnerable to rising rates and/or loss of portfolio value from low returns and lack of diversification.
Whilst we believe that index-based asset allocations can still be a vital part of any portfolio, shifting some of an investor’s portfolio focus towards non-index assets through an unconstrained fixed income strategy can better position investors and other stakeholders against the aforementioned pitfalls.
Unconstrained fixed income assets can make a portfolio less vulnerable to rising rates, increase its yield potential and improve its overall level of diversification.
Dr Michael Hasenstab is chief investment officer for Templeton Global Macro at Franklin Templeton Investments.